Basic competitive models gives an answer of the control problems of an economy i.e., who makes the decision of what to produce, how to produce and for whom to produce. We know that, economics has been evolved and developed in the framework of a free market economy in which the resources of the society are owned by individuals and firms. Thus a market economy recognises and protects property rights, i.e., the rights that govern the ownership, use and disposal of resources and the goods and services produced with their help.
Basic assumptions of competitive models / features
Rational self-interested consumers
Consumer behavior assumes that there is a budget constraint through which the consumer makes a rational choice. Rational choice means that consumers try to maximise their satisfaction or act in a consistent manner given their budget constraints.
Given their budget constraints, there will be an opportunity set of goods and services. opportunity set means the combination of goods and services that they can buy with the given money income and prices of the goods and services.
So, the Rationality assumption about the behavior of consumer implies that they will make choice to promote their self interest. Different individuals’ different taste and preferences affect their rational choice while they pursue their respective self-interests.
Profit-maximizing Firms
Just like consumers, economists assume that they (firms) will also pursue their self-interest in making choices. Generally, rational behavior (in terms of firms) means what goods will be produced and in what quantities, and also how those products will be produced as guided by the motive of profit maximization. They also face the constraint of limited resources.
Competitive market
In the basic competitive model neither the firm nor the consumers have any market power to influence the prices of the goods and services they want to sell and buy. In fact it is assumed that the perfect competition prevails in market. Under perfect competition there are large number of buyers and sellers and their is no control over the price level. i.e., each firm and consumer is price taker.
All the producers produce goods and services with the primary motive of profit. Earning of profits from using resources owned by them also provides incentives to the firms and individuals to produce goods and services efficiently. The prices of goods and resources provides information to the individuals and firms about the relative scarcity of different goods and services.
In market economy following factors plays an important and crucial role in the functioning of market economy:
Property Rights
These are the social institutions that govern the ownership, use and disposal of resources, goods and services. There are different types of property which individuals and firms can privately own.
Real property : It includes land, buildings, capital equipments etc.
Financial Property : It includes shares and bonds, bank deposits etc.
Intellectual Property : It represents the products of creative effort and includes books written, audio etc.
There are two attributes of property rights, namely, the right of the owner to use the property as he likes and the right to sell it provide incentives to the owners to use their property efficiency.
For Example, the owner of a factory building will try to make most profitable use of it by producing a commodity which yields him maximum profits. This gives him incentives to think carefully and try to obtain adequate information before making a decision about what to produce and in what quantity. The owner also try to maintain it properly so that when in future he wants to sell it he can do so at a good price.
Property rights should be enforced by the government for efficient use of all the resources, as with the advancement of technology it is a big challenge these days.
Profits and prices : Incentives and Information
As we all know that everyone works and saves for wages and interest respectively. Firms will not produce goods and services and bear risk of loosing money if sufficient incentives are not given to them. Profits depends on the prices of goods and services produced and cost incurred. As in perfect competition firms are the price takers and have no control over price. They can increase their profits by minimising the cost of production. Thus profits serve as incentive for the firm to produce efficiently.
The working of price system ensures that those individuals and firms will get goods who are willing and able to pay for them. Prices of goods and services indicates how much money individuals are prepared to pay for them. In other words prices convey information to the firms about how individuals value different goods and services.