While Keynes postulated that the growth and development of the economy could be controlled and manipulated through the consumer, the demand side of the equation, the classical school believes that those factors that influence the decisions of enterprises (businesses) to invest and expand are the critical issue. Neither of these schools of thought are absolutely right, as both are simply parts of an equation … there are times for monetary stimulus and there are times for fiscal stimulus.
Taxation and the regulatory environment will have the clearest impact on decisions of business, while money supply will have a bigger impact on the decisions of consumers.
Classical economic theory suggests that provided there is ease of access to and exit from markets, man's natural instinct to do the best for himself will result in new entries to and exits from a market tending toward a state of “perfect competition”. It does not say that perfect competition will exist at a point of time, simply that over time there will be entries and exits from a market that bring prices closer to cost of production which is the only point at which we can say “perfect competition” exists.
Most of us are taught that easy homily, “price is determined by supply and demand”. This is only a part truth as it only exists while a market is in a state of disequilibrium. The enterprise prices it's goods on the basis of cost taking into account a profit margin based on the level of risk involved in producing the particular item or commodity.
In a normal enterprise (not a monopoly), the optimum price of a product is achieved when the marginal cost of producing an additional item, without adding additional factors of production like capital, labour or rent, is equal to the price including desired profit. This is the point at which the enterprise would maximise its profits out of the product without additional investment.
If we find that at the point described above the enterprise is able to increase it's profits by increasing the price of the product (i.e. does not result in a reduction of quantity sold) we would expect that competition will enter that market driving the price down toward that optimum described above. Conversely if that optimum price results in reduction of quantity being sold (smaller profits) we would expect the less efficient enterprises to leave the market.
From the above diversion into a simplified description of a “market economy” we should be able to draw a conclusion that markets are never right at a point in time, they can only tend toward equilibrium, if freedom of entry is universal and exit natural. Distortions to the market exist in respect of monopolies (which I will discuss later) and where a level of inflation is considered normal by the consumer.
While there is no doubt that the economy would improve, if consumers went on a spending spree, increasing the demand for goods as well as their personal debt burden. Any Government, however, that went on a campaign asking consumers to start spending as though there is no tomorrow, would be guilty of a crime against the people. Yet, this might very well bring about real growth in the economy.
From this brief outline of the market, we should see that in the long run it is able to regulate, or perhaps better to say normalise, the economy. From a political point of view, reliance on the supply side to do its job is slow, and far more difficult to sell to the electorate at large as being pro-active. The supply side is more dependent on cultural and educational factors than actual political initiatives.
Politicians like headline catching slogans, an example from Cameron's conservative conference speech;
“we need a whole new economy more enterprising, more aspirational”.
This might well be what is needed, but requires many other things to be in place before it can bare fruit, and, yes, his speech does point to some of those other things, it fails to give a time scale or even a clear idea of how we get from a to b, rather emphasising the foreign companies that have created operations in the UK.
We see, in the current coalition government, a lot of slogans and initiatives that point in the right direction for supply side stimulus but, alas, the electorate is impatient and will not wait for them to take effect!
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