The Market Mechanism

Underlying Assumptions

Now that you have a basic understanding of the way in which the economy operates, it is time to develop a model which will help us to explore some of the more sophisticated interactions which occur. Before we do that, it is important to realise that this model is based on some very important assumptions.

Assumption #1 – All people act in a rational manner to maximise their standard of living

At first glance this might appear logical, but the truth is that this assumption is necessary because not all people act in this way. For example, some people act to improve the living standards of other people. Those who volunteer their time to work for charities fit into this group. For the purposes of our model, we will assume that everyone is acting in their own self interest.

Assumption #2 – There are many buyers in the market, and there are many sellers

It is necessary for us to assume that there is competition, and if this is the case then there must be many buyers and sellers. If, for example, there was only one seller of a product, we would refer to this as a monopoly. When a monopoly is left unchecked, the decision makers will no longer act rationally. If there was only one supplier of electricity, then they could charge whatever they wanted for us to access their service. For this model to work, we need to assume that this problem does not exist.

Assumption #3 – Products can only be distinguished by price

In the economy today we have many choices for the way in which we can spend our money, and advertisers spend a great deal of time (and money!) trying to convince us that certain products are unique. In this model, we will assume that the only way we can distinguish between two similar products is the price. You might know that there are Granny Smith apples and Fuji apples, but for our purposes they are just “apples”.

Assumption #4 – Buyers and sellers have perfect knowledge of the market

Obviously this is not true, although the development of the internet has helped to increase our knowledge in this area. It is necessary for us to assume this, because if it was true then it would mean that we would always seek to buy the “cheapest” apple (remember that we can only distinguish by price; quality is not an issue here). As a result, sellers would put themselves at a disadvantage if they tried to sell their products at a price which is higher than anyone else – no one would buy anything from them.

Assumption #5 – Resources are perfectly interchangeable

While this is clearly impossible in the real world, for our purposes we are going to assume that it is a simple process for us to allocate our resources in any market that we choose. In other words, there are no barriers that prevent us from entering or leaving a market; we can use our resources to provide one service one day, and then change to something entirely different on the next day.

Assumption #6 – There is no government intervention

Related to assumption #5, we also assume that the government is not making decisions about resources for us. If the government did intervene in the market, then the price would be affected. We are going to use the model to determine prices, and so the impact of the government must be ignored.

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