Hey!
I can help! It’s important to have an economic goal, meaning that a market is doing a good job of distributing resources and outputs to make buyers and sellers happy. We answer three questions to understand if allocation is good. Does whatever we produce go to people who value it the most? Is what is produced made at the lowest possible cost so that sales take place among the right sellers? Is the best quantity being produced to satisfy everyone?
I’ll use the industry for lumber as an example.
Let’s first look at price and quantity; there are only so many trees and if we log these trees too quickly, we run out. Because we still have a lot of trees now, the price of lumber may be cheap, we may overconsume lumber now, and the price of lumber in the future, when there are very few trees left, may be much higher than now. Because the price in the future would not match the current price, the price of lumber in the market is not accurate. Along with questioning the price, we should question the quantity.
The quantity of lumber produced, in regards to monetary values, should be at a point where the consumer’s perceived value of the good meets the producers value of the good given its cost to make. However, monetary values in a market often overlook the cost to people’s well being as a result of production. The quantity may be inaccurate because producing lumber can harm society; cutting down trees drives global climate change and worsens environmental conditions because trees take in greenhouse gases (like carbon dioxide). Considering all of these things, the quantity of trees logged should be reduced, indicating that the “quantity” aspect of this market is not accurate, should be lower, and, subsequently, the price is inaccurate.
In the lumber industry, there are different types of producers. There are giant companies, like Weyerhaeuser Co and Georgia-Pacific Co, who sell the largest quantities of lumber. Then there are large companies, who, while unable to compete with the prices set by the “giants,” can sell their products because they can maintain long term relationships with customers. Medium and small companies tend to rely on relationships with local lumber buyers and users.
Looking at 1989 production statistics, the largest 5 companies only produced 5 percent of the total lumber output. With their resources and ability to grow, the few giant firms essentially set the price in the market because they can offer consistently lower prices than other firms but are not responsible for the majority of lumber output. Firms in any market should be price takers and all sell at about the same given price. The giants, while a small part of the industry, are able to control the competitive price for lumber to be sold at.
The producers, or, the “giants,” who have market power use it for their own profit and not considering the true value of the lumber and they are lowering an already too low price. Other firms that could compete in the market cannot. To have the right producers, there should be smaller, more equal firms, that individually do not set the price. Essentially, they are not selling the lumber at its true value, which leads to the wrong consumers buying it at the wrong price.
Now we can see if the lumber being produced is going to the consumers who value it the most. If the current price of lumber is too low, then consumers may not accurately pay what the lumber’s true value is and consumers who do not value it at its true value would get it. Buying the lumber in general means that the value of lumber to the consumer, in the form of money, should equal the value of lumber in terms of its availability and the cost of logging and producing it. The consumers that value the lumber the most should be the ones who get it, but the price is incorrect (see above). If the price was accurate, then the consumers that truly valued the lumber the most would be the ones who get it.
The industry for lumber demonstrates that capitalism and the free market are not always accurate because producers can be fixated on profit and manipulate prices to increase profit; consumers, subsequently, do not pay the true value of lumber and the price and quantity do not reflect all the costs.
Hope this helps!
Chris