CHAPTER 1
An Introduction to Financial Institutions, Instruments, and Markets

THE ROLE OF AN ECONOMIC SYSTEM

Economic systems are designed to collect savings in an economy and allocate the available resources efficiently to those who either seek funds for current consumption in excess of what their resources would permit, or else for investments in productive assets.

The key role of an economic system is to ensure efficient allocation. Efficient and free flow of resources from one economic entity to another is a sine qua non for a modern economy. This is because the larger the flow of resources and the more efficient their allocation, the greater is the chance that the requirements of all economic agents can be satisfied, and consequently the greater are the odds that the economy's output will be maximized.

The functioning of an economic system entails making decisions about both the production of goods and services and their subsequent distribution. The success of an economy is gauged by the extent of wealth creation. A successful economy consequently is one that makes and implements judicious economic decisions from the standpoints of production and distribution. In an efficient economy, resources will be allocated to those economic agents who are able to derive the optimum value of output by employing the resources allocated to them.

Why are we giving so much importance to the efficiency of an economic system? The emphasis on efficiency is because every economy is characterized by a relative scarcity of resources as compared to the demand for them. In principle, the demand for resources by economic agents can be virtually unlimited, but in practice, economies are characterized by a finite stock of resources. Efficient allocation requires an extraordinary amount of information as to what people need, how best goods and services can be produced to cater to these needs, and how best the produced output can be distributed.

Economic systems may be classified as command economies or as free market economies. This definition refers to the two extreme ends of the economic spectrum. In practice, most modern economies tend to display characteristics of both kinds of systems, and they differ only with respect to the level of government control.

A COMMAND ECONOMY

In a command economy, such as the former Soviet Union, all production and allocation decisions are taken by a central planning authority. The planning authority is expected to estimate the resource requirements of various economic agents, and then rank them in order of priority based on their relevance to social needs. Production plans and resource allocation decisions are then made so as to ensure that resources are directed to users in descending order of need. In practice, communist and socialist systems, which were based on this economic model, ensured that citizens complied with the directives of the state by imposing stifling legal, and occasionally, coercive measures.

The failure of the command economies was inherent in their structure. As we have discussed, efficient economic systems needed to aggregate and process an enormous amount of information. When this task was entrusted to a central planning authority, this not only proved to be infeasible in practice, but the quality of information was also substandard. The central planning authority was supposed to be omniscient and was expected to have perfect information as to what resources were available and what the relative requirements of the socioeconomic system were. This was necessary for them to ensure that optimal decisions were made about production as well as distribution.

Command economies were in practice plagued by blatant political interference. The planning authority was often prevented from making optimal decisions due to political pressures. The system gave the planners enormous powers that permeated all facets of the social system and not just the economy. One of the hallmarks of such systems was the absence of pragmatism, and a naïve idealism that was out of touch with realities. Planners used their authority to devise and impose stifling rules and regulations. These regulations, which were in principle intended to ensure optimal decision making, sometimes went to the ridiculous extent of imposing penalties on producers whose output exceeded what was allowed by the permit or license given to them.

Such economies were a colossal failure in practice and were characterized by an output that was invariably far less than the ambitious targets that were set at the outset of each financial year. When confronted with the specter of failure the planners tended to place the blame on those who were responsible for implementing the plans. The bureaucrats in charge of implementation passed the buck back by making allegations of improper decision making on the part of the planners. Eventually the contradictions in the system lead either to the total repeal of such systems or else to substantial structural changes that brought in key features of a market economy.

A MARKET ECONOMY

Such economies work in principle as follows. Economic agents are expected to make the most profitable use of the resources at their disposal. What is profit? Profit is defined as the revenues from sales less the costs of production of the goods sold. Thus, profit is a function of the prices of the inputs or the factors of production, such as land, labor, and capital, and the prices of the output. An optimal economic decision is defined as the one that maximizes profit. Economic agents who generate surpluses of income over expenditure will obviously be able to attract more and better resources. Failure, as manifested by sustained losses, will result in those economic agents being denied access to the resources being sought by them.

In such systems the prices of both inputs and outputs are determined by factors of supply and demand. These economies, in contrast to command economies, are characterized by decentralized decision making. In principle, agents are expected to make a rational decision by evaluating competing resource needs based on their ability to generate surpluses. In practice, every decision maker will have a required rate of return on investment. The threshold return, or the return exceeding which the venture will be deemed to be profitable, is the cost of capital for the decision maker. A project is deemed to be worth the investment only if the expected rate of return from it is greater than the cost of the capital that is being invested.

As can be surmised, the key decision variables in these economies are the prices of inputs and outputs. Hence, for such economies to work in an optimal fashion, it is imperative that prices accurately convey the value of a good or a service, from the standpoints of producers who employ factors of production and consumers who consume the end products. The informational accuracy of prices results in the efficient allocation of resources for the following reasons. If the inputs for the production process, such as labor and capital, are accurately priced, then producers can take optimal production-related decisions. Similarly, if the consumers of goods and services perceive their prices to be accurate, they will make optimal consumption decisions. The accuracy of input-related costs and output prices will manifest itself in the form of profit maximization, which is the primary motivating factor for agents in such economies to engage in economic enterprise.

How do such systems ensure that prices of inputs and outputs are informationally accurate? In practice, this is ensured by allowing economic agents to trade in markets for goods and services. If an agent has the perception that the price of an asset is different from the value that he places on it, he will seek to trade. If the prevailing price is lower than the perceived value, buyers will seek to buy more of the good than the quantity on offer. If so, the market price will be bid up due to demand being greater than the amount on offer. This demand supply disequilibrium will persist till the price reaches the optimal level. Similarly, if the price of the good is perceived to be too high relative to the value placed on it by agents, sellers will seek to offload more than what is being demanded. Once again, the supply-demand imbalance will cause prices to decline till equilibrium is restored. Thus, differing perceptions of value will manifest themselves as supply-demand imbalances; resolving these will ultimately help ensure that the prices of assets accurately reflect their value.

Opinion: While free market economies have to a large extent been more successful than command economies, no one would advocate a total absence of the government's role in economic decision making. Unfettered capitalism is unlikely to find acceptance anywhere. There are disadvantaged sections of every society whose fate cannot be left to the market, and whose well-being must be ensured by policy makers to promote overall welfare. While societies characterized by command economies have historically not permitted free speech, in a country like the United States, even mild criticism of the market is considered to be heresy.

CLASSIFICATION OF ECONOMIC UNITS

Economic agents are usually divided into three categories or sectors:

• The government sector
• The business sector
• The household sector

The government sector consists of the central or federal government of a country, state, or provincial governments, and local governments or municipalities. The business sector consists of sole...