Preliminary Economic Concepts and Principles:
How a Market System Functions(“Economics” – Chapter 4 and Coda)Want to gain a basic understanding of “how a free market organizes economic activity”…Money – asset that is socially and legally accepted as payment for goods/services. Three functions of money:Medium of Exchange – an asset used as payment when purchasing goods/services (defines “what is money”)Store of Value – an asset that serves as a means of holding wealthUnit of Measure – a basic measure of economic activity (e.g., in the United States all “prices” are expressed in “dollar terms”) => eases comparisons of the value of different goods/services (e.g., if a gallon of milk costs $2 and a gallon of gas costs $4, then gas is twice as expensive as milk)Recall that the two primary decision making institutions are “households” and “enterprises” (or “firms”), and that much of the interaction between them takes place in “markets”…So, how exactly do “households” and “firms” interact with each other in markets?Interaction in two distinct markets:Markets for “Factors of Production”Markets for “Finished Goods and Services”Markets for “Goods and Services” (output of firms)Markets for “Factors of Production” (labor, land, capital, etc.)FirmsHouseholdsMarkets for “Factors of Production”Labor, Land, Capital, and other factors of production hiredSupply of Labor, Land, Capital, and other factors of productionIncome as Wages and RentsWages and Rents paidMarkets for “Goods and Services” (output of firms)Markets for “Factors of Production” (labor, land, capital, etc.)FirmsHouseholdsMarkets for “Finished Goods and Services”Consumption of Finished Goods and ServicesOutput of Finished Goods and ServicesFirm RevenuesConsumer ExpendituresMarkets for “Goods and Services” (output of firms)Markets for “Factors of Production” (labor, land, capital, etc.)FirmsHouseholdsTogether these “two distinct markets” lead to the following simplified representation of the Circular Flow of Economic Activity (in a free market economy):HouseholdsSupply of Labor, Land, Capital, and other factors of productionConsumption of Finished Goods and ServicesConsumer ExpendituresIncome as Wages and RentsMarkets for “Goods and Services” (output of firms)Markets for “Factors of Production” (labor, land, capital, etc.)Labor, Land, Capital, and other factors of production hiredOutput of Finished Goods and ServicesFirm RevenuesWages and Rents paidFirmsHow do free markets work?The free interaction between buyers and sellers in markets leads to an outcome that can be described by:an equilibrium quantity of trade (an amount traded)an equilibrium price (a price at which trade takes place)The model of “Supply and Demand” will be developed in order to explain:how buyers and sellers interact with each other in a free market andwhat particular price and quantity of trade would emerge as a result of their interaction.Demand and Supply:Behavior of buyers and sellers in markets is summarized by demand and supply.Demand – the relationship between the price of a good and the quantity that consumers are willing and able to purchase, all other factors fixed.Supply – the relationship between the price of a good and the quantity that firms are willing and able to sell, all other factors fixed.Graphically:priceprice4.502.750Demand000Supply3,5005.254,750quantityquantity1,2501.502,400“Demand” refers to the entire blue curve above (each point on the curve corresponds to a pair of “price” and “quantity demanded”); “Supply” refers to the entire red curve above (each point on the curve corresponds to a “pair” of “price” and “quantity supplied”).Law of Demand – all other factors fixed, a greater quantity of a good will be demanded at lower prices (demand curves are downward sloping).Law of Supply – all other factors fixed, a greater quantity of a good will be supplied at higher prices (supply curves are upward sloping).Two interpretations of the curves:“Horizontal Interpretation” – start by focusing on a particular price, and then go over to the curve horizontally to determine the corresponding quantity demanded (or supplied) at this particular price“Vertical Interpretation” – start by focusing on a particular quantity demanded (or supplied), and then go up to the curve vertically to determine the corresponding price at which this particular quantity would be demanded (or supplied)priceprice4.502.750Demand000Supply3,5005.254,750quantityquantity1,2501.502,400Buyer’s Reservation Price – the maximum dollar amount a buyer is willing to give up in order to acquire an itemAt any particular quantity demanded, the height of the demand curve illustrates the “reservation price” of the buyer of that unit.Seller’s Reservation Price – the minimum dollar amount a seller is willing to accept in order to part with an itemAt any particular quantity supplied, the height of the supply curve illustrates the “reservation price” of the seller of that unit.A “reservation price” is essentially a “cutoff price” at which the behavior of the buyer or seller changes…Market Equilibrium – Interaction of Demand/Supply:The “free interaction” of buyers and sellers in a market will lead to “a particular level of trade” taking place at “a particular price.”Equilibrium – a “stable state” for a system which will persist as long as outside factors do not change.In the context of market equilibrium we need to identify a “price/quantity pair” that is stable in the sense that no individual buyer and no individual seller can alter their own behavior in such a way as to increase their own surplus.DemandSupplyquantity00price502030Consider the following market…What prices are “stable”…?Is a “high price” of stable?Excess Supply at a price of $50: quantity supplied (of 75) is greater than quantity demanded (of 15) [i.e., “more sellers than buyers”] => “downward pressure” on priceDemand0quantity0priceSupply50S(50)=75D(50)=15Buyers willing/able to purchase 15 units; sellers willing/able to sell 75 units => “more sellers than buyers” or equivalently “excess supply”60 (=75-15) of the sellers who would like to sell the item for $50 are not able to find buyers – each of these sellers would have an incentive to instead accept $49.99 => “downward pressure on price”Any price for which there is “excess supply” is not stableIs a “low price” of stable?D(20)=105DemandSupply20quantity0Excess Demand at a price of $20: quantity demanded (of 105) is greater than quantity supplied (of 40) [i.e., “more buyers than sellers”] => “upward pressure” on price0priceS(20)=40Buyers willing/able to purchase 105 units; sellers willing/able to sell 40 units => “more buyers than sellers” or equivalently “excess demand”65 (=105-40) of the buyers who would like to purchase the item for $20 are not able to find sellers – each of these buyers would have an incentive to instead offer $20.01 => “upward pressure on price”Any price for which there is “excess demand” is not stable0priceDemandSupplyquantity0Only “stable price” is at the intersection of the demand curve and the supply curve.p*=30q*=D(30)=S(30)=55Only at this price do we have (quantity demanded)=(quantity supplied) => “the same number of buyers and sellers looking to trade.”At : buyers are willing/able to purchase 55 units and sellers are willing/able to purchase 55 units (no “excess demand” and no “excess supply”)All potential buyers that don’t make a purchase at this price do not want to make a purchase at this price. All potential sellers that don’t make a sale at this price do not want to make a sale at this price.Nobody (no buyer, no seller, no potential buyer, and no potential seller) has anything to gain by changing their own behavior => “Stable Outcome”Market Equilibrium occurs at the intersection of supply and demand:“equilibrium price”: price at this intersection, “equilibrium quantity”: quantity at this intersection, The equilibrium in the model of Supply and Demand is:“stable” (if we are there we will stay there, unless outside forces change; but this had to be true by the definition of equilibrium)“unique” (there is one and only one equilibrium, a property which follows from the “Law of Demand” and “Law of Supply”) “self enforcing” (at higher prices there is downward pressure on price; at lower prices there is upward pressure on price – therefore if we start at any other price, we will be pushed toward the equilibrium price)Underlying Determinants of Demand and Supply:When we first introduced demand and supply we said they were relationship between price and quantity “all other factors fixed.”Two questions at this point:What are these “other factors”?What happens if these other factors change?Short answers:These “other factors” are anything other than “own price” that influences the decision regarding purchasing or selling the item.As these other factors change we can realize an increase or decrease in demand or supply (i.e., a shift of the entire demand curve or the entire supply curve), which will ultimately lead to changes in equilibrium price and equilibrium quantity.Increase in Demand – change in demand consistent with consumers being more willing to purchase the good, in that at every price the new quantity demanded is greater than the previous quantity demanded (visually, a “rightward shift” of the demand curve) [illustrated as the change from “Demand (B)” to “Demand (A)” below]Decrease in Demand – change in demand consistent with consumers being less willing to purchase the good, in that at every price the new quantity demanded is less than the previous quantity demanded (visually, a “leftward shift” of the demand curve) [illustrated as the change from “Demand (A)” to “Demand (B)” below]quantitypriceChange in Demand:Demand (A)Demand (B)00Increase in Supply – change in supply consistent with firms being more willing to sell the good, in that at every price the new quantity supplied is greater than the previous quantity supplied (visually, a “rightward shift” of the supply curve) [illustrated as the change from “Supply (A)” to “Supply (B)” below]Decrease in Supply – change in supply consistent with firms being less willing to sell the good, in that at every price the new quantity supplied is less than the previous quantity supplied (visually, a “leftward shift” of the supply curve) [illustrated as the change from “Supply (B)” to “Supply (A)” below]Change in Supply:priceSupply (A)Supply (B)quantity00Determinants of Demand (factors that change demand):The following changes will result in an increase in demand:A decrease in the price of a Complement Good (e.g., demand for hotdogs would increase if the price of hotdog buns were to decrease)An increase in the price of a Substitute Good (e.g., demand for Pepsi would increase if the price of Coke were to increase)An increase in income (for a Normal Good – most goods are normal goods)A decrease in income (for an Inferior Good – some goods, such as “generic brands,” are inferior)An increased preference by consumers for the good (e.g., new study suggesting “drinking 24 ounces of milk per day will reduce obesity” would increase demand for milk)An increase in “market size” (e.g., increase in population)An expectation of higher future prices (e.g., if you have reason to suspect that gasoline will cost $1 more per gallon next week, you would fill up your tank today?)(*** changing these factors “in the opposite direction” would result in a decrease in demand ***)Determinants of Supply (factors that change supply):The following changes will result in an increase in supply:A decrease in the cost of any factors of production needed to produce the good (e.g., decrease in the wage rate paid to labor would increase supply)An improvement in technology that reduces production costsA favorable realization of “natural events” (e.g., “good weather” for the growing of an agricultural commodity)An increase in “market size” (e.g., increase in the number of suppliers of the good)An expectation of lower future prices (e.g., if a gas station owner has reason to suspect the market price will be $1 less tomorrow, they would want to unload as much gasoline as possible today)(*** changing these factors “in the opposite direction” would result in a decrease in supply ***)Change in Equilibrium resulting from change in Demand:priceDemand (A)Low PriceDemand (B)0High QuantitySupplyHigh Price0quantityLow QuantityIncrease in demand (for whatever reason): shift from “Demand (B)” to “Demand (A)” will increase equilibrium price and increase equilibrium quantity.Decrease in demand (for whatever reason): shift from “Demand (A)” to “Demand (B)” will decrease equilibrium price and decrease equilibrium quantity.…recall that the equilibrium is “self enforcing,” so that we don’t need to do anything to get to the new equilibrium (i.e., market forces will push us toward the new equilibrium outcome)…Change in Equilibrium resulting from change in Supply:0High QuantitySupply (A)priceSupply (B)High PriceLow PriceDemandquantity0Low QuantityIncrease in supply (for whatever reason): shift from “Supply (A)” to “Supply (B)” will decrease equilibrium price and increase equilibrium quantity.Decrease in supply (for whatever reason): shift from “Supply (B)” to “Supply (A)” will increase equilibrium price and decrease equilibrium quantity.…recall that the equilibrium is “self enforcing,” so that we don’t need to do anything to get to the new equilibrium (i.e., market forces will push us toward the new equilibrium outcome)…Important Role of Profit: In a free market economy profits serve as a “signaling device,” directing resources to their most valuable use.If firms are earning “large, positive profits” in an industry, this acts as a signal for current firms to increase their output or for new firms to enter the industry. This leads to additional productive resources being attracted to this market.If instead firms are earning “large, negative profits” in an industry, this acts as a signal for current firms to decrease their output or to exit the industry. This leads to productive resources being diverted away from this market toward other (more highly valued) uses.This argument relies upon “Freedom to Engage in Economic Activity” => for markets to efficient allocate productive resources, resources must be allowed to engage in whatever activity offers the greatest return.Profits can only serve as an effective signal insofar as someone is able to recognize, appreciate, and respond accordingly to different levels of profit. => the Entrepreneur is the individual who plays this roleEntrepreneur – someone who organizes and manages a business, typically with considerable initiative and exposure to risk.Realizing this efficient movement of resources requires (in part) that firms earning negative profits be allowed to go bankruptPrompted Joseph Schumpeter (1883-1950) to describe capitalism as a “gale of creative destruction”Spontaneous Order of Markets:Spontaneous Order – the natural and undirected emergence of order out of seeming chaosIn a market system, the actions of individuals pursuing their own self-interest gives rise to outcomes that are better for society than what would be realized by deliberate, intentional planning“The last President of the Soviet Union, Mikhail Gorbachev, is said to have asked British Prime Minister Margaret Thatcher: How do you see to it that people get food? The answer was that she didn’t. Prices did that. Moreover, the British people were better fed than people in the Soviet Union…”– “Basic Economics” by Thomas Sowell (page 12)The spontaneous order of a free market is better at producing food and getting it to the tables of households than is a system of central planningFriedrich von Hayek argued that markets result in “a more efficient allocation of societal resources than any design could achieve”Adam Smith’s “Invisible Hand”: in a free market system individuals are “led by an invisible hand to promote an end which was no part of his intention…by pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.”“I, Pencil” by Leonard Read (Coda in “Economics” textbook) illustrates spontaneous order in markets…“I, Pencil” – a first person genealogy of a simple lead pencil (written by Leonard Read)Pencil claims: “Not a single person on the face of earth knows how to make me.” => production of each single pencil requires the collective efforts of millions of people all over the worldtrees grown in California, cut down by loggerssaws, trucks, ropes, trains necessary to harvest and transport the wood (each with numerous inputs)food and beverages to nourish workerswood is then kiln dried and tintedpower for mill from the dam of a hydroplantglue to hold layers of wood in pencil togethergraphite from Ceylon (Sri Lanka)zinc and copper mined to make the brass ferruleclay from Mississippi, wax from Mexico, pumice from Italymillions of people all doing their small part to ultimately make each pencilno one person knows how to make a pencil from start to finish => the knowledge is spread out over millions of people all over the globeto make each pencil, we must first somehow coordinate the actions of all these different people, in order to have each one contribute his own little piece of knowledge or skill to the processbut, this “cooperation” takes place spontaneously, without anyone overseeing or dictating the processthe individual incentives present in the market system result in: “the configuration of human energies – millions of tiny know-hows configurating naturally and spontaneously in response to human necessity and desire and in the absence of any human master-mind!”entrepreneurs, workers, and consumers all make decisions based upon and in response to pricese.g., a potential lumberjack in Californiaif pencils are more highly valued by consumers, the price and quantity produced of pencils will increasemore people must be employed as lumberjacks (we need more wood to make the additional pencils)the wage rate paid to lumberjacks must increase in order to attract more people to the professioneach individual lumberjack does not intend or necessarily care about “making a pencil”rather, he simply wants to earn a wage in order to generate income for his householdwhat results in more pencils being produced and more people being employed as lumberjacks is not a concern with the social need for more pencils on the part of the lumberjack, entrepreneur, or anyone else…rather, it is the individual pursuit of self-interest by each personThree surprising features of the scenario above:no one person possesses the know-how to make a pencilmost who helped make the pencil did not intend to or necessarily care to specifically make a pencilbut yet, the entire process takes place (and valued goods, such as pencils, are produced) without any planner overseeing or dictating the process ................
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