Chapter 2

HOW A MARKET ECONOMY WORKS: THE PRICE

SYSTEM

1. Markets and Business Organizations Markets bring buyers and sellers

together for the purpose of determining conditions of exchange, such as quantities of purchase and prices.

Wide variety of markets exists, small and large, distant or close.

Visual markets bring buyers and sellers together in cyber space via personal computers.

1.1 Forms of Businesses

Sole proprietor Partnership Corporation

1.1.1 The Sole Proprietorship The sole proprietorship is owned by

one individual who makes all the business decisions, receives all the profits, and bears sole financial responsibility.

Minimal legal work is required to set it up. The proprietor is responsible for deciding

who should be hired, what products to produce, how much to advertise, and where to locate.

1.1.2 A Partnership A partnership is owned by two or more

partners who make all the business decisions, share the profits, and bear financial responsibility jointly.

Partnerships are based on agreements that spell out ownership shares and the duties of each partner.

Partners may contribute equal or different amounts of financial capital; one partner may specialize in finance, another in sales.

1.1.3 A Corporation A corporation is owned by stockholders; it

is authorized by law to act as a legal person. The stockholders elect a board of directors, which appoints the management.

Management carries out the actual operation of the corporation.

If the corporation cannot pay its debts, the shareholders are not personally liable for these debts.

1.1.3 A Corporation – cont. A corporate charter is required to set up a

corporation, which is then incorporated in a specific state and becomes a legal person, subject to the laws of that state.

A stockholder’s share of the corporation equals the number of shares he or she owns divided by the total number of shares outstanding.

Unlike the sole proprietor and partner, there is usually a separation of ownership and management.

(A Profile of American Business example)

1.1.4 Property Rights In a capitalist society, most property and

business are owned by private individuals who exercise property rights.

Property rights are the rights of an owner to use and exchange property.

Private property rights ensure that owners will use private property to maximum personal advantage. In the case of privately owned businesses, private property rights will be exercised to maximize profits.

2. The Circular Flow of Economic Activity Economic activity is circular. Households buy goods and

services (G&S) with the incomes they earn by furnishing labor, land, and capital to business firms.

The money spent by households comes back to them as income from the sale of the factors they own.

2.1 The Circularity of Economic Activity The circular-flow diagram

summarizes the flows of G&S from enterprises to households and the flows of the factors of production from households to business firms.

The outer circle shows the physical flows of G&S and productive factors; the inner circle shows the payments for G&S and for productive factors.

2.1 The Circularity of Economic Activity – cont.

The flows between households and firms are conducted through two markets: Product markets are markets in

which G&S are bought and sold. Factor markets are markets in

which the factors of production are bought and sold.

2.2 Intermediate Goods The circular-flow diagram captures the

movements of G&S to households A large number of transactions take place

within the business sector as firms exchange intermediate goods (e.g. steel, plastic products).

Although intermediate goods do not enter the circular flow, they affect the flows between businesses and households.

The efficiency with which the business sector uses intermediate goods determines the size of the flows of G&S to households.

2.3 Household Production

G&S produced and used within the household also do not enter the circular flow.

Homemakers provide cooking, cleaning, etc. to other family members.

3. The Price System The circular-flow diagram brings

home economic interdependency. Complex flows of intermediate goods

take place within the business sector. Will there be chaos and anarchy?

Market allocation systems use relative prices and private property rights to solve the resource allocation problem.

4. Relative Prices The price system (relative prices not

money prices) solves the economic problems of what, how and for whom.

A money price is a price expressed in monetary units (such as dollars, yen, pesos). Money prices do not play a meaningful role

in resource allocation because they do not provide information on what goods are “cheap” or “expensive.”

A relative price is a price expressed in terms of other commodities.

4. Relative Prices – cont. The price system is the entire set of

millions of relative prices. Relative prices are constantly

changing and can move in directions opposite to the general level of money prices.

Changes in relative prices provide important signals (Fall of autos prices; and fall of cell phone price in 2000s)

4.1 The Principle of Substitution A relative price is the ratio of two money prices

(white bread = $2; wheat bread = $1; then white bread is twice as expensive as wheat bread.)

Consumers and producers substitute or trade off one good for another as relative prices change.

The principle of substitution states that we substitute one good for another as relative prices change.

Virtually no good is fully protected from the competition of substitutes (aluminum competes with steel, etc.)

4.1 The Principle of Substitution – cont. The only goods that are impervious to

substitutes are goods as minimal quantities of water, salt, and certain lifesaving medication.

(Substitutes and how we communicate example.)

Relative prices signal users to make substitutions.

Rising relative prices motivate us to seek out substitutes. If the price of one good rises relative to its substitute, users switch to relative cheaper substitutes.

4.2 Equilibrium and the Invisible Hand

“Every individual endeavors to employ his capital so that its produce may be of greater value. He generally neither intends to promote the public interest, nor knows how much he is promoting it. He intends only his own security, only his own gain. And he is 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 effectively that when he really intends to promote it.” – Adam Smith The Wealth of Nations (1937)

4.2 Equilibrium and the Invisible Hand –

cont.

The invisible hand states that a capitalist economy can function well without government direction by using the signals of the price system.

The millions of relative prices that make up the price system inform buyers and sellers what goods are cheap and what goods are expensive.

4.2 Equilibrium and the Invisible Hand –

cont. As businesses use this information to gain

profits and buyers use this information to determine their best buys, the economy runs itself without direction or planning from the government.

The equilibrium price is that price at which the amount of the good people is prepared to buy equals the amount offered for sale.

(Equilibrium in Electricity Market example)

4.3 The Price System and “What”, “How” and “From Whom”

No individual is required to be concern about the economy as a whole; the price system solves what, how and for whom by itself.

Government is not required to coordinate economic activities, some government actions such as price control can interfere with the market’s check and balances.

4.3.1 “What” The what problem is solved by

consumers and producers responding to relative prices.

The dollar votes cast by consumers determine what is produced.

Dollar votes show the willingness of people to buy particular goods at specified prices

4.3.2 “How” The price system solves the how

problem through relative price signals. Business firms produce goods by

combining resources in the least costly way.

If business firms fail to use lowest-cost combinations, the competition of other firms will reduce their profits and, possibly, drive them out of business.

4.3.3 “From Whom” The market assigns relative prices to the

resources owned by each household. The distribution of income among

households depends on the relative prices of the factors of production and on the distribution of property rights to scarce land, labor and capital.

For example, people who are fortunate enough to be able to provide high-priced labor services (brain surgeons) receive a large share of output and visa versa.

4.4 Imperfections: Public Goods and Externalities The invisible hand has imperfections.

The price system does not guarantee a satisfactory solution for the for whom problem. It may lead to an unfair distribution of

income It may not work well when firms gain

monopoly control over markets. It may also fail to deal with externalities,

such as pollution. It may produce business cycles—booms and

busts of employment and inflation.

4.4 Imperfections: Public Goods and Externalities –cont.

Laissez-faire is the doctrine that the government should limit its activities to essential state functions, such as national defense, a legal system, public roads, and police protection.

Public goods are characterized by two features: More can be consumed by one consumer without less

being available for other consumers, and Non-payers cannot be excluded from using the product.

These two features make it difficult for private markets to provide public goods. There is no incentive to “pay one’s share” voluntarily as public goods cannot be sold.

4.4 Imperfections: Public Goods and Externalities –cont.

One solution is for the government to provide such goods, paying for them with tax returns.

Another problem with invisible hand is that we impose external costs on others that are not reflected in our private economic calculations.

An external cost is an unpriced cost that is imposed on others (Pollution of river by upstream factory.)

Government programs must ensure that those who impose these external costs include them as part of their private calculations.