Chapter 3 – Free Markets at Work

Free markets – how choices of consumers and firms become trade and transactions.

Modeling behavior in a free market: Demand and Supply.

What a free market does effectively, and what it can’t do.

How free markets can get messed up.

Essentials of a Free Market

Consumers -- choosing a variety of goods and services based upon maximizing utility subject to the budget constraint.

Firms -- specialization into producing different types of goods, based upon maximizing profits.

A high degree of competition among different firms producing the same good, with no single firm having an advantage over another firm in the industry (Perfect Competition).

More Essentials of a Free Market

A price for a good or service which is known to buyers and sellers.

Mutually Beneficial Exchange – trade or purchasing something takes place only if it serves to benefit both the buyers and the sellers.

Applications: buying goods, hiring labor, world trade.

The Role of Money in Free Markets

Money – primary role is as a Facilitator of Trade, to serve as a lubricant to make trade take place as smoothly as possible.

“Engine Oil” to the engine of trade in free markets.

Specific Roles of Money as a Facilitator of Trade

Medium of Exchange -- Money is exchanged for goods and services.

Standard of Value -- Value is measured in dollars (the “price tag”).

Store of Value -- People can use money when they wish, present versus future.

Modeling the Free Market: Demand and Supply

Every good or service (e.g. coffee) has consumers who wish to buy it (Demand), along with firms who wish to sell it (Supply).

A theory and model which predicts: (1) how much of the good will ultimately be sold, (2) the price it will sell for, and (3) how these conditions change due to specific events.

Demand

Demand, or Quantity Demanded, (QD) -- the amount of a given good or service (e.g. coffee) that one or more people intend to purchase.

Demand for Coffee: Causes

The Price of Coffee (P)

P (ceteris paribus) QDA Whole Bunch of Other Causes

(e.g. Tastes)

Tastes (ceteris paribus) QD

Formalizing the Theory of DemandGraph QD versus one of its causes -- the

price of coffee (P).Inverse relationship implies that the curve

is downward sloping.Changes in P are described as a movement

along the curve.Graph is drawn assuming that Tastes (and

any other causes) are constant (ceteris paribus).

Describing Changes in One of the “Other Causes”

A Change in Tastes (or a change in any cause other than the price) is described by a shift of the Demand curve.

Contrast this with a change in P -- movement along the curve.

Different descriptions occur only because P is the cause that appears on the graph.

Shifting the Demand Curve

A change -- other than P -- that makes QD increase is described as a rightward shift of the curve, or an Increase in Demand.

A change -- other than P -- that makes QD decrease is described as a leftward shift of the curve, or a Decrease in Demand.

Supply

Supply, or Quantity Supplied, (QS) -- the amount of a given good or service (e.g. coffee) that firms intend to produce and sell.

Supply of Coffee -- Causes

Price of Coffee (P)

P (ceteris paribus) QSA Whole Bunch of Other Causes

(e.g. Price of Energy)

Price of Energy (ceteris paribus) QS

Formalizing the Theory of Supply

Graph QS against one of its causes -- the price level (P).

Positive relationship implies that the curve is upward sloping.

Changes in P are described as a movement along the curve.

Graph is drawn assuming that the Price of Energy and all other causes are constant.

Describing Changes in One of the “Other Causes”

A Change in the Price of Energy (or a change in any cause other than the price) is described by a shift of the Supply curve.

Contrast this with a change in P -- movement along the curve.

Different descriptions occur only because P is the cause that appears on the graph.

Shifting the Supply Curve

A change -- other than P -- that makes QS increase is described as a rightward shift of the curve, or an Increase in Supply.

A change -- other than P -- that makes QS decrease is described as a leftward shift of the curve, or a Decrease in Supply.

Equilibrium: The Market in Action

Equilibrium (P* and Q*) -- The values where the price of coffee and quantity traded of coffee will ultimately settle, given that the strategies of demands and suppliers play out.

Properties of Equilibrium

If the price of coffee is anywhere other than P*, natural market forces bring it to equilibrium.

If P > P*, there exists excess supply, and pressure for the price to fall.

If P < P*, there exists excess demand, and pressure for the price to rise.

More Properties of Equilibrium

P*and Q* represent the price and quantity traded as predicted by the theory and model.

In general, we observe the equilibrium.

Shifts in either the Demand or Supply curves change the equilibrium.

Shifts and Changing the Equilibrium -- Applications

Example 1 – Coffee is found to be more attractive to drink (e.g. medical finding), which affects Tastes.

Tastes QD Increase in Tastes increases QD,

described by shifting the Demand curve rightward.

Draw the picture and evaluate the answer.

Another Application

Example 2 -- The price of energy (PE) increases.

PE hinders production, therefore reduces QS.

This behavior is described as a leftward shift of the Supply curve.

Draw the graphs and evaluate.

Demand and Supply in a Competitive Economy

In an economy with perfect competition throughout: There exists a market, i.e, Demand and

Supply, for each good and service. There exists a market, i.e. Demand and

Supply, for each factor or input (labor, materials, physical capital) used to produce each good or service.

The Circular Flow

Consumers – Demand goods and services, Supply inputs (e.g. labor).

Firms – Supply goods and services, Demand inputs (e.g. labor).

The Circular Flow – the web of connections between the various goods and input markets in the economy that determine quantities traded and prices, connected by income generated by production and used for purchasing.

General Competitive Equilibrium

General Competitive Equilibrium (GCE)– the situation in which all perfectly competitive markets are in equilibrium simultaneously.

Most efficient, optimal type of overall economy, specifics later.

Very possible to have economy in general equilibrium without GCE, sub-optimal with distortions.

The “Nice Assumptions”

The “Nice Assumptions” – ideal conditions in all markets that lead to General Competitive Equilibrium.

1. No Market Power.2. No Market Failure.

Nice Assumption #1 -- No Market Power

No Market Power -- advantages in the market are transitory and can be eliminated by competition.

-- equal access to information

-- equal access to markets

Nice Assumption #2 -- No Market Failure

No Market Failure -- markets form quickly and function smoothly and efficiently to coordinate choices of individuals and firms.

-- markets form quickly when needed -- markets function smoothly and efficiently to coordinate choices

The Roles of Government in a Free Market Economy

Try to eliminate market power when it exists -- enforce laws.

Try to eliminate market failure when it exists -- regulate externalities, provide for public goods.

Above are ideal roles. In practical terms, how much should government to intervene, possibly create additional distortions?