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The Market System in Action
Session 3
Professor Dermot McAleese
OUTLINE
The market system
The role of prices
Demand and supply
Taxes, subsidies and quantitative restrictions
The efficiency of the free market
Free market in the social context
Large number of sellers and buyers (free entry and exit)
Full information
Consumers maximise utility
Firms maximise profit
Flexible prices
COMPETITIVE MARKET
THE MARKET SYSTEM
Product
market
Labour
market
Capital
market
FOREIGN SECTOR
GOVERNMENT
Sell goods
Buy labour
Invest in capital goods
FIR
MS
Buy goods
Sell labour
Borrow money
Save money
HO
USE
HO
LD
S
MARKET ECONOMY
TOTAL ECONOMIC ACTIVITY
SHADOW ECONOMY
FORMAL ECONOMY
Non-marketed economic activity
Marketed economic activity
Non-marketed economic activity
TOTAL MARKET ECONOMY
Marketed economic activity
THE SHADOW ECONOMY
Measurement monetary aggregates method
income expenditure discrepancy
special investigations
Causes high taxes and perceived lack of ‘fairness’
high burden of regulations
high unemployment combined with high unemployment compensation
onerous employment regulations
cultural and personal behavioural characteristics
Cures lower tax rates and ‘broaden’ tax base
improve regulation and legal restrictions
enhance monitoring and international co-operation
Source: F. Schneider, ‘The shadow economies of Western Europe’, Economic Affairs, September 1997.
Table 1. Size of the shadow economy (% GDP)
Country 1990 1997
Austria 5 9Belgium 20 22Canada 14 15Denmark 11 18Germany 12 15Greece 27 30France 9 15Ireland 12 16Italy 23 27Netherlands 14 14Norway 15 19Spain 21 23Sweden 16 19Switzerland 7 8UK 10 13USA 7 9
China
Illicit syphoning of funds from projects and companies has amounted to 13-16% of China’s GDP over the
past decadeSource: Asian Wall Street Journal, March 2001,
citing research of Professor Hu Angang, Qinghua University
Price is determined by DEMAND and SUPPLY
Price as incentive
Price as source of information
Market equilibrium (D=S)
THE ROLE OF PRICES
THE ROLE OF PRICES
Pri
ce
PE
P1
O HQEQ Quantity
E
OPS
S
D
BA
SHIFTS IN DEMAND AND SUPPLY
Causes of shifts in demand
level of income available to consumers
price of substitute / complementary goods
income distribution
demographic structure
tastes and fashion
seasonal factors
Causes of shifts in supply
technological innovation
changes in prices (L, K, inputs)
natural and man-made disasters
strikes / government regulations
organisation and management restructuring
SHIFTS IN DEMAND AND SUPPLY
“…..It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but their self-love…”
Adam Smith Wealth of Nations, Book 1, Chapter II, p. 18
INCIDENCE OF TAXS1
S
QQT
V
P
PT
Quantity
Price
F
$2R
E
U
PRICE CEILING
Pri
ce
PE
Ceiling
O QER Quantity
E
S
D
BA
Water is becoming an increasingly scarce resource. About 70% of water supplies in countries such as China and Morocco is consumed by farmers for irrigation at below-cost prices.
• Explain the effect of the subsidy on the equilibrium level of water used.
• Instead of such subsidisation, could any more efficient policy be used to protect the income of farmers?
• Should farmers be charged the full economic cost for the water they use?
Do-it-yourself: Demand and Supply in Action
E7 The minimum price set by the European Commission for many foodstuffs and dairy products is set above the world equilibrium price. The objective of this price ‘floor’ is to support farm incomes. Use a supply and demand diagram to illustrate the effects of setting the minimum price on a) food prices in the EU b) farm incomes
c) government spending and d) other countries.
Exercises
E1. Draw a graph showing the demand curve and the supply curve of personal computers. How would the graph be affected by:
a rise in the price of software
a rise in the price of electric typewriters
a fall in the price of desktop printers
an expected increase in next year's PC prices
a 10 per cent sales tax on computers
a fall in income tax
(p. 94)
THE EFFICIENCY OF THE MARKET SYSTEM
Price
per
unit
Output
Cost of
production
Utility
Marginal
utility
Marginal
cost
E
S
D
W
VR
QO
P
QE
S
QT
PE
mu > mc
mu < mc
mu = mc
‘INVISIBLE HAND’ OF THE MARKET SYSTEM
Seeking only to satisfy their individual wants and needs, consumers are led to do so in a way that puts least strain on society’ s resources for the level of satisfaction achieved
Businesses, pursuing private profits, are led to produce goods and services which consumers want, at lowest cost
Owners of capital and land, seeking only to increase their wealth, are led to deploy their assets in the most socially productive ways
Employees, attempting to maximise their welfare, are led to select the training and careers which are most valuable to society
Assumptions: prefect competition, full information and completeness
Stable and reliable medium of exchange
Transparent prices, competition and full information
Private property and legal framework
Minimum standards of truth, trust, acceptance and obligation
Equitable distribution of income
FIVE CONDITIONS FOR AN EFFECTIVE FREE MARKET SYSTEM
QUESTIONS
Demand for cigarettes is insensitive (inelastic) with respect to price, but demand for a particular type or brand of cigarette could be very elastic. Use demand and supply curves to analyse the following:To encourage better quality cigarettes the government will raise the tax rate on low
quality brands while lowering the tax rate on more expensive cigarettes. This is aimed at strengthening the position of bigger producers such as Hongta Group, while pushing many smaller local manufacturers out of business. EIU China Country Report August 2001
Discuss what you would consider to be the main determinants of demand and supply of rented apartments. Suppose the government decides that rents are too high and sets a maximum rent. What would you expect the consequences of this action to be for (a) apartment owners, (b) existing renters and (c) future renters?
The government gains revenue by imposing a sales tax. Who stands to lose the most, the consumer or the producer or both?
Exercises
E6. (a) Consider the economic consequences of a prohibition on the consumption of alcohol. What happens to the supply curve? What happens to the demand curve? How will the prohibition affect equilibrium consumption and price? What further indirect effects are likely to follow? (According to some writers, prohibition is likely to raise the level of violence by increasing the marginal benefits and lowering the marginal costs of breaking the law.)
(b) Suppose the head of an anti-drugs enforcement agency reports, as evidence of the agency's success in deterring drug users, that the street price of drugs has fallen. Is this evidence conclusive? What other factors might have caused the fall in price?
Question for Class
Use demand and supply analysis to illustrate the effects of China’s removal on restrictions on imports of automobiles. Import tariffs on automobiles will fall to 25% by mid 2006 from present level of 70-90%.
What will be the effect on:• the price of imports in RMBs?• the dollar price of imports?• employment in import competing industries?• government tax revenues?