Description of economy and basic economic problems. Types of taxes: progressive, proportional and regressive. Application of law of demand and of Supply. Collusion is a secret arrangement between two or more firms to fix prices or share the market.

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Introduction: What is Economics?

One of the things that young people discover as they grow older is that you can't have everything. You are reminded of it every time you shop. Although you may see twenty or thirty items that you would really like to buy, you know that you will have to limit your selection to one or two. Everyone goes through life having to make choices.

Governments, too, cannot have everything. Every year the most important political debates concern questions about spending taxpayers' money.

Neither individuals nor societies can have all the things they would like to have. There simply is not enough of everything to go around. Economists note that there is no limit to the amounts or kinds of things that people want. There is, however, a limit to the resources, things used to produce goods and services, available to satisfy those wants. Once that limit is reached, nothing else can be produced.

In other words, when a nation's resources (all its workers, factories, farms, etc.) Are fully employed, the only way it will be able to increase the production of one thing will be by reducing the production of something else. This happened during World War II. In its efforts to increase the production of tanks and other military vehicles, our nation's factories stopped producing automobiles. Therefore, if somebody tries to sell you a 1944 Ford or Chevrolet, run, do not walk, to the nearest exit - none were produced that year.

To summarize: human wants are unlimited, but the resources necessary to satisfy those wants are limited. Thus, every society is faced with the identical problem, the problem of scarcity.

Since there is not enough of everything to go around, everyone - individuals, business firms and government - needs to make choices from among the things they want. In the process they will try to economize, to get the most from what they have. With this in mind, we can define economics as the social science that describes and analyses how society chooses from among scarce resources to satisfy its wants.

The need to choose is imposed on us all by our income, wealth and ability to borrow. Individuals and families are limited by the size of their personal income, savings and ability to borrow. Similarly, business firms are limited by their profits, savings and borrowings and governments by their ability to tax and borrow.

Income, earnings, profits and taxes enable people, institutions and governments to purchase goods, products you can see or touch, and services, work performed for pay that benefits others. The problem that each must face, however, is that once the decision has been made to choose one set of alternatives, one loses the opportunity to choose the other.

Business is faced with the problem of choices and opportunity costs. The opportunity cost of something is its cost measured in terms of what you have to give up to get it. In planning an advertising campaign, for example, a local store might have to choose between a newspaper ad or a direct-mail campaign. If it puts its efforts into newspaper advertising, the opportunity cost is the benefits of a direct-mail campaign.

Like individual and business firms, government also pays opportunity costs. If, for example, the federal government chooses to increase its spending for roads by reducing the number of warships to be built, the opportunity cost of the improved road network would be a more powerful navy.

The resources that go into the creation of goods and services are called the factors of production. The factors of production include natural resources, human resources, capital and entrepreneurship. Each factor of production has a place in the economic system, and each has a particular function. People who own or use a factor of production are entitled to a “return or reward”. This generates income which, as it is spent, becomes a kind of fuel that drives the economy.

Natural Resources or “Land”. Natural resources are the things provided by nature that go into the creation of goods and services. They include such things as mineral, wildlife and timber resources, as well as the air we breathe. Economists also use the term “land” when we speak of natural resources as a factor of production. The price paid for the use of land is called rent. Rent becomes income to the owner of the land.

Human Resources or “Labor”. Economists call the physical and mental efforts that people put into creation of goods and services labor. The price paid for the use of labor is called wages. Wages represent income to workers, who own their labor.

Capital. To the economists, physical capital (or “capital” as it is commonly called) is something created by people to produce other goods and services. A factory, tools and machines are capital resources because they can be used to produce other goods and services. The term capital is often used by business people to refer to money that they can use to buy factories, machinery and other similar productive resources. Payment for the use of someone else's money, or capital, is called interest.

Entrepreneurship. Closely associated with labor is the concept of entrepreneurship, the managerial or organizational skills needed by most firms to produce goods and services. The entrepreneur brings together the other three factors of production. When they are successful, entrepreneurs earn profits. When they are not successful, they suffer losses. The reward to entrepreneurs for the risks, innovative ideas and efforts that they put into the business are profits, whatever remains after the owners of land, labor and capital have received their payments.

Basic Economic Problems

The central problem of economics is to determine the most efficient ways to allocate the factors of production and solve the problem of scarcity created by society's unlimited wants and limited resources. In doing so, every society must provide answers to the following three questions:

What goods and services are to be produced and in what quantities are they to be produced?

How are those goods and services to be produced?

Who will receive and consume (get to use) those goods and services?

What Goods and Services Are to be Produced and in What Quantities Are They to be Produced?

Individuals and societies can obtain things by producing them themselves, exchanging things that they already own for them, or receiving them as gifts. Since a society cannot have everything, it must decide which goods and services it will have now and which ones it is willing to postpone having or give up completely. For example, there are those who say that the United States should put more of its efforts into improving production of basic commodities, such as automobiles and steel. They wish to prevent the further loss of trade to competitors such as the Japanese. In order to achieve this goal, they urge our nation to devote more effort to developing basic goods and services rather than luxury items.

Sometimes the choices can be quite difficult. For example, there are nations today, known as less-developed countries (LDC's), that are so poor it takes the effort of most of their labor force just to feed and clothe their people. For such a society to raise its living standards it would be necessary to increase production beyond present levels. But if everyone in the country is already working at a full-time job, how can total production be increased?

One way to increase total production in the future would be to modernize. This might require shifting workers out of the production of food and clothing and into the production of additional capital such as machines, tools and factories. To do so, however, would mean that less food and clothing would be produced for present use in order to increase output some time in the future. For a nation with large numbers of people living in poverty even the slightest reduction in the food supply could trigger widespread hunger. Fortunately, there are many international agencies and generous nations, such as the United States, that have provided aid to the LDC's, helping them modernize while feeding their people.

How Are Those Goods and Services to be Produced?

There is more than one way to build a home or a school, manufacture an automobile, or farm a piece of land. Will the school consist of many stories or one floor? Will the automobile assembly line use robots? How much farmland will be used for corn and how much for wheat?

With the exception of the school building, which in most instances would be a government project, all these questions would be answered in this country by private individuals. In other parts of the world, however, how to manufacture an automobile might well be a decision made by the government. As for farming practices, some societies leave that to government to decide, others follow long-honored traditions, while in still others the farmer decides.

Who Will Get to Use the Goods and Services Produced by the Economy?

Since there will not be enough produced to satisfy everybody's wants, some way will have to be devised to determine how the output is divided. Who, for example, will get to ride in limousines; who will have to use public trans portation; and who will have to walk?

Society has answered these questions in many ways. In some countries those of noble birth are entitled to a larger share of the nation's output than others. In other countries membership in a particular political party has been the key to wealth. Here, in the United States, the market system and the ownership of wealth are the key elements in determining who will be rich, middle class or poor.

Two Economic Issues

Trying to understand what economics is about by studying definitions is like trying to learn to swim by reading an instruction manual. Formal analysis makes sense only once you have some practical experience. In this section we discuss two economic issues to show how society allocates scarce resources between competing uses. In each case we see the importance of the questions what, how, and for whom to produce.

The Oil Price Shocks

Oil is an important commodity in modern economies. Oil and its derivatives provide fuel for heating, transport, and machinery, and are basic inputs for the manufacture of industrial petrochemicals and many household products ranging from plastic utensils to polyester clothing. From the beginning of this century until 1973 the use of oil increased steadily. Over much of this period the price of oil fell in comparison with the prices of other products. Economic activity was organized on the assumption of cheap and abundant oil.

In 1973-74 there was an abrupt change. The main oil-producing nations, mostly located in the Middle East but including also Venezuela and Nigeria, belong to OPEC - the Organization of Petroleum Exporting Countries. Recognizing that together they produced most of the world's oil, OPEC decided in 1973 to raise the price for which their oil was sold. Although higher prices encourage consumers of oil to try to economize on its use, OPEC correctly forecast that cutbacks in the quantity demanded would be small since most other nations were very dependent on oil and had few commodities available as potential substitutes for oil. Thus OPEC correctly anticipated that a substantial price increase would lead to only a small reduction in sales. It would be very profitable for OPEC members.

Oil prices are traditionally quoted in US dollars per barrel. Figure 1-1 shows the price of oil from 1970 to 1986. Between 1973 and 1974 the price of oil tripled, from $2.90 to $9 per barrel. After a more gradual rise between 1974 and 1978, there was another sharp increase between 1978 and 1980, from $12 to $30 per barrel. The dramatic price increases of 1973-74 and 1978-80 have become known as the OPEC oil price shocks, not only because they took the rest of the world by surprise but also because of the upheaval they inflicted on the world economy which had previously been organized on the assumption of cheap oil prices.

FIGURE 1-1. The Price of Oil. 1970-86. (Source: IMF, International Financial Statistics.)

Much of this book teaches you that people respond to prices. When the price of some commodity increases, consumers will try to use less of it but producers will want to sell more of it. These responses, guided by prices, are part of the process by which most Western societies determine what, how, and for whom to produce.

Consider first how the economy produces goods and services. When, as in the 1970s, the price of oil increases sixfold, every firm will try to reduce its use of oil based products. Chemical firms will develop artificial substitutes for petroleum inputs to their production processes; airlines will look for more fuel-efficient aircraft; electricity will be produced from more coal-fired generators. In general, higher oil prices make the economy produce in a way that uses less oil.

How does the oil price increase affect what is being produced? Firms and households reduce their use of oil-intensive products which are now more expensive. Households switch to gas fired central heating and buy smaller cars. Commuters form car pools or move closer to the city. High prices not only choke off the demand for oil related commodities; they also encourage consumers to purchase substitute commodities. Higher demand for these commodities bids up their price and encourages their production. Designers produce smaller cars, architects contemplate solar energy, and research laboratories develop alternatives to petroleum in chemical production. Throughout the economy, what is being produced reflects a shift away from expensive oil using products towards less oil-intensive substitutes.

The for whom question in this example has a clear answer. OPEC revenues from oil sales increased from $35 billion in 1973 to nearly $300 billion in 1980. Much of their increased revenue was spent on goods produced in the industrialized Western nations. In contrast, oil-importing nations had to give up more of their own production in exchange for the oil imports that they required. In terms of goods as a whole, the rise in oil prices raised the buying power of OPEC and reduced the buying power of oil-importing countries such as Germany and Japan. The world economy was producing more for OPEC and less for Germany and Japan.

Although this is the most important single answer to the 'for whom' question, the economy is an intricate, interconnected system and a disturbance anywhere ripples throughout the entire economy. In answering the 'what' and `how' questions, we have seen that some activities expanded and others contracted following the oil price shocks. Expanding industries may have to pay higher wages to attract the extra labor that they require. For example, in the British economy coal miners were able to use the renewed demand for coal to secure large wage increases. The opposite effects may be expected if the 1986 oil price slump persists. The OPEC oil price shocks example illustrates how society allocates scarce resources between competing uses. A scarce resource is one for which the demand at a zero price would exceed the available supply. We can think of oil as having become more scarce in economic terms when its price rose.

Types of Economic Systems

Every society has worked out a way to answer the question of What, How and Who. These economic systems, as they are called, generally fall into one of three categories: traditional, command and market economies.

The Traditional Economy

As the name implies, the answers to the What, How and Who questions are decided by tradition in these economies.

Traditional economic systems are usually found in the more remote areas of the world. Such systems may characterize isolated tribes or groups, or even entire countries. They are less common today than they were in earlier decades. Typically, in a traditional economy, most of the people live in rural areas and engage in agriculture or other basic activities such as fishing or hunting. The goods and services produced in such a system tend to be those that have been produced for many years or even generations. They are produced as they always have been. In short, the questions of what the traditional society produces and how it is produced are determined by very slowly changing traditions.

Who gets to keep what is produced in such an economy? Since there is little produced, there is little to go around. Most individuals live near a subsistence level: They have enough to sustain them but little more than that. In some years, when the harvest is poor, some will not be able to subsist and will either leave the society or die. In better years, when the yield is high, there may be more than enough to allow subsistence. When such a surplus exists, it will be distributed traditionally. For example, the bulk of the produce might go to a tribal chief or large landholder, while the balance is distributed according to custom.

The Command Economy

Countries such as the Soviet Union, Albania, and China are examples of command economies. Groups of high-level technicians, made up of engineers, economists, computer experts and industry specialists known as "planners," advise political leaders who develop and implement a plan for the entire economy.

Essentially, it is the planners who decide what goods and services will be produced. If they want ship production expanded and mining operations cut back, they issue the orders to do so. If more food is needed, the planners might direct tractor production to be increased or fertilizers to be imported from the West. Those same plans might also encourage labor to remain on the farms and direct that transportation and storage facilities be made available to move and hold farm products.

How are goods produced in a command economy? The planners decide which products will be made. They decide where to locate a new truck assembly plant and whether the factory will use more labor or more modern machinery.

It is the planners, too, with guidance from the country's political leadership, who decide who will receive the goods and services produced. By setting wage rates for everyone, as well as interest rates, profits and rents, the planners directly answer the question: Who will receive the goods and services produced?

The Market Economy

When the fastest-rising young rock group, the And-So-Forths, appeared recently in a televised concert, they wore old-fashioned saddle shoes. That week shoe stores around the country reported receiving calls for saddle shoes "like the And-So-Forths wear." Although some of the storekeepers thought the first customers to ask for the strange shoe style were joking, they soon got the message. Before long, saddle shoes could be seen in most of the nation's shoe stores.

The events described in the paragraph above probably would not have taken place in a traditional or a command economy. Changes in clothing styles in a traditional society could occur only over a period of many years. Those who make the decisions in a command economy might give in to public pressure and produce saddle shoes, but it is their decision to make. In a market economy, or free enterprise system as it is sometimes called, it is likely that if consumers really want saddle shoes, they will get them.

A market, or free enterprise, economy is one in which the decisions of many individual buyers and sellers interact to determine the answers to the questions of What, How and Who.

In addition to buyers and sellers, there are several other essential elements in a market economy. One of these is private property. By "private property" we mean the right of individuals and business firms to own the means of production. Although markets exist in traditional and command economies, the major means of production (firms, factories, farms, mines, etc.) Are usually publicly owned. That is, they are owned by groups of people or by the government. In a market economy the means of production are owned by private individuals. Private ownership gives people the incentive to use their property to produce things that will sell and earn them a profit.

This desire to earn profits is a second ingredient in a market economy. Often referred to as the profit motive, it provides the fuel that drives sellers to produce the things that buyers want, and at a price they are willing to pay.

The profit motive also gives sellers the incentive to produce at the lowest possible cost. Why? Because lower costs enable them to (1) increase their profit margins, the difference between cost and selling price, or (2) reduce prices to undersell the competition, or (3) both.

Economists often compare markets to polling booths. However, unlike the booths in which people vote for politicians, markets provide a kind of economic polling booth for buyers to cast their votes (in the form of purchases) for the goods and services they want. Producers who interpret the votes correctly by producing the things that buyers demand can earn profits. Those who interpret the voting incorrectly, producing too much or too little, or charging a price that is too high or too low, do not earn profits. In fact, they often lose money.

As hundreds of thousands of followers of the And-So-Forths descended upon their local shoe stores in search of saddle shoes, the store managers did their best to find the hot new item. They did this because they knew that the sales of these shoes would add to their profits. Manufacturers soon learned about the calls for the new shoe style from their wholesale customers and did their best to satisfy the requests because they too were interested in profits.

Mixed Economies

What most distinguishes command economies from market economies is the role of government and the ownership of the means of production. We have seen that in command economies factories, farms, stores, and other productive resources are government owned. We have also noted that the economic questions of What, How, and Who are answered by government planners. In contrast, market economies look to the decisions of individual buyers and sellers to answer the same questions, and the means of production are privately owned. Government plays a relatively minor part in this model.

There are, however, no "pure" market economies in the world today. While we can say that markets account for most economic decisions in this country, government has been playing an ever-widening and important role. For example, 50 years ago, government purchased 15 percent of all American goods and services. It now purchases 20 percent.

This blend of market forces and government participation has led economists to describe our economic system and those of most other democratic countries as mixed economies.

Recent changes in the economies of the Soviet Union, China, and certain other communist countries, have served to bring elements of the market into those command economies. As the number of privately owned businesses has increased, economists have begun to refer to those nations as having “mixed economies.”

Positive and Normative Economics

In studying economics it is important to distinguish two branches of the subject. The first is known as `positive economics', the second as `normative economics'.

Positive economics deals with objective or scientific explanations of the working of the economy.

The aim of positive economics is to explain how society makes decisions about consumption, production, and exchange of goods. The purpose of this investigation is twofold: to satisfy our curiosity about why the economy works as it does, and to have some basis for predicting how the economy will respond to changes in circumstances. Normative economics is very different.

Normative economics offers prescriptions or recommendations based on personal value judgments.

In positive economics, we hope to act as detached scientists. Whatever our political persuasion, whatever our view about what we would like to happen or what we would regard as `a good thing', in the first instance we have to be concerned with how the world actually works. At this stage, there is no scope for personal value judgments. We are concerned with propositions of the form: if this is changed then that will happen. In this regard, positive economics is similar to the natural sciences such as physics, geology, or astronomy.

Here are some examples of positive economics in action. Economists of widely differing political persuasions would agree that, when the government imposes a tax on a good, the price of that good will rise. The normative question of whether this price rise is desirable is entirely distinct. Similarly, there would be substantial agreement that the following proposition of positive economics is correct: favorable weather conditions will increase wheat output, reduce the price of wheat, and increase the consumption of wheat. Many propositions in positive economics would command widespread agreement among professional economists.

Of course, as in any other science, there are unresolved questions where disagreement remains. These disagreements are at the frontiers of economics. Research in progress will resolve some of these issues but new issues will arise and provide scope for further research.

Although competent and comprehensive research can in principle resolve many of the outstanding issues in positive economics, no corresponding claim can be made about the resolution of disagreement in normative economics. Normative economics is based on subjective value judgments, not on the search for any objective truth. The following statement combines positive and normative economics: `The elderly have very high medical expenses compared with the rest of the population, and the government should subsidize health bills of the aged'. The first part of the proposition - the claim that the aged have relatively high medical bills - is a statement in positive economics. It is a statement about how the world works, and we can imagine a research program that could determine whether or not it is correct. Broadly speaking, this assertion happens to be correct. The second part of the proposition - the recommendation about what the government should do - could never be 'proved' to be correct or false by any scientific research investigation. It is simply a subjective value judgment based on the feelings of the person making the statement. Many people might happen to share this subjective judgment, for example those people who believe that all citizens alive today should be able to purchase roughly equal amounts of luxury and recreational goods after paying for the necessities of life. But other people might reasonably disagree. You might believe that it is more important to devote society's scarce resources to improving the environment.

There is no way that economics can be used to show that one of these normative judgments is correct and the other is wrong. It all depends on the preferences or priorities of the individual or the society that has to make this choice. But that does not mean that economics can throw no light on normative issues. We can use positive economics to spell out the detailed implications of making the choice one way or the other. For example, we might be able to show that failure to subsidize the medical bills of the elderly leads middle-aged people to seek a lot of unnecessary medical checkups in an attempt to detect diseases before their treatment becomes expensive. Society might have to devote a great deal of resources to providing check-up facilities, leaving less resources available than had been supposed to devote to improving the environment. Positive economics can be used to clarify the menu of options from which society must eventually make its normative choice.

Microeconomics and macroeconomics

Many economists specialize in a particular branch of the subject. For example, there are labor economists, energy economists, monetary economists, and international economists. What distinguishes these economists is the segment of economic life in which they are interested. Labor economics deals with problems of the labor market as viewed by firms, workers, and society as a whole. Urban economics deals with city problems: land use, transport, congestion, and housing. However, we need not classify branches of economics according to the area of economic life in which we ask the standard questions what, how, and for whom. We can also classify branches of economics according to the approach or methodology that is used. The very broad division of approaches into microeconomic and macro-economic cuts across the large number of subject groupings cited above.

Microeconomic analysis offers a detailed treatment of individual decisions about particular commodities.

For example, we might study why individual households prefer cars to bicycles and how producers decide whether to produce cars or bicycles. We can then aggregate the behavior of all households and all firms to discuss total car purchases and total car production. Within a market economy we can discuss the market for cars. Comparing this with the market for bicycles, we may be able to explain the relative price of cars and bicycles and the relative output of these two goods. The sophisticated branch of microeconomics known as general equilibrium theory extends this approach to its logical conclusion. It studies simultaneously every market for every commodity. From this it is hoped that we can understand the complete pattern of consumption, production, and exchange in the whole economy at a point in time.

If you think this sounds very complicated you are correct. It is. For many purposes, the analysis becomes so complicated that we tend to lose track of the phenomena in which we were interested. The interesting task for economics, a task that retains an element of an in economic science, is to devise judicious simplifications which keep the analysis manageable without distorting realm too much. It is here that microeconomists and macroeconomists proceed down different avenues. Microeconomists tend to offer a detailed treatment of one aspect of economic behavior but ignore interactions with the rest of the economy in order to preserve the simplicity of the analysis. A microeconomic analysis of miners' wages would emphasize the characteristics of miners and the ability of mine owners to pay. It would largely neglect the chain of indirect effects to which a rise in miners' wages might give rise. For example, car workers might use the precedent of the miners' pay increase to secure higher wages in the car industry, thus being able to afford larger houses which burned more coal in heating systems. When microeconomic analysis ignores such indirectly induced effects it is said to be partial analysis.

In some instances, indirect effects may not be too important and it will make sense for economists to devote their effort to very detailed analyses of particular industries or activities. In other circumstances, the indirect effects are too important to be swept under the carpet and an alternative simplification must be found.

Macroeconomics emphasizes the interactions in the economy as a whole. It deliberately simplifies the individual building blocks of the analysis in order to retain a manageable analysis of the complete interaction of the economy.

For example, macroeconomists typically do not worry about the breakdown of consumer goods into cars, bicycles, televisions, and calculators. They prefer to treat them all as a single bundle called 'consumer goods' because they are more interested in studying the interaction between households' purchases of consumer goods and firms' decisions about purchases of machinery and buildings.

Demand, Supply and the Market. The Role of the Market

Markets bring together buyers and sellers of goods and services. In some cases, such as a local fruit stall, buyers and sellers meet physically. In other cases, such as the stock market, business can be transacted over the telephone, almost by remote control. We need not go into these details. Instead, we use a general definition of markets.

A market is a shorthand expression for the process by which households' decisions about consumption of alternative goods, firms' decisions about what and how to produce, and workers' decisions about how much and for whom to work are all reconciled by adjustment of prices.

Prices of goods and of resources, such as labor, machinery and land, adjust to ensure that scarce resources are used to produce those goods and services that society demands.

Much of economics is devoted to the study of how markets and prices enable society to solve the problems of what, how, and for whom to produce. Suppose you buy a hamburger for your lunch. What does this have to do with markets and prices? You chose the cafe because it was fast, convenient and cheap. Given your desire to eat, and your limited resources, the low hamburger price told you that this was a good way to satisfy your appetite. You probably prefer steak but that is more expensive. The price of steak is high enough to ensure that society answers the 'for whom' question about lunchtime steaks in favor of someone else.

Now think about the seller's viewpoint. The cafe owner is in the business because, given the price of hamburger meat, the rent and the wages that must be paid, it is still possible to sell hamburgers at a profit. If rents were higher, it might be more profitable to sell hamburgers in a cheaper area or to switch to luxury lunches for rich executives on expense accounts. The student behind the counter is working there because it is a suitable part-time job which pays a bit of money. If the wage were much lower it would hardly be worth working at all. Conversely, the job is unskilled and there are plenty of students looking for such work, so owners of cafes do not have to offer very high wages.

Prices are guiding your decision to buy a hamburger, the owner's decision to sell hamburgers, and the student's decision to take the job. Society is allocating resources - meat, buildings, and labor - into hamburger production through the price system. If nobody liked hamburgers, the owner could not sell enough at a price that covered the cost of running the cafe and society would devote no resources to hamburger production. People's desire to eat hamburgers guides resources into hamburger production. However, if cattle contracted a disease, thereby reducing the economy's ability to produce meat products, competition to purchase more scarce supplies of beef would bid up the price of beef, hamburger producers would be forced to raise prices, and consumers would buy more cheese sandwiches for lunch. Adjustments in prices would encourage society to reallocate resources to reflect the increased scarcity of cattle.

There were several markets involved in your purchase of a hamburger. You and the cafe owner were part of the market for lunches. The student behind the counter was part of the local labor market. The cafe owner was part of the local wholesale meat market and the local market for rented buildings. These descriptions of markets are not very precise. Were you part of the market for lunches, the market for prepared food, or the market for sandwiches to which you would have turned if hamburgers had been more expensive? That is why we have adopted a very general definition of markets which emphasizes that they are arrangements through which prices influence the allocation of scarce resources.

The Market

We already defined markets in a very general way as arrangements through which prices guide resource allocation. We now adopt a narrower definition. A market is a set of arrangements by which buyers and sellers are in contact to exchange goods or services.

Some markets (shops and fruit stalls) physically bring together the buyer and the seller. Other markets (the London Stock Exchange) operate chiefly through intermediaries (stockbrokers) who transact business on behalf of clients. In supermarkets, sellers choose the price, stock the shelves, and leave customers to choose whether or not to make a purchase. Antique auctions force buyers to bid against each other with the seller taking a passive role.

Although superficially different, these markets perform the same economic function. They determine prices that ensure that the quantity people wish to buy equals the quantity people wish to sell. Price and quantity cannot be considered separately. In establishing that the price of a Rolls Royce is ten times the price of a small Ford, the market for motor cars simultaneously ensures that production and sales of small Fords will greatly exceed the production and sales of Rolls Royse. These prices guide society in choosing what, how, and for whom to purchase.

To understand this process more fully, we require a model of a typical market. The essential features on which such a model must concentrate are demand, the behaviour of buyers, and supply, the behaviour of sellers. It will then be possible to study the interaction of these forces to see how a market works in practice.

Demand, Supply and Equilibrium

Demand is the quantity of a good buyers wish to purchase at each conceivable price. Thus demand is not a particular quantity, such as six bars of chocolate, but rather a full description of the quantity of chocolate the buyer would purchase at each and every price which might be charged. The first column of Table 1 shows a range of prices for bars of chocolate. The second column shows the quantities that might be demanded at these prices. Even when chocolate is free, only a finite amount will be wanted. People get sick from eating too much chocolate. As the price of chocolate rises, the quantity demanded falls, other things equal. We have assumed that nobody will buy any chocolate when the price is more than ?0.40 per bar. Taken together, columns (1) and (2) describe the demand for chocolate as a function of its price.

Table. The demand for and supply of chocolate


(? / bar)


(million bars/ year)


(million bars/ year)

























Supply is the quantity of a good sellers wish to sell at each conceivable price. Again, supply is not a particular quantity but a complete description of the quantity that sellers would like to sell at each and every possible price. The third column of Table 2-1 shows how much chocolate sellers wish to sell at each price. Chocolate cannot be produced for nothing. Nobody would wish to supply if they receive a zero price. In our example, it takes a price of at least ?0.20 per bar before there is any incentive to supply chocolate. At higher prices it becomes increasingly lucrative to supply chocolate bars and there is a corresponding increase in the quantity of bars that would be supplied. Taken together, columns (1) and (3) describe the supply of chocolate bars as a function of their price.

Notice the distinction between demand and the quantity demanded. Demand describes the behaviour of buyers at every price. At a particular price such as ?0.30, there is a particular quantity demanded, namely 80 million bars/year. The term 'quantity demanded' makes sense only in relation to a particular price. A similar distinction applies to supply and quantity supplied.

In everyday language, we would say that when the demand for football tickets exceeds their supply some people will not get into the ground. Economists must be more precise. At the price charged for tickets, the quantity demanded exceeded the quantity supplied. Although the size of the ground sets an upper limit on the quantity of tickets that can be supplied, a higher ticket price would have reduced the quantity demanded, perhaps leaving empty space in the ground. Yet there has been no change in demand, the schedule describing how many people want admission at each possible ticket price. The quantity demanded has changed because the price has changed.

As in our discussion of tube fares in the previous chapter, we must recognize that the demand schedule relating price and quantity demanded and the supply schedule relating price and quantity supplied are each constructed on the assumption of 'other things equal'. In the demand for tube tickets, the 'other things' were the cost of alternative modes of transport. In the demand for football tickets, one of the 'other things' that is important is whether or not the game is being shown on television. If it is, the quantity of tickets demanded at each and every price will be lower than if the game is not televised. To understand how a market works, we must first explain why demand and supply are what they are. (Is the game on television? Has the ground capacity been extended by building a new stand?) Then we must examine how the price adjusts to balance the quantities supplied and demanded, given the underlying supply and demand schedules relating quantity to price.

Let us think again about the market for chocolate described in Table 1. Other things equal, the lower the price of chocolate, the higher the quantity demanded. Other things equal, the higher the price of chocolate, the higher the quantity supplied. A campaign by dentists warning of the effect of chocolate on tooth decay, or a fall in household incomes, would change the `other things' relevant to the demand for chocolate. Either of these changes would reduce the demand for chocolate, reducing the quantities demanded at each price. Cheaper cocoa beans, or technical advances in packaging chocolate bars, would change the 'other things' relevant to the supply of chocolate bars. They would tend to increase the supply of chocolate bars, increasing the quantity supplied at each possible price.

Supply, Demand and the Market Price

Earlier we learned that every society must provide answers to the same three questions: What goods and services will be produced? How will those goods and services be produced? Who will receive them? We also learned that different societies and nations have created different economic systems to provide answers to these fundamental questions. Traditional economies look to customs and traditions for their answers. Others, known as command economies, rely upon governments to provide the answers. In free enterprise systems, market prices answer most of the What, How and Who questions.

Prices in a Market Economy

Prices perform two important economic functions: They ration scarce resources and they motivate production.

As a general rule, the more scarce something is, the higher its price will be, and the fewer people will want to buy it. Economists describe this as the rationing effect of prices. In other words, since there is not enough of everything to go around, in a market system goods and services are allocated, or distributed, based on their price. Did you ever attend an auction or see one conducted on TV? What you saw was the rationing effect of prices in action. The person leading the sale (the auctioneer) offered individual items for sale to the highest bidder. If there was only one item, it went to the single highest bidder. If there were two items, they went to the two highest bidders, and so on.

Prices increases and decreases also send messages to suppliers and potential suppliers of goods and services. As prices rise, the increase serves to attract additional producers. Similarly, price decreases drive producers out of the market. In this way prices encourage producers to increase or decrease their level of output. Economists refer to this as the production-motivating function of prices.

But what causes prices to rise and fall in a market economy?


The Law of Demand. Demand is a consumer's willingness and ability to buy a product or service at a particular time and place. If you would love to own a new pair of athletic shoes but can't afford them, economists would describe your feeling as desire, not demand. If however you had the money and were ready to spend it on shoes, you would be included in their demand calculations.

The law of demand describes the relationship between prices and the quantity of goods and services that would be purchased at each price. It says that all else being equal, more items will be sold at a lower price than at a higher price.

Suppose that last April two of your friends developed their own special recipe for homemade ice cream, and they decided to sell ice cream cone to students every day after school. They conducted a survey to see if students were interested in the idea. Each student was asked the following question: “Would you spend $.50 to have an ice cream cone for an after-school snack?” This question was repeated using higher and higher prices up to $2 per cone.

The Demand Schedule. The results of the survey were assembled in a demand schedule, a table showing the quantities of a product that would be purchased at various prices at a given time.


Demand Schedule for Ice Cream Cones Near Your School, April 1

Price Per Cone

Quantity Demanded















Why Demand Behaves the Way It Does. The survey results illustrate the law of demand in action. As you can see, the number of ice cream cones that students were ready, willing and able to buy was greater at the lowest prices than at the higher prices. Demand behaves the way it does for some of the following reasons.

Ш More people can afford to buy an item at a lower price than at a higher price.

Ш At a lower price some people will substitute ice cream cones for other items (such as candy bars or soft drinks), thereby increasing the demand.

Ш At a higher price some people will substitute other items for ice creams.

Ш How many ice cream cones can you eat? Some people will eat more than one if the price is low enough. Sooner or later, however, we reach the point where enjoyment decreases with every bite no matter how low the cost. What is true of ice cream applies to most everything. After a certain point is reached, the satisfaction derived from a good or service will begin to diminish. Economists describe this effect diminishing marginal utility. “Utility” refers to the usefulness of something. Thus “diminishing marginal utility” is the economist's way of describing the point reached when the last item consumed will be less satisfying than the one before.

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