Download 1 The U.S. Market System Every nation in the world must address

The U.S. Market System
Every nation in the world must address three economizing decisions: What to produce.
How to produce those goods. And for whom to produce goods. These economizing
decisions are addressed by each country's economic system of which there are several
different forms. However, we will minimize them to two: planned and market
economies.
Planned economies are characterized by centralized decision making and state ownership
of the means of production. This simply means that the government owns most, if not
all, of the major industrial plants and that pricing decisions are made by the central
planners and not determined by the costs of production.
Market systems, however, are characterized by private ownership of the means of
production, decentralized decision-making, unregulated prices and little interference by
government. In our course we will be concentrating on an examination of a market
system and how it attempts to resolve the three economizing decisions.
We all know that in general our market has two different groups, consumers and
producers, that are confronting one and another. The consumers' objective is to get as
much as he can at the lowest possible price. Producers', however, are trying to make as
much profits as possible without producing too much. Thus, there is an inherent conflict
that exists within our market economy that must be resolved, before either of these
groups can realize their objective.
Up to this point we have tried to use the concept of scarcity to set the foundation for our
study of the economy. With some minor modifications we can continue that analysis and
demonstrate how we as consumers behave. We have learned that indifference curve
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maps can be used to demonstrate the consumer's continual quest for more. However, as
consumers we must concede that the scarcity of resources rarely, if ever, enters our
minds. One thing, however, is scarce for us consumers and that is our income. We
would all eagerly consume more if only we had more money. I don't know about you but
every dollar I earn is spent on the goods that my family desires. Very simply my income
= the sum of the value of my purchases. Or in mathematical symbols Y0 = p1q1+ p2q2 .
This formula represents my budget constraint, it limits the amount that I can consume just
as scarcity does. In the formula “Y0” represents income (upper case Y always represents
income in economics). p1q1 represents the total amount spent on good q1, where p1
represents the price of good q1, and q1 represents the total units of q1 consumed.
Correspondingly, p2q2 represents the total amount spent on good q2.
In our market system we are actually using money as a rationing device, to allocate and
distribute our scarce resources as efficiently as possible. Our resources go to those who
have the willingness and ability to purchase the resources at their market price.
Therefore to improve our model of consumer behavior we can add this budget constraint
and thus make our model more realistic.
Consumer behavior can also be explained by just watching what they do to maximize
their limited incomes. If the consumer is going to be consistent with our basic
observation #1, that is want more, then he must find ways to accomplish that with his
given income. The way we do this, of course, is by engaging in comparative shopping.
We will tend to buy more goods when their price is low than when it is high. This very
simple observation is known as the Law of Demand in economics. This law states: that
there is a negative relationship between price and quantity demanded.
This can be further illustrated by a demand schedule. A demand schedule is
nothing more than a series of prices and quantities at which demand exists. It looks like
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this:
Price
Quantity
$10
1
9
2
8
3
7
4
6
5
But what do we mean by "when demand exists"? For demand to exist certain
preconditions must be met. The product we are viewing must satisfy our tastes and or
desires; we must have the ability to purchase it; and the willingness to reach deep into our
pockets pull out the money and hand it over to the owner of that product to gain
possession. For demand to exist all of these preconditions must be met.
Now we can take the values from the demand schedule and convert them to a
graph that illustrates a demand curve. Demand curves are simply downward sloping lines
to the right and they look like this:
This demand curve tells us how much demand will exist for a certain product at
various prices. The curve represents the level of demand that will exist at some instant in
time, therefore, several assumptions are made about that time period:
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First, we assume that income will remain constant throughout the range of the curve.
This assumption must be made because the demand we exert is a result of our budget
constraint.
Second, we assume that our tastes and desires for this product are constant during this
time.
Third, that prices of all related goods will be held constant.
Finally, that our expectations of future prices remains constant.
Now there are two more things in regard to demand curves that we should be aware of.
The first is what economists call changes in quantity demanded. When such a change
occurs it is illustrated by a movement along the demand curve. As we have already
learned, movements along curves are accomplished by a change in an endogenous
variable. In this case price is the endogenous variable that is most likely to change and
cause consumers to increase the quantity of their purchases.
Changes in demand meanwhile are illustrated by a shift of the demand curve. Shifts we
have learned are caused by changes in one or more of the exogenous variables that affect
the curve. Thus, the shift will be in the direction of the change of the exogenous
variables in question.
Consumers represent only one side of the action that takes place in the market. Another
group called producers also plays an active and obviously important role. In general we
can say that the producers' goal is to make as much as they can possibly can. Make as
much money that is. There is a number of ways that this goal can be satisfied, but, the
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easiest way is to continually raise the price of their product as the consumer seeks to
consume more. This behavior is what we economists call the law of supply. The law of
supply states that there is a positive relationship between price and quantity supplied.
Again this law can be demonstrated by constructing a supply schedule. In this case a
supply schedule is a series of prices and quantities at which supply exists. It looks
like this:
Price
Quantity
$1
1
2
2
3
3
4
4
From this supply schedule we can construct a supply curve that looks as follows:
Notice that every combination of points on this curve obey the law of supply. We
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should also note that a number of assumptions are implied throughout the range of this
curve:
The first is that the costs of production (wages, machinery, raw materials) will remain
constant throughout the range of the curve.
Second future prices are assumed to be constant. That is they are not expected to change
during the time of this supply curve.
Third, the demand for all other goods is assumed to be constant.
Now with these supply curves we must be able to make the same distinctions as we did
with demand curves. Changes in quantity supplied occur when an endogenous
variable, such as price, changes. This change will be illustrated by a movement along the
curve. Changes in supply meanwhile are caused by changes in exogenous variables and
are illustrated by shifts in the curve.
Construction of the laws of supply and demand have provided a convenient method to
present the objectives of both the consumer and producer. Once present it becomes
obvious that a conflict is unavoidable. The consumer wants as much as he can possibly
get, at the lowest possible price; and, the producer wants to charge as much as possible,
to make more money. These two, incompatible forces must be resolved in our market
system. To demonstrate how this is done we construct both the supply and demand
curves on one graph. It looks like this:
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On this graph what is happening at price P1?
S
P1
D
Q
Well, reading across we find that at this comparatively high price the quantity demanded
is low, while the quantity supplied is high.
S
P1
D
Q
When the quantity supplied exceeds the quantity demanded a situation known as a
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surplus exists.
surplus
S
P1
D
Q
For the producer this means that his products are sitting on the shelves and are not,
therefore, earning him money. Therefore, the producer will begin to lower his price.
Suppose that the producer, in this case lowers his price to P2 what happens.
P1
S
P2
D
Q
Well at P2, which is a comparatively low price, the producer is willing and able to supply
a few units but the consumer wants many units. In this case the quantity demanded
exceeds the quantity supplied, at that price, and so a shortage exists.
P1
S
P2
shortage
D
Q
But, that low price attracted many consumers toward your product. Once that desire for
the product is established the consumer will do almost anything to obtain it. For example
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they may even begin to bid against each other by offering you higher and higher prices
for your product.
Shortages and surpluses will cause movements along the respective supply and demand
curves until a state of balance is reached. This state is known as an equilibrium.
P1
S
Equilibrium
P2
D
Q
We can demonstrate the time and movements that are required to reach equilibrium by
taking a look at the Green revolution and the Soviet Wheat Deal.
Back in the 1960's the U.S. was producing a wheat surplus. This surplus was used to
satisfy Asian and African countries need for food. Thus, this foreign demand for food, in
addition to the domestic demands, shifted the demand curve for wheat outward to the
right. As a result the market clearing price for wheat rose. This relatively high price
encouraged farmers to grow more which in turn created a bigger surplus allowing the
U.S. to feed even more people.
The scientific community, however, began to express some concern about what the U.S.
was doing, with the fear that domestic crop failures had the potential to affect millions of
people in other countries. To protect themselves from starvation it was thought essential
that they take the appropriate steps to increase their domestic food production. This
increase in food production was known as the Green Revolution.
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The revolution consisted of providing food poor nations with advanced agricultural
techniques, development of hybrid plants, and the technical expertise to transform their
traditional farming methods to those that are more productive. Unfortunately all of the
techniques that were necessary required tremendous energy sources that prevented this
transformation from being successful.
In the 1970's European and Asian crops failed once again causing an increased demand
for U.S. wheat. (Is this a ∆ in demand or a ∆ in quantity demanded?) As a result wheat
prices rise. With wheat prices rising farmers are being encouraged to produce more
wheat and therefore less of other grains can be produced.
In 1973 the Soviet Union's wheat crop fails and they turn to the U.S. for help. President
Nixon agrees to sell USSR several million metric tons of wheat. Will this represent a ∆
in demand or a ∆ in quantity demanded. Again wheat prices rise.
With wheat prices now at historic high levels domestic consumers seek other alternatives
such as corn or soybeans. This leaves less corn and soybeans available for livestock and
so the cattle ranchers respond by decreasing the size of their herds. This change in
supply shifts the supply curve to the left and thus market clearing prices rise.
Now there are times when the market price proves to be too high for society and
government then intervenes. Take the case of rent control in New York City. High rental
prices were preventing the middle class and poor to afford housing in the city so
government intervened passing what is known as a price ceiling to legally mandate lower
prices. This legally mandated price would force the market price lower than the
equilibrium. Now we have learned that good policy-makers must consider the secondary
effects, so can you think of any consequences to the imposed rent control?
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The major consequence is that a shortage of rent controlled apartments would arise. This
leads to the next problem of “black market” creation. When the shortage is apparent,
consumers will begin to bid prices upward. But by law the rental price is fixed at some
price, so to secure an apartment the consumer would have to agree to pay the owner
additional money “under the table”.
Other times producers feel the market price is too low and they lobby government for
help. In this case the government legislates price floors. A price floor is the minimum
legal price as legislated by government. A good example of this is the dairy industry.
Dairy farmers argued that due to the high level of competition they were making very
low profits. So they convinced government to impose a price floor so higher profits
could be enjoyed. When this is done government is also forced to purchase any goods
the consumer fail to buy, to ensure that the price floor is maintained. Producers, knowing
that they have a customer that will buy everything that is produced are inclined to
produce more and more milk. Once again there is a secondary effect realized, can you
see it?
The consequence here is that government is now stuck with large volumes of a product
with a very short shelf life. So government must build refrigeration for the milk, and then
convert the milk to cheese to extend its shelf life. Ultimately the tax payers must foot the
bill, while the dairy farmers enjoy higher profits.
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