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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
COMPETITIVE MARKET
Large number of sellers and buyers (free
entry and exit)
Full information
Consumers maximise utility
Firms maximise profit
Flexible prices
THE MARKET SYSTEM
FOREIGN SECTOR
Product
FIRMS
Sell
goods
Buy
labour
Buy
goods
Labour
market
Invest in
capital
goods
Borrow
money
Capital
market
GOVERNMENT
Sell
labour
HOUSEHOLDS
market
Save
money
MARKET ECONOMY
TOTAL
ECONOMIC
ACTIVITY
FORMAL
ECONOMY
Nonmarketed
economic
activity
SHADOW
ECONOMY
Marketed
economic
activity
Marketed
economic
activity
TOTAL MARKET
ECONOMY
Nonmarketed
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
Table 1. Size of the shadow economy (% GDP)
Country
Austria
Belgium
Canada
Denmark
Germany
Greece
France
Ireland
Italy
Netherlands
Norway
Spain
Sweden
Switzerland
UK
USA
1990
1997
5
20
14
11
12
27
9
12
23
14
15
21
16
7
10
7
9
22
15
18
15
30
15
16
27
14
19
23
19
8
13
9
Source: F. Schneider, ‘The shadow economies of Western Europe’,
Economic Affairs, September 1997.
China
Illicit syphoning of funds from
projects and companies has amounted
to 13-16% of China’s GDP over the
past decade
Source: Asian Wall Street Journal, March 2001,
citing research of Professor Hu Angang, Qinghua
University
THE ROLE OF PRICES
 Price is determined by DEMAND
and SUPPLY
 Price as incentive
 Price as source of information
 Market equilibrium (D=S)
Price
THE ROLE OF PRICES
A
B
S
P1
PE
E
OPS
D
O
Q
QE
H
Quantity
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
SHIFTS IN DEMAND AND SUPPLY
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
“…..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 TAX
S1
Price
F
S
R
$2
PT
E
P
V
U
QT
Q
Quantity
Price
PRICE CEILING
S
E
PE
Ceiling
B
A
D
O
R
QE
Quantity
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 belowcost 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
mu > mc
S
per
unit
Cost of
production
R
Marginal
P
V
utility
mu = mc
PE
E
W
S
mu < mc
Utility
Marginal
D
cost
O
Q
QE
QT
Output
‘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
FIVE CONDITIONS FOR AN EFFECTIVE FREE
MARKET SYSTEM
 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
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?