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Chapter 2
HOW A MARKET ECONOMY
WORKS: THE PRICE SYSTEM
1. Markets and Business
Organizations
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Markets bring buyers and sellers together
for the purpose of determining conditions of
exchange, such as quantities of purchase and
prices.
Wide variety of markets exists, small and
large, distant or close.
Visual markets bring buyers and sellers
together in cyber space via personal
computers.
1.1 Forms of Businesses
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Sole proprietor
Partnership
Corporation
1.1.1 The Sole Proprietorship
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The sole proprietorship is owned by one
individual who makes all the business
decisions, receives all the profits, and bears
sole financial responsibility.
Minimal legal work is required to set it up.
The proprietor is responsible for deciding who
should be hired, what products to produce,
how much to advertise, and where to locate.
1.1.2 A Partnership
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A partnership is owned by two or more
partners who make all the business decisions,
share the profits, and bear financial
responsibility jointly.
Partnerships are based on agreements that
spell out ownership shares and the duties of
each partner.
Partners may contribute equal or different
amounts of financial capital; one partner may
specialize in finance, another in sales.
1.1.3 A Corporation
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A corporation is owned by stockholders; it is
authorized by law to act as a legal person.
The stockholders elect a board of directors,
which appoints the management.
Management carries out the actual operation
of the corporation.
If the corporation cannot pay its debts, the
shareholders are not personally liable for
these debts.
1.1.3 A Corporation – cont.
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A corporate charter is required to set up a
corporation, which is then incorporated in a specific
state and becomes a legal person, subject to the
laws of that state.
A stockholder’s share of the corporation equals the
number of shares he or she owns divided by the total
number of shares outstanding.
Unlike the sole proprietor and partner, there is usually
a separation of ownership and management.
(A Profile of American Business example)
1.1.4 Property Rights
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In a capitalist society, most property and
business are owned by private individuals
who exercise property rights.
Property rights are the rights of an owner
to use and exchange property.
Private property rights ensure that owners
will use private property to maximum
personal advantage. In the case of privately
owned businesses, private property rights will
be exercised to maximize profits.
2. The Circular Flow of
Economic Activity
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Economic activity is circular.
Households buy goods and services
(G&S) with the incomes they earn by
furnishing labor, land, and capital to
business firms.
The money spent by households comes
back to them as income from the sale
of the factors they own.
2.1 The Circularity of
Economic Activity
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The circular-flow diagram summarizes the
flows of G&S from enterprises to households
and the flows of the factors of production
from households to business firms.
The outer circle shows the physical flows of
G&S and productive factors; the inner circle
shows the payments for G&S and for
productive factors.
2.1 The Circularity of
Economic Activity – cont.
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The flows between households and
firms are conducted through two
markets:
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Product markets are markets in which
G&S are bought and sold.
Factor markets are markets in which the
factors of production are bought and sold.
2.2 Intermediate Goods
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The circular-flow diagram captures the movements of
G&S to households
A large number of transactions take place within the
business sector as firms exchange intermediate
goods (e.g. steel, plastic products).
Although intermediate goods do not enter the
circular flow, they affect the flows between
businesses and households.
The efficiency with which the business sector uses
intermediate goods determines the size of the flows
of G&S to households.
2.3 Household Production
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G&S produced and used within the
household also do not enter the circular
flow.
Homemakers provide cooking, cleaning,
etc. to other family members.
3. The Price System
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The circular-flow diagram brings home
economic interdependency.
Complex flows of intermediate goods
take place within the business sector.
Will there be chaos and anarchy?
Market allocation systems use relative
prices and private property rights to
solve the resource allocation problem.
4. Relative Prices
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The price system (relative prices not money
prices) solves the economic problems of
what, how and for whom.
A money price is a price expressed in
monetary units (such as dollars, yen, pesos).
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Money prices do not play a meaningful role in
resource allocation because they do not provide
information on what goods are “cheap” or
“expensive.”
A relative price is a price expressed in
terms of other commodities.
4. Relative Prices – cont.
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The price system is the entire set of
millions of relative prices.
Relative prices are constantly changing
and can move in directions opposite to
the general level of money prices.
Changes in relative prices provide
important signals (Fall of autos prices;
and fall of cell phone price in 2000s)
4.1 The Principle of
Substitution
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A relative price is the ratio of two money prices
(white bread = $2; wheat bread = $1; then white
bread is twice as expensive as wheat bread.)
Consumers and producers substitute or trade off one
good for another as relative prices change.
The principle of substitution states that we
substitute one good for another as relative prices
change.
Virtually no good is fully protected from the
competition of substitutes (aluminum competes with
steel, etc.)
4.1 The Principle of
Substitution – cont.
The only goods that are impervious to
substitutes are goods as minimal quantities of
water, salt, and certain lifesaving medication.
(Substitutes and how we communicate
example.)
 Relative prices signal users to make
substitutions.
 Rising relative prices motivate us to seek out
substitutes. If the price of one good rises
relative to its substitute, users switch to
relative cheaper substitutes.
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4.2 Equilibrium and the
Invisible Hand
“Every individual endeavors to employ his capital so
that its produce may be of greater value. He
generally neither intends to promote the public
interest, nor knows how much he is promoting it. He
intends only his own security, only his own gain. And
he is led by an invisible hand to promote an end
which was no part of his intention. By pursuing his
own interest he frequently promotes that of society
more effectively that when he really intends to
promote it.” – Adam Smith The Wealth of Nations
(1937)
4.2 Equilibrium and the
Invisible Hand – cont.
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The invisible hand states that a
capitalist economy can function well
without government direction by using
the signals of the price system.
The millions of relative prices that make
up the price system inform buyers and
sellers what goods are cheap and what
goods are expensive.
4.2 Equilibrium and the
Invisible Hand – cont.
As businesses use this information to gain
profits and buyers use this information to
determine their best buys, the economy runs
itself without direction or planning from the
government.
 The equilibrium price is that price at which
the amount of the good people is prepared to
buy equals the amount offered for sale.
(Equilibrium in Electricity Market example)
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4.3 The Price System and
“What”, “How” and
“From Whom”
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No individual is required to be concern about
the economy as a whole; the price system
solves what, how and for whom by itself.
Government is not required to coordinate
economic activities, some government actions
such as price control can interfere with the
market’s check and balances.
4.3.1 “What”
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The what problem is solved by
consumers and producers responding to
relative prices.
The dollar votes cast by consumers
determine what is produced.
Dollar votes show the willingness of
people to buy particular goods at
specified prices
4.3.2 “How”
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The price system solves the how problem
through relative price signals.
Business firms produce goods by combining
resources in the least costly way.
If business firms fail to use lowest-cost
combinations, the competition of other firms
will reduce their profits and, possibly, drive
them out of business.
4.3.3 “From Whom”
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The market assigns relative prices to the
resources owned by each household.
The distribution of income among households
depends on the relative prices of the factors
of production and on the distribution of
property rights to scarce land, labor and
capital.
For example, people who are fortunate
enough to be able to provide high-priced
labor services (brain surgeons) receive a
large share of output and visa versa.
4.4 Imperfections: Public
Goods and Externalities
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The invisible hand has imperfections. The
price system does not guarantee a
satisfactory solution for the for whom
problem.
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It may lead to an unfair distribution of income
It may not work well when firms gain monopoly
control over markets.
It may also fail to deal with externalities, such as
pollution.
It may produce business cycles—booms and busts
of employment and inflation.
4.4 Imperfections: Public Goods
and Externalities –cont.
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Laissez-faire is the doctrine that the government
should limit its activities to essential state functions,
such as national defense, a legal system, public
roads, and police protection.
Public goods are characterized by two features:
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More can be consumed by one consumer without less being
available for other consumers, and
Non-payers cannot be excluded from using the product.
These two features make it difficult for private
markets to provide public goods. There is no
incentive to “pay one’s share” voluntarily as public
goods cannot be sold.
4.4 Imperfections: Public Goods
and Externalities –cont.
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One solution is for the government to provide such
goods, paying for them with tax returns.
Another problem with invisible hand is that we
impose external costs on others that are not reflected
in our private economic calculations.
An external cost is an unpriced cost that is imposed
on others (Pollution of river by upstream factory.)
Government programs must ensure that those who
impose these external costs include them as part of
their private calculations.