Transcript The Working of Free Markets

Chapter 3 –
Free Markets at Work
Free markets – how choices of
consumers and firms become trade
and transactions.
Modeling behavior in a free market:
Demand and Supply.
 What a free market does effectively,
and what it can’t do.
How free markets can get messed up.
Essentials of a Free Market
Consumers -- choosing a variety of goods
and services based upon maximizing utility
subject to the budget constraint.
Firms -- specialization into producing
different types of goods, based upon
maximizing profits.
A high degree of competition among
different firms producing the same good,
with no single firm having an advantage over
another firm in the industry (Perfect
Competition).
More Essentials
of a Free Market
A price for a good or service which is
known to buyers and sellers.
Mutually Beneficial Exchange – trade
or purchasing something takes place
only if it serves to benefit both the
buyers and the sellers.
Applications: buying goods, hiring
labor, world trade.
The Role of
Money in Free Markets
Money – primary role is as a
Facilitator of Trade, to serve as a
lubricant to make trade take place
as smoothly as possible.
“Engine Oil” to the engine of trade
in free markets.
Specific Roles of Money
as a Facilitator of Trade
Medium of Exchange -- Money is
exchanged for goods and services.
Standard of Value -- Value is
measured in dollars (the “price
tag”).
Store of Value -- People can use
money when they wish, present
versus future.
Modeling the Free Market:
Demand and Supply
Every good or service (e.g. coffee) has
consumers who wish to buy it
(Demand), along with firms who wish to
sell it (Supply).
A theory and model which predicts:
(1) how much of the good will
ultimately be sold, (2) the price it will
sell for, and (3) how these conditions
change due to specific events.
Demand
Demand, or Quantity Demanded,
(QD) -- the amount of a given good
or service (e.g. coffee) that one or
more people intend to purchase.
Demand for Coffee: Causes
The Price of Coffee (P)
P (ceteris paribus)  QD
A Whole Bunch of Other Causes
(e.g. Tastes)
Tastes (ceteris paribus)  QD
Formalizing the
Theory of Demand
Graph QD versus one of its causes
-- the price of coffee (P).
Inverse relationship implies that
the curve is downward sloping.
Changes in P are described as a
movement along the curve.
Graph is drawn assuming that
Tastes (and any other causes) are
constant (ceteris paribus).
Describing Changes in One
of the “Other Causes”
A Change in Tastes (or a change in
any cause other than the price) is
described by a shift of the Demand
curve.
Contrast this with a change in P -movement along the curve.
Different descriptions occur only
because P is the cause that
appears on the graph.
Shifting the Demand Curve
A change -- other than P -- that
makes QD increase is described as
a rightward shift of the curve, or an
Increase in Demand.
A change -- other than P -- that
makes QD decrease is described
as a leftward shift of the curve, or
a Decrease in Demand.
Supply
Supply, or Quantity Supplied, (QS)
-- the amount of a given good or
service (e.g. coffee) that firms
intend to produce and sell.
Supply of Coffee -- Causes
Price of Coffee (P)
P (ceteris paribus)  QS
A Whole Bunch of Other Causes
(e.g. Price of Energy)
Price of Energy
(ceteris paribus)  QS
Formalizing the
Theory of Supply
Graph QS against one of its
causes -- the price level (P).
Positive relationship implies that
the curve is upward sloping.
Changes in P are described as a
movement along the curve.
Graph is drawn assuming that the
Price of Energy and all other
causes are constant.
Describing Changes in One
of the “Other Causes”
A Change in the Price of Energy
(or a change in any cause other
than the price) is described by a
shift of the Supply curve.
Contrast this with a change in P -movement along the curve.
Different descriptions occur only
because P is the cause that
appears on the graph.
Shifting the Supply Curve
A change -- other than P -- that
makes QS increase is described as
a rightward shift of the curve, or an
Increase in Supply.
A change -- other than P -- that
makes QS decrease is described as
a leftward shift of the curve, or a
Decrease in Supply.
Equilibrium:
The Market in Action
Equilibrium (P* and Q*) -- The
values where the price of coffee
and quantity traded of coffee will
ultimately settle, given that the
strategies of demands and
suppliers play out.
Properties of Equilibrium
If the price of coffee is anywhere other
than P*, natural market forces bring it
to equilibrium.
If P > P*, there exists excess supply,
and pressure for the price to fall.
If P < P*, there exists excess demand,
and pressure for the price to rise.
More
Properties of Equilibrium
P*and Q* represent the price and
quantity traded as predicted by the
theory and model.
In general, we observe the
equilibrium.
Shifts in either the Demand or
Supply curves change the
equilibrium.
Shifts and Changing the
Equilibrium -- Applications
Example 1 – Coffee is found to be more
attractive to drink (e.g. medical
finding), which affects Tastes.
Tastes  QD
Increase in Tastes increases QD,
described by shifting the Demand
curve rightward.
Draw the picture and evaluate the
answer.
Another Application
Example 2 -- The price of energy
(PE) increases.
PE hinders production, therefore
reduces QS.
This behavior is described as a
leftward shift of the Supply curve.
Draw the graphs and evaluate.
Demand and Supply in a
Competitive Economy
In an economy with perfect
competition throughout:
There exists a market, i.e, Demand
and Supply, for each good and
service.
There exists a market, i.e. Demand
and Supply, for each factor or input
(labor, materials, physical capital)
used to produce each good or
service.
The Circular Flow
Consumers – Demand goods and
services, Supply inputs (e.g. labor).
Firms – Supply goods and services,
Demand inputs (e.g. labor).
The Circular Flow – the web of
connections between the various
goods and input markets in the
economy that determine quantities
traded and prices, connected by
income generated by production and
used for purchasing.
General
Competitive Equilibrium
General Competitive Equilibrium
(GCE)– the situation in which all
perfectly competitive markets are in
equilibrium simultaneously.
Most efficient, optimal type of overall
economy, specifics later.
Very possible to have economy in
general equilibrium without GCE, suboptimal with distortions.
The “Nice Assumptions”
 The “Nice Assumptions” – ideal
conditions in all markets that lead
to General Competitive
Equilibrium.
1. No Market Power.
2. No Market Failure.
Nice Assumption #1 -No Market Power
No Market Power -- advantages in
the market are transitory and can
be eliminated by competition.
-- equal access to information
-- equal access to markets
Nice Assumption #2 -No Market Failure
No Market Failure -- markets form
quickly and function smoothly and
efficiently to coordinate choices of
individuals and firms.
-- markets form quickly when
needed
-- markets function smoothly and
efficiently to coordinate choices
The Roles of Government in
a Free Market Economy
Try to eliminate market power when it
exists -- enforce laws.
Try to eliminate market failure when it
exists -- regulate externalities, provide
for public goods.
Above are ideal roles. In practical
terms, how much should government
to intervene, possibly create additional
distortions?