Chapter 2 How a Market Economy Works: The Price System

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1 Chapter 2 How a Market Economy Works: The Price System After reading Chapter 2, HOW A MARKET ECONOMY WORKS: THE PRICE SYSTEM, you should be able to: Explain what is meant by a Market Explain the differences between Sole Proprietorships, Partnerships, and Corporations. Define Property Rights and explain how these rights lead to an efficient use of resources. Explain the interactions between households and firms illustrated by the circular flow diagram. Define the terms Relative Price, Price System and the Principle of Substitution. Discuss the themes behind Adam Smith s Invisible Hand and relate the invisible hand to the price system and equilibrium. Explain how the price system solves the economic problem of what, how, and for whom. Discuss some imperfections of the invisible hand mechanism. Define a Public Good and explain why both features of a public good are important. Define External Cost and provide some examples. Outline I. Markets and Business Organizations A Market brings buyers and sellers of a good together to determine conditions of trade, such as the price and quantity sold. A Virtual Market brings buyers and sellers together in cyberspace. A) The three forms of business organization are: 1. Sole Proprietorship: a business owned and run by an individual who makes all the decisions and receives all the profits or losses. 2. Partnership: a business owned and run by two or more people who share in all the profits or losses. 3. Corporation: a business with the legal status of an individual, owned by many shareholders, who share in the profits but have limited liability for any losses. This type of business is frequently run by professional managers. B) Property Rights are the legal rights of owners to use or trade their property as they desire. Private owners are guided by relative prices to use their property in such a way as to maximize their personal advantage.

2 Chapter 2 How a Market Economy Works: The Price System 13 III. The Circular Flow A) Business firms use inputs, provided by households, to produce products to supply to households. Firms pay money for the use of the inputs and receive money from the sale of their output. B) Households use the income earned from providing productive factors to business firms in order to purchase products from firms. Households receive money for the use of their productive factors, and they pay money to purchase products. C) The circular flow only shows the flow of final goods and services. Intermediate Goods and Household Production do not enter the circular flow. IV. The Price System A) Relative Prices 1. A Relative Price is a price expressed in terms of other commodities. 2. A Money Price is the price of a product expressed in monetary units. Money prices do not really tell us whether a good is cheap or expensive. If the money price of a movie ticket is $10.00 and the money price of renting a DVD is $5.00, then the relative price of a movie ticket is 2 DVD rentals. B) Principle of Substitution states that consumers will substitute one good for another as relative prices change. If the price of a good increases relative to its substitutes, consumers will switch to the relatively cheaper goods. If the price of a movie ticket increases to $15, its relative price is now 3 DVD s. Consumers will have an incentive to substitute DVD s for movie tickets. C) Equilibrium and the Invisible Hand The Invisible Hand states that a capitalist economy can function well without government direction by using signals of the price system. Buyers and sellers base their decisions on the relative prices contained in the price system. 1. If more of a product is produced than the amount consumers wish to buy, then its relative price falls. As the relative price falls, the amount produced decreases, while the amount demanded increases. This eliminates any surplus. Likewise, if consumers wish to buy more of a product than firms produce, then its relative price rises. This will eliminate any shortage. 2. The invisible hand drives prices to their equilibrium levels. The Equilibrium Price is that price at which the amount of the good people are prepared to buy equals the amount offered for sale. D) What, How and for Whom are three questions solved by the price system. 1. What: What goods and services are produced will depend on the relative price consumers are willing to pay. Dollar Votes show the willingness of people to buy particular goods at specified prices. Holding costs the same, firms will produce goods with high relative prices. 2. How: Firms produce goods using the lowest cost combination of inputs and will substitute one input for another when their relative prices change. 3. For Whom: People with high priced resources consume many goods and services; people with low priced resources consume fewer goods and services.

3 14 Gregory Essentials of Economics, Sixth Edition V. Imperfections: Public Goods and Externalities A) One policy conclusion of the invisible hand is Laissez-Faire: the doctrine that the government should limit its activities to essential state functions. There are situations when the invisible hand will not work well and government intervention may be necessary. B) Public Goods, such as national defense, have two features. 1. More can be consumed by one consumer without less being available for other consumers. 2. Nonpayers cannot be excluded from using the product. 3. Therefore, consumers have no incentive to pay for the good and private markets will not provide them. C) An External Cost, such as pollution, is an unpriced cost that is imposed on others. If these external costs are not accounted for too much output will be produced. Review Questions True/False If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question give a short statement that supports your answer. 1. Households supply labor to businesses and demand goods and services from businesses. 2. Firms buy land, labor, and capital from households and provide goods and services for households to purchase. 3. Households receive money in the form of wages from business firms and spend this money by purchasing goods and services from the firms. 4. Computer chips purchased by IBM from Intel are an example of an intermediate good. 5. Shareholders of corporations have limited liability for the debts of the company. 6. Money prices play a key role in determining resource allocation. 7. Adam Smith s idea of an invisible hand guarantees that an economy settles upon the most equitable division of income. 8. It is possible for a good s relative price to fall while its money price rises. 9. The principle of substitution suggests consumers buy more goods whose relative prices rise, since these goods must be high quality items. 10. Property rights involve the rights of owners of real estate but have nothing to do with the rights of factory owners.

4 Chapter 2 How a Market Economy Works: The Price System Shareholders in large corporations often play major parts in running the business. 12. Each partner in a partnership is liable for any losses or debts of the company. 13. One characteristic of a public good is that free riders cannot easily be excluded. 14. In all markets, the actual buyer and seller must meet face-to-face. Multiple Choice Questions Circle the letter corresponding to the correct answer. 1. An equilibrium price is established when (a) the number of sellers equals the number of buyers. (b) everyone who wants the good gets it. (c) sellers are unable to sell any more of the good. (d) buyers cannot find sellers willing to sell to them. (e) none of the above. 2. Which of the following is not a possible imperfection in the operation of the invisible hand and the price system? (a) The fact that most people work for business firms rather than being self-employed (b) The possibility of a highly unfair distribution of income (c) The presence of economy-wide business cycles (d) The chance that one firm could gain control over an entire market (e) The possibility that the price system cannot supply public goods 3. Not shown in the circular-flow diagram is the flow of (a) factors of production from households to businesses. (b) goods from businesses to households. (c) wage payments from businesses to households. (d) payments for goods and services from households to businesses. (e) none of the because all these flows are shown in the circular flow diagram. 4. The principle of substitution suggests that (a) every individual endeavors to employ his or her capital so that what it produces has the greatest value. (b) prices will always be equilibrium prices. (c) no single person need know all prices to function in daily economic life. (d) users are usually able to switch from one good to another as relative prices change. (e) changes in relative prices signal what goods are cheap and what goods are expensive.

5 16 Gregory Essentials of Economics, Sixth Edition 5. How does the price system solve the how problem of resource allocation? (a) Business firms use the principle of substitution and seek the least-cost combination of productive factors. (b) Consumers tell business firms how to produce the goods. (c) Business firms always use the highest quality productive factors to manufacture their products. (d) Government actions tell firms how to produce their products. (e) None of the above. 6. Which of the following is a relative price? (a) a price of 15,000 dollars for a Honda Civic (b) a price of 4 food processors for a microwave oven (c) a wage of 15 dollars per hour (d) a price of 2000 yen for a steak dinner (e) none of the above 7. Which of the following is an example of a public good? (a) A municipal sewer system (b) Government provided flood insurance for people living in a flood prone area (c) The public school system (d) National defense (e) All of the above 8. An example of a good where one person s benefits from the good does not interfere with another is (a) a crowded movie theater. (b) a bushel of wheat. (c) an uncrowded movie theater. (d) free medical care provided by Medicaid. (e) gasoline. Essay Questions Write a short essay answering each question. 1. Suppose the price of gold is 400 dollars per ounce and the price of silver is 10 dollars per ounce. What is the relative price of gold? If the dollar price of gold and silver both rise 10 percent, what would be the relative price of gold? Suppose from the initial prices, the money price of gold rises 10 percent while the money price of silver did not change. What would be the relative price of gold? 2. Is it possible for the relative price of a good to fall while its money price rises? If so, give a numerical example. 3. Describe how a market based economy solves the what problem of resource allocation. Be sure to discuss the role played by property rights and relative prices. 4. Discuss how the price system solves the what problem when consumers change their desires and want more of a particular good. Mention the roles played by the invisible hand and equilibrium prices. 5. Describe how the price system solves the for whom problem. What issues can arise with regard to this solution?

6 Chapter 2 How a Market Economy Works: The Price System Market allocation cannot be desirable, for it forces firms to produce things as cheaply as possible. Obviously no one wants only cheap and poorly produced goods. Comment on this. 7. Is turkey at 40 cents per pound a good buy? 8. What is limited liability? What business organization enjoys limited liability? 9. Why is it that we pay realtors 6 percent commissions or buy our used textbooks from the college bookstore at a high markup when we could buy at lower prices from the immediate sellers? 10. Is mail delivery a public good? Answers to Review Questions True/False 1. True. This is an example of the circular flow: households participate in both the factors market and the goods market. 2. True. This is another example of the circular flow of services and goods. 3. True. This is an example of the circular flow of money. Business firms and households are linked firmly together through the circular flow. 4. True. Intermediate goods are items purchased by a business firm for use in another product. In other words, intermediate goods are components of the final goods ultimately produced and sold. 5. True. This is the major advantage of the corporate form of business organization. 6. False. Relative prices, not money prices, play the important role. 7. False. One of the problems of allowing the price system to work without any checks from the government is that the resulting distribution of income may be deemed unfair. 8. True. If a good s money price rises less rapidly than the money prices of other goods, its relative price falls. 9. False. The principle of substitution says consumers buy fewer goods whose relative prices rise. 10. False. Property rights are the rights owners have with respect to all kinds of property. 11. False. Professional managers typically control the day-to-day activities of the business. 12. True. This is a drawback to the partnership as a method of business organization. 13. True. Public goods have high exclusion costs; it is hard to exclude people who want a free ride. 14. False. The stock exchange, where stock brokers act as agents, is an example of a market where the actual buyers and sellers rarely meet.

7 18 Gregory Essentials of Economics, Sixth Edition Multiple Choice Questions 1. (e) The equilibrium price is that price at which the number of goods producers wish to sell just equals the number demanders want to purchase. 2. (a) People working for business firms is a reflection of specialization and not an imperfection of the invisible hand. 3. (e) The circular-flow diagram illustrates the linkages between firms and households. 4. (d) This is the definition of the principle of substitution. 5. (a) If a firm does not use the least-cost method of production, ultimately it will be driven from business by firms that do and are therefore able to under-cut the original firm s price. 6. (b) This gives the price of one good (a microwave oven) in terms of another type of good (food processors). All the other prices are in terms of a monetary unit. 7. (d) It would be easy (though perhaps undesirable) to exclude nonpayers from a sewer system, flood insurance, or school system. Thus, although the government frequently provides all the goods listed in the question, only national defense meets the nonexclusion characteristic of a pure public good. 8. (c) Only in this case does one person s consumption of the given good not deprive someone else from consuming the same good. Essay Questions 1. The relative price of gold is 40 ounces of silver per ounce of gold. If both dollar prices rise 10 percent, the dollar price of gold is $440 per ounce, the dollar price of silver is $11 per ounce, so the relative price remains 40 ounces of silver per ounce of gold. If only the dollar price of gold rises, the relative price of gold would be 44 ounces of silver per ounce of gold. 2. It is possible for the relative price of a good to fall while its monetary price rises. This happens when the good s money price rises less rapidly than the money prices of other goods. For example, assume the initial price of gold is $400 per ounce and silver is $10 per ounce. Then the relative price of gold is 40 ounces of silver per ounce of gold. If the money price of gold rises 10 percent to $440 per ounce while the money price of silver rises 100 percent to $20 per ounce, the relative price of gold declines to 22 ounces of silver per ounce of gold. 3. What is produced depends on consumers desires for the various goods as reflected in the number of dollar votes they are willing to cast for different products. The more dollar votes cast for a particular good, the higher is its relative price. Businesses, motivated by the fact that their property rights allow them to keep any profit they can earn from the use of their property, produce goods with high relative prices. 4. When consumers want more of a good, they cast more dollar votes for it. This raises its relative price. The invisible hand points out that producers, searching for profit, produce more of the good to gain advantage of its higher relative price. Additionally, consumers, following the principle of substitution, are led by the higher relative price to cut back from their initial increase in demand for the good. These actions of producers and consumers tend to restore the market to a (new) equilibrium price where the amount firms supply equals the amount consumers demand. The actions are an example of how the invisible hand causes markets to reach equilibrium.

8 Chapter 2 How a Market Economy Works: The Price System People s income depends on the quantities and relative prices of the resources they own. The major issue that arises from this method of solving the for whom problem is that the resulting distribution of income may be unfair. 6. The statement displays a basic error about the market mechanism. The claim that firms use the least-cost combination of productive resources says nothing about the quality of the goods produced. If people desire high quality goods, they will cast a large number of dollar votes for them. Thus, quality goods will have a high relative price and firms will be motivated to produce high quality goods as cheaply and efficiently as possible. 7. It is impossible to tell if turkey is a good buy, for this is a money price rather than a relative price. In today s supermarket, with steak at $5.00 per pound, turkey at 40 cents per pound is relatively cheap. In the markets of 1800 (when turkey actually cost 40 cents per pound) steak was 3 cents per pound, so turkey was quite expensive. This example illustrates the importance of relative prices and the irrelevance of money prices. 8. Limited liability means that an owner of a company is not liable for the company s debts. Corporations enjoy limited liability. If a corporation goes bankrupt, the corporation s owners (that is, its shareholders) do not have to pay the company s debts. This can be contrasted with the situation for a partnership and sole proprietorship. If either of these go bankrupt, the partners or sole proprietor is personally responsible for paying the company s debts. Limited liability is an immense advantage possessed by the corporate form of business organization. 9. If we tried to buy homes directly from sellers or used textbooks directly from other students, we would have to use our time and resources to acquire information on where the products were located, their characteristics, and their prices. It is actually cheaper to acquire this information through realtors or through college bookstores in return for paying a commission or higher used-book price. 10. No, the delivery of mail is not a public good; it fails to meet the two characteristics. Mail delivery is rival in consumption: if the postal carrier delivers a letter to my house, the carrier has less time available to deliver letters to others. And, it is easy to exclude someone from postal service: if the customer does not buy a stamp, the letter is not delivered. Additional Questions 1. In the United States the price of a Big Mac is $2.71 and the price of a coke is $1.25. In Great Britain the price of a Big Mac is 1.99 an the price of a coke is In which country is the relative price of a Big Mac higher? By how much would the price of a Big Mac need to change in Great Britain for the relative prices to be the same? 2. Why does the circular flow diagram underestimate the total value of all goods and services produced in an economy? 3. Explain how the invisible hand would prevent lasting shortages?

9 20 Gregory Essentials of Economics, Sixth Edition Answers 1. The relative price of a Big Mac in the United States is 2.17 cokes per Big Mac. In Great Britain the relative price of a Big Mac is 1.90 cokes. For the relative price of Big Macs to be the same in both countries the price of a Big Mac in Great Britain would need to be The circular flow diagram only shows the goods and services produced by businesses. It does not show goods that are produced and consumed within the household. If you pay a cleaning service to clean your house that would be included in the circular flow. If you clean your house the value of that service would not. 3. If there is a shortage manufacturers are produce less than what people are willing to buy at the current price. Prices must rise in the market. As the relative price increases, consumers begin to purchase substitute goods and reduce the amount of the good they are willing to buy. Also, as the relative price of the good increases, firms have an incentive to produce more of the good. The relative price will continue to increase until the amount that consumers are willing to buy is equal to the amount that firms are willing to sell.