How a Market System Functions

(“Economics” – Chapter 4 and Coda)

Want to gain a basic understanding of “how a free market

organizes economic activity”…

Money – asset that is socially and legally accepted as

payment for goods/services. Three functions of money:
1. Medium of Exchange – an asset used as payment
when purchasing goods/services (defines “what is
money”)
2. Store of Value – an asset that serves as a means of
holding wealth
3. Unit of Measure – a basic measure of economic
activity (e.g., in the United States all “prices” are
expressed in “dollar terms”) => eases comparisons
of the value of different goods/services (e.g., if a
gallon of milk costs $2 and a gallon of gas costs $4,
then gas is twice as expensive as milk)

Recall that the two primary decision making institutions are

“households” and “enterprises” (or “firms”), and that much
of the interaction between them takes place in “markets”…
 So, how exactly do “households” and “firms” interact
with each other in markets?

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 Interaction in two distinct markets:
i. Markets for “Factors of Production”
ii. Markets for “Finished Goods and Services”

Households

Markets for “Factors Markets for “Goods

of Production” (labor, and Services”
land, capital, etc.) (output of firms)

Firms

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 Markets for “Factors of Production”

Households

Supply of
Labor, Land,
Capital, and Income as
other factors Wages and
of production Rents

Markets for “Factors Markets for “Goods

of Production” (labor, and Services”
land, capital, etc.) (output of firms)

Labor, Land,
Capital, and
other factors Wages and
of production Rents paid
hired

Firms

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 Markets for “Finished Goods and Services”

Households

Consumption
of Finished
Consumer Goods and
Expenditures Services

Markets for “Factors Markets for “Goods

of Production” (labor, and Services”
land, capital, etc.) (output of firms)

Firm
Revenues Output of
Finished
Goods and
Services

Firms

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 Together these “two distinct markets” lead to the following
simplified representation of the Circular Flow of
Economic Activity (in a free market economy):

Households

Supply of Consumption
Labor, Land, of Finished
Capital, and Income as Consumer Goods and
other factors Wages and Expenditures Services
of production Rents

Markets for “Factors Markets for “Goods

of Production” (labor, and Services”
land, capital, etc.) (output of firms)

Labor, Land,
Capital, and Firm
Wages and Revenues Output of
other factors
of production Rents paid Finished
Goods and
hired
Services

Firms

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How do free markets work?
 The free interaction between buyers and sellers in
markets leads to an outcome that can be described by:
i. an equilibrium quantity of trade (an amount
traded)
ii. an equilibrium price (a price at which trade takes
place)

The model of “Supply and Demand” will be developed in

order to explain:
 how buyers and sellers interact with each other in a
free market and
 what particular price and quantity of trade would
emerge as a result of their interaction.

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 Demand and Supply:

Behavior of buyers and sellers in markets is summarized by

demand and supply.

Demand – the relationship between the price of a good and

the quantity that consumers are willing and able to
purchase, all other factors fixed.

Supply – the relationship between the price of a good and

the quantity that firms are willing and able to sell, all other
factors fixed.

Graphically:
price price

Supply

5.25
4.50

2.75
Demand 1.50

0 quantity 0 quantity
1,250 3,500 2,400 4,750
0
0

“Demand” refers to the entire blue curve above (each point

on the curve corresponds to a pair of “price” and “quantity
demanded”); “Supply” refers to the entire red curve above
(each point on the curve corresponds to a “pair” of “price”
and “quantity supplied”).

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 Law of Demand – all other factors fixed, a greater quantity
of a good will be demanded at lower prices (demand curves
are downward sloping).

Law of Supply – all other factors fixed, a greater quantity

of a good will be supplied at higher prices (supply curves
are upward sloping).

Two interpretations of the curves:

“Horizontal Interpretation” – start by focusing on a

particular price, and then go over to the curve horizontally
to determine the corresponding quantity demanded (or
supplied) at this particular price

“Vertical Interpretation” – start by focusing on a

particular quantity demanded (or supplied), and then go up
to the curve vertically to determine the corresponding price
at which this particular quantity would be demanded (or
supplied)
price price

Supply

5.25
4.50

2.75
Demand 1.50

0 quantity 0 quantity
1,250 3,500 2,400 4,750
0
0

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Buyer’s Reservation Price – the maximum dollar amount
a buyer is willing to give up in order to acquire an item
 At any particular quantity demanded, the height of the
demand curve illustrates the “reservation price” of the
buyer of that unit.

Seller’s Reservation Price – the minimum dollar amount a

seller is willing to accept in order to part with an item
 At any particular quantity supplied, the height of the
supply curve illustrates the “reservation price” of the
seller of that unit.

A “reservation price” is essentially a “cutoff price” at

which the behavior of the buyer or seller changes…

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Market Equilibrium – Interaction of Demand/Supply:
The “free interaction” of buyers and sellers in a market will
lead to “a particular level of trade” taking place at “a
particular price.”

Equilibrium – a “stable state” for a system which will

persist as long as outside factors do not change.
 In the context of market equilibrium we need to
identify a “price/quantity pair” that is stable in the
sense that no individual buyer and no individual
seller can alter their own behavior in such a way as
to increase their own surplus.

Consider the following market…

price
Supply

50

30

Demand
20

0 quantity

What prices are “stable”…?

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Is a “high price” of p H  50 stable?

Excess Supply at a price of $50:

quantity supplied (of 75) is
price greater than quantity demanded
Supply (of 15) [i.e., “more sellers than
buyers”] => “downward
pressure” on price
50

Demand

0 quantity

S(50)=75
D(50)=15

 Buyers willing/able to purchase 15 units; sellers

willing/able to sell 75 units => “more sellers than
buyers” or equivalently “excess supply”
 60 (=75-15) of the sellers who would like to sell the
item for $50 are not able to find buyers – each of these
sellers would have an incentive to instead accept
$49.99 => “downward pressure on price”
 Any price for which there is “excess supply” is not
stable

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 Is a “low price” of p L  20 stable?

price
Supply

Excess Demand at a price of

$20: quantity demanded (of
105) is greater than quantity
supplied (of 40) [i.e., “more
Demand buyers than sellers”] =>
20 “upward pressure” on price

0 quantity

0
S(20)=40 D(20)=105

 Buyers willing/able to purchase 105 units; sellers

willing/able to sell 40 units => “more buyers than
sellers” or equivalently “excess demand”
 65 (=105-40) of the buyers who would like to
purchase the item for $20 are not able to find sellers –
each of these buyers would have an incentive to
instead offer $20.01 => “upward pressure on price”
 Any price for which there is “excess demand” is not
stable

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Only “stable price” is at the intersection of the demand
curve and the supply curve.
price
Supply

p*=30

Demand

0 quantity

q*=D(30)=S(30)=55

 Only at this price do we have (quantity

demanded)=(quantity supplied) => “the same
number of buyers and sellers looking to trade.”
 At p  30 : buyers are willing/able to purchase 55
*

units and sellers are willing/able to purchase 55 units

(no “excess demand” and no “excess supply”)
 All potential buyers that don’t make a purchase at this
price do not want to make a purchase at this price. All
potential sellers that don’t make a sale at this price do
not want to make a sale at this price.
 Nobody (no buyer, no seller, no potential buyer, and
no potential seller) has anything to gain by changing
their own behavior => “Stable Outcome”

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Market Equilibrium occurs at the intersection of supply and
demand:
 “equilibrium price”: price at this intersection, p *  30
 “equilibrium quantity”: quantity at this intersection,
q *  55

The equilibrium in the model of Supply and Demand is:

 “stable” (if we are there we will stay there, unless
outside forces change; but this had to be true by the
definition of equilibrium)
 “unique” (there is one and only one equilibrium, a
property which follows from the “Law of Demand”
and “Law of Supply”)
 “self enforcing” (at higher prices there is downward
pressure on price; at lower prices there is upward
pressure on price – therefore if we start at any other
price, we will be pushed toward the equilibrium price)

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Underlying Determinants of Demand and Supply:

When we first introduced demand and supply we said they

were relationship between price and quantity “all other
factors fixed.”

Two questions at this point:

1. What are these “other factors”?
2. What happens if these other factors change?

Short answers:
1. These “other factors” are anything other than “own
price” that influences the decision regarding
purchasing or selling the item.
2. As these other factors change we can realize an
increase or decrease in demand or supply (i.e., a shift
of the entire demand curve or the entire supply curve),
which will ultimately lead to changes in equilibrium
price and equilibrium quantity.

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Increase in Demand – change in demand consistent with
consumers being more willing to purchase the good, in
that at every price the new quantity demanded is greater
than the previous quantity demanded (visually, a
“rightward shift” of the demand curve) [illustrated as the
change from “Demand (B)” to “Demand (A)” below]

Decrease in Demand – change in demand consistent with

consumers being less willing to purchase the good, in
that at every price the new quantity demanded is less
than the previous quantity demanded (visually, a
“leftward shift” of the demand curve) [illustrated as the
change from “Demand (A)” to “Demand (B)” below]

Change in Demand:

price

Demand (A)

Demand (B)
0 quantity

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Increase in Supply – change in supply consistent with
firms being more willing to sell the good, in that at every
price the new quantity supplied is greater than the
previous quantity supplied (visually, a “rightward shift”
of the supply curve) [illustrated as the change from
“Supply (A)” to “Supply (B)” below]

Decrease in Supply – change in supply consistent with

firms being less willing to sell the good, in that at every
price the new quantity supplied is less than the previous
quantity supplied (visually, a “leftward shift” of the
supply curve) [illustrated as the change from “Supply
(B)” to “Supply (A)” below]

Change in Supply:

price
Supply (A)

Supply (B)

0 quantity

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Determinants of Demand (factors that change demand):

The following changes will result in an increase in demand:

1. A decrease in the price of a Complement Good
(e.g., demand for hotdogs would increase if the
price of hotdog buns were to decrease)
2. An increase in the price of a Substitute Good
(e.g., demand for Pepsi would increase if the price
of Coke were to increase)
3. An increase in income (for a Normal Good – most
goods are normal goods)
4. A decrease in income (for an Inferior Good –
some goods, such as “generic brands,” are inferior)
5. An increased preference by consumers for the
good (e.g., new study suggesting “drinking 24
ounces of milk per day will reduce obesity” would
increase demand for milk)
6. An increase in “market size” (e.g., increase in
population)
7. An expectation of higher future prices (e.g., if
you have reason to suspect that gasoline will cost $1
more per gallon next week, you would fill up your
tank today?)

(*** changing these factors “in the opposite direction”

would result in a decrease in demand ***)

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Determinants of Supply (factors that change supply):

The following changes will result in an increase in supply:

1. A decrease in the cost of any factors of
production needed to produce the good (e.g.,
decrease in the wage rate paid to labor would
increase supply)
2. An improvement in technology that reduces
production costs
3. A favorable realization of “natural events” (e.g.,
“good weather” for the growing of an agricultural
commodity)
4. An increase in “market size” (e.g., increase in the
number of suppliers of the good)
5. An expectation of lower future prices (e.g., if a
gas station owner has reason to suspect the market
price will be $1 less tomorrow, they would want to
unload as much gasoline as possible today)

(*** changing these factors “in the opposite direction”

would result in a decrease in supply ***)

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Change in Equilibrium resulting from change in Demand:

price
Supply

High Price

Demand (A)
Low Price
Demand (B)
0 quantity

Low Quantity High Quantity

 Increase in demand (for whatever reason): shift from

“Demand (B)” to “Demand (A)” will increase
equilibrium price and increase equilibrium
quantity.
 Decrease in demand (for whatever reason): shift from
“Demand (A)” to “Demand (B)” will decrease
equilibrium price and decrease equilibrium
quantity.

…recall that the equilibrium is “self enforcing,” so that we

don’t need to do anything to get to the new equilibrium
(i.e., market forces will push us toward the new equilibrium
outcome)…

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Change in Equilibrium resulting from change in Supply:

price Supply (A)

Supply (B)
High Price

Low Price
Demand

0 quantity

Low Quantity High Quantity

 Increase in supply (for whatever reason): shift from

“Supply (A)” to “Supply (B)” will decrease
equilibrium price and increase equilibrium
quantity.
 Decrease in supply (for whatever reason): shift from
“Supply (B)” to “Supply (A)” will increase
equilibrium price and decrease equilibrium
quantity.

…recall that the equilibrium is “self enforcing,” so that we

don’t need to do anything to get to the new equilibrium
(i.e., market forces will push us toward the new equilibrium
outcome)…

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Important Role of Profit: In a free market economy profits
serve as a “signaling device,” directing resources to
their most valuable use.
 If firms are earning “large, positive profits” in an
industry, this acts as a signal for current firms to increase
their output or for new firms to enter the industry. This
leads to additional productive resources being
attracted to this market.
 If instead firms are earning “large, negative profits” in
an industry, this acts as a signal for current firms to
decrease their output or to exit the industry. This leads
to productive resources being diverted away from this
market toward other (more highly valued) uses.

 This argument relies upon “Freedom to Engage in

Economic Activity” => for markets to efficient allocate
productive resources, resources must be allowed to
engage in whatever activity offers the greatest return.
 Profits can only serve as an effective signal insofar as
someone is able to recognize, appreciate, and respond
accordingly to different levels of profit. => the
Entrepreneur is the individual who plays this role
 Entrepreneur – someone who organizes and manages
a business, typically with considerable initiative and
exposure to risk.
 Realizing this efficient movement of resources requires
(in part) that firms earning negative profits be allowed to
go bankrupt
 Prompted Joseph Schumpeter (1883-1950) to describe
capitalism as a “gale of creative destruction”

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Spontaneous Order of Markets:

Spontaneous Order – the natural and undirected

emergence of order out of seeming chaos
 In a market system, the actions of individuals pursuing
their own self-interest gives rise to outcomes that are
better for society than what would be realized by
deliberate, intentional planning

“The last President of the Soviet Union, Mikhail

Gorbachev, is said to have asked British Prime Minister
Margaret Thatcher: How do you see to it that people get
food? The answer was that she didn’t. Prices did that.
Moreover, the British people were better fed than people in
the Soviet Union…”
– “Basic Economics” by Thomas Sowell (page 12)

 The spontaneous order of a free market is better at

producing food and getting it to the tables of
households than is a system of central planning

 Friedrich von Hayek argued that markets result in “a

more efficient allocation of societal resources than any
design could achieve”
 Adam Smith’s “Invisible Hand”: in a free market system
individuals are “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
effectually than when he really intends to promote it.”

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“I, Pencil” by Leonard Read (Coda in “Economics”
textbook) illustrates spontaneous order in markets…
 “I, Pencil” – a first person genealogy of a simple lead
pencil (written by Leonard Read)
 Pencil claims: “Not a single person on the face of earth
knows how to make me.” => production of each single
pencil requires the collective efforts of millions of people
all over the world
 trees grown in California, cut down by loggers
 saws, trucks, ropes, trains necessary to harvest and
transport the wood (each with numerous inputs)
 food and beverages to nourish workers
 wood is then kiln dried and tinted
 power for mill from the dam of a hydroplant
 glue to hold layers of wood in pencil together
 graphite from Ceylon (Sri Lanka)
 zinc and copper mined to make the brass ferrule
 clay from Mississippi, wax from Mexico, pumice
from Italy
 millions of people all doing their small part to ultimately
make each pencil
 no one person knows how to make a pencil from start to
finish => the knowledge is spread out over millions of
people all over the globe
 to make each pencil, we must first somehow coordinate
the actions of all these different people, in order to have
each one contribute his own little piece of knowledge or
skill to the process
 but, this “cooperation” takes place spontaneously,
without anyone overseeing or dictating the process

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 the individual incentives present in the market system
result in: “the configuration of human energies – millions
of tiny know-hows configurating naturally and
spontaneously in response to human necessity and desire
and in the absence of any human master-mind!”
 entrepreneurs, workers, and consumers all make
decisions based upon and in response to prices
 e.g., a potential lumberjack in California
 if pencils are more highly valued by consumers, the
price and quantity produced of pencils will increase
 more people must be employed as lumberjacks (we
need more wood to make the additional pencils)
 the wage rate paid to lumberjacks must increase in
order to attract more people to the profession
 each individual lumberjack does not intend or
necessarily care about “making a pencil”
 rather, he simply wants to earn a wage in order to
generate income for his household
 what results in more pencils being produced and more
people being employed as lumberjacks is not a concern
with the social need for more pencils on the part of the
lumberjack, entrepreneur, or anyone else…rather, it is
the individual pursuit of self-interest by each person

Three surprising features of the scenario above:

1. no one person possesses the know-how to make a pencil
2. most who helped make the pencil did not intend to or
necessarily care to specifically make a pencil
3. but yet, the entire process takes place (and valued goods,
such as pencils, are produced) without any planner
overseeing or dictating the process
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