1 The Market Economy

Objectives
After working through this topic you should be able to:
 Explain the concepts of scarcity and opportunity cost
 Identify the basic choices facing any economy
 Describe the essential structure of a market economy/system
 Explain and use the supply and demand model.
 Identify and explain the role of prices in the market system

Key Concepts
Scarcity supply
opportunity cost equilibrium
allocation of resources equilibrium price
circular flow model comparative statics
Demand role of prices

 Chapter 1

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Scarcity, Choice & Cost
Virtually all resources (i.e. land, labour, capital) are scarce - i.e. there
are not enough to satisfy all the wants of all people in any given
period. Hence:
 Choices have to be made amongst all the alternative uses of the
resources - all the goods that could be produced
 Such choice inevitably involves a cost in terms of the foregone
alternatives - the opportunity cost
 Opportunity cost = value of the most highly valued foregone
alternative = value of the resource in its next best alternative use

Allocation of Resources
Because of scarcity, every economy/society has to have some means
of organising the allocation of resources such that three major
decisions are made:
1. What to Produce - what goods & in what quantities
2. How to produce the goods - the methods of production
3. Who gets the output - a “fair” distribution

 Now try seminar question 1

Economic Systems
An economic system is the method of organising the allocation of
resources. Two polar cases are:
 Market system - a mode of organisation in which resource
allocation is determined by the independent decisions and actions
of individual consumers and producers.
 Centrally planned economy - a mode of organisation in which all
resource allocation is determined by the decisions of government
bodies
The UK, in common with most other industrial societies, relies
primarily on a market system. However, there is also some
government direction of resource allocation - the UK is an example
of a mixed economy.

The Workings of a Market Economy

Structure

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 The following diagram shows the basic structure of a market system
(ignoring the role of government)

Expenditure Product
Markets Revenue

Goods Goods
demanded supplied
Households Firms

Inputs Inputs
supplied demanded

Incomes Factor Costs

Markets

Flow of goods and services

Flow of money

Figure 1-1: The Circular Flow Model

 Firms sell goods to households and buy inputs from households.

 Households buy goods from firms and sell inputs to firms
 The demand and supply in product and factor markets determine
the prices of goods and inputs respectively.

Demand and Supply Model

How are all the individual buying and selling decisions taken in a
market system co-ordinated? Answer - via price changes.
Prices are determined by and, in turn, co-ordinate buying and selling
(i.e. demand and supply) decisions in markets. The demand and
supply model shows how prices fulfil this crucial co-ordinating role

Demand
A demand function for a good A can be written as follows:
D A  F  PA , Y , Ps , PC , T 
i.e. the demand for a good A (DA) depends upon:

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  Price of the good (PA)
 Income of consumers (Y)
 Prices of related goods - complements (PC) and substitutes (PS)
 Tastes (T) - preferences of consumers
A demand schedule shows the relation between the market price (P A)
and the quantity demanded of a good during a given time period, all
other determinants held constant (ceteris paribus)
Numerical example: Demand Schedule
Price per unit Quantity per
period
2 19
4 18
6 17
8 16
10 15
12 14

14
12
10
Price per unit

8
6
4
2 D

0
0 10 20 30

Quantity per period

 If the price changes - a movement along the demand curve

 If another variable changes - a shift in the demand curve
e.g. an increase in income shifts the demand curve to the right
(normal good) or to the left (inferior good)

 Now try seminar question 2

Supply
A supply function for a good A can be written as follows:

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 S A  F  PA , PF , T 
i.e. the supply of a good A (SA) depends upon:
 Price of the good (PA)
 Prices of inputs (factors) (PF)
 Technology - the available production methods
A supply schedule shows the relation between the market price (PA)
and the quantity of a good firms are willing to supply in a given
period of time, all other determinants held constant (ceteris paribus)
Numerical example: Supply Schedule
Price per unit Quantity per
period
2 4
4 8
6 12
8 16
10 20
12 24

14
12 S

10
Price per unit

8
6
4
2
0
0 10 20 30

Quantity per period

 If the price changes - a movement along the supply curve

 If another variable changes - a shift in the supply curve
e.g. if the wage rate paid to labour increases, the supply curve shifts
to the left.

 Now try seminar question 3

Equilibrium

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 The concept of equilibrium is central to microeconomic models.
Equilibrium is a position of balance, which persists because there is
no incentive for anyone to change their behaviour.
Market equilibrium exists when demand = supply; i.e. when the
amount consumers want to buy at a particular price equals the
amount firms want to sell at that price. The price which equates
demand and supply (i.e. clears the market) is the equilibrium price.
Numerical example: Market equilibrium
Price per unit Quantity Quantity
demanded per supplied per
period period
2 19 4
4 18 8
6 17 12
8 16 16
10 15 20
12 14 24

14
12 S

10
Price per unit

8
6
4
2 D

0
0 10 16 20 30

Quantity per period

The equilibrium price is 8 and the equilibrium quantity traded is 16

 If price is above equilibrium - excess supply (glut) - price falls
 If price is below equilibrium - excess demand (shortage) - price
rises

Comparative Statics
What happens if one of the held constant variables determining
demand and/or supply changes? Clearly, a new equilibrium price and
quantity will occur.
Numerical example: Decrease in Income

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 Suppose that consumers’ incomes decrease (and the good is normal)
- the demand curve shifts to the left as less is demanded at every
price. Assume that demand falls by 5.
Price per unit Old Quantity New Quantity Quantity
demanded per demanded per supplied per
period period period
2 19 14 4
4 18 13 8
6 17 12 12
8 16 11 16
10 15 10 20
12 14 9 24

14
12 D2 S

10
Price per unit

8
6
4
2 D1

0
12 16
0 10 20 30

Quantity per period

The new equilibrium price is 6 and quantity traded is 12; i.e. both
quantity and price fall.

 Now try seminar questions 4 & 5

The Role of Prices

The demand and supply model clarifies the fundamental role of prices
in the market system. Specifically, prices perform the following
essential functions:
 Prices convey information - about relative scarcity or abundance
of goods and inputs to households and firms
 Prices ration scarce resources - by equating demand and supply

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  Prices determine incomes - a household’s income from the
market depends on the prices of the inputs it supplies to the
market.

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 The Market Economy: Seminar Questions

1. Evaluate each of the following statements:

a) A society can always produce more automobiles if it chooses to do
so. Hence, there can never be any real scarcity of automobiles.
b) Governments have the power to raise all the money they want by
taxation. Hence, scarcity is not a problem for governments.
c) Citizens of Sweden are lucky because they have free health care,
while citizens of the United States have to pay for it.
2. Explain what happens to the demand curve for a good when the following
changes occur, ceteris paribus.
a) A rise in the price of a substitute good
b) A rise in the price of a complementary good
c) A fall in the price of the good
3. Explain what happens to the supply curve for a good when the following
changes occur, ceteris paribus
a) A fall in the price of components used to make the good
b) An improvement in the productivity of the labour producing the
good
c) A rise in the price of the good.
4. Suppose that the market demand curve for haircuts in some town is:
D  80  2 P  5I
where D is quantity demanded per month, P is price per haircut, and I is
consumer income (in tens of thousands of pounds). The supply curve is:
S  2P
where S is the quantity supplied per month.
a) According to this model, are haircuts a normal or inferior good?
b) Suppose I = 3. find the equilibrium price and quantity of haircuts.
c) Because of a recession, I falls to 2. What happens in the haircut
market?
5. In the late 1980s, improvements in technology led to a dramatic lowering
in the price of fax machines. Use a supply and demand model to predict
the impact of this development on the overnight document-delivery
business. Use the diagram to predict changes in the number of pieces of
overnight mail, and the price per piece.