Chapter Eleven: The Price System and the Case for Free Markets

Efficient Resource Allocation and Pricing Efficient Allocation of Resources: is one that takes advantage of every opportunity to make some individuals better off in their own estimation while not worsening the lot of anyone else. Society must somehow choose: - How much of each good to purchase - What input quantities to use in the production process - How to distribute the resulting outputs among consumers No point below the PPF curve can represent an efficient allocation of resources. Every point on the curve is efficient Can Price Increases Ever Serve the Public Interest? Higher prices can serve the public interest better than lower ones. Keeping prices low can worsen the effects of shortages of food and other vital goods Scarcity and the Need to Coordinate Economic Decisions A market system uses prices to coordinate economic activity. High prices discourage consumption of the most scarce resources, whereas low prices encourage consumption of comparatively abundant resources. Invisible hand Three Coordination Tasks in the Economy Laissez Faire: Refers to the practice of minimal government interference with the workings of the market system. The term means that people should be left alone in carrying out their economic affairs. Output Selection: - A free market system decides what should be produced via what we have called the law of supply and demand. - Under laissez faire, the allocation of societys resources among different products depends on consumer preferences (demands) and the production costs of the goods demanded. Prices (and the resulting profitability of the different products) vary so as to bring the quantity of each commodity produced into line with the quantity demanded. - No central planner arranges resource allocation. Instead, the lure of profits, which is the invisible hand. Production Planning: - Includes the division of societys scare inputs among enterprises. - In a free market, inputs are assigned to the firms that can make the most productive (most profitable) use of them. Firms that cannot make a sufficiently productive use of some input will be priced out of the market for that item Distribution of Products Among Consumers: - Objective is to distribute the available supplies to match differing consumer preferences as well as possible. - The Trade Off The price system carries out the distribution process by rationing goods on the basis of preferences and relative incomes. The price system DOES favor the rich, and this is a problem that market economists must confront. - However, we may still want to think twice before declaring ourselves opposed to the price system. If equality is our goal, might not a more reasonable solution be to use the tax system to equalize incomes, and then let the market mechanism distribute goods in accord with preferences? Input-Output Analysis: The Near Impossibility of Perfect Central Planning Input-Output Analysis: A mathematical procedure that takes account of the interdependence among the economys industries and determines the amount of output each industry must provide as inputs to the other industries in the economy.

Example: Unless economic planners allocate enough gas to the trucking industry, products will not get to market. And unless they allocate enough tricks to haul gas to gas stations, consumers will not be able to get around. Trucking activity depends on gas production but gas production also depends on trucking activity Because the output required from any one industry depends on the output from every other industry, planners can be sure that the production of the various outputs is sufficient to meet both consumer and industrial demands only by taking explicitly account of the interdependencies among industries. If they change the output target for one industry, they must also adjust every other industrys output target. Any single change in production sets off a chain of adjustments throughout the economy that require further adjustments A full rigorous central-planning solution to the production problem is a tremendous task, requiring overwhelming quantity of information and some incredibly difficult calculations. Yet this very complex job is carried out automatically and unobtrusively by the price mechanism in a free-market economy.

Which Buyers and Which Sellers Get Priority? Other things being equal, the price mechanism ensures that those consumers who want a scarce commodity most will receive it, and that those sellers who can supply it most efficiently will get to supply the commodity. The price mechanism always ranks potential consumers of a good in the order of the intensity of their preference for the good, as indicated by the amount they are willing to spend for it. Example: Efficient Resource Allocation in Output Selection Perfect competition does guarantee efficiency in determining the relative quantities of the different commodities that the economy produces. Proof comes in two steps: - Derive a criterion for efficient output selection, that is, a test that tells us whether or not production is being carried out efficiently - Show that the prices that emerge from the market mechanism under perfect competition pass the test. Step One: Rule for Efficient Output Selection: - Marginal Analysis Efficiency in the choice of output quantities requires that, for each of the economys outputs, the MC of the last unit produced be equal to the MU of the last unit consumed. MC = MU - The efficient decision about the output quantities is the one that maximizes the total benefit (total utility) to society, minus the cost to society of producing the output quantities that are chosen. In other words, the goal is to maximize the surplus that society gainstotal utility minus total cost. To maximize the difference between total utility and total cost, we must find the outputs that equalize the corresponding marginal figuresmarginal utility and marginal costto one another, as the preceding efficient rule tells us. Step Two: The Price Systems Critical Role: - Under perfect competition, producers and consumers will make uncoordinated decisions that we can expect automatically to produce exactly the quantity of each good that satisfies the MC = MU rule for efficiency. That is, under the idealized conditions of perfect competition, the market mechanism, without any government intervention and without anyone else directing it or planning for it, is capable of allocating societys scare resources efficiently. The Invisible Hand at Work The price system lets consumers and producers pursue their own best interests. Prices are the dollar costs of commodities to the consumers, so in pursuing their own best interests, consumers will buy the commodities that give them the most satisfaction per dollar. The market mechanism leads consumers to squeeze the greatest possible benefit out of the social resources used up in making the goods and services they buy. When all prices are set equal to marginal costs, the price system gives correct cost signals to consumers. It has set prices at levels that induce consumers to use societys resources with the same care they devote to watching their own money, because the money cost of a good to the consumer has been set equal to the opportunity cost of the good to society.

Everything consumers need to know to make their decisions is embodied in the market price, which, under perfect competition, accurately reflects marginal costs.

Other Roles of Prices: Income Distribution and Fairness Prices influence the distribution of income between buyers and sellers. Ex. High rents make owners richer but tenants poorer Markets serve only those demands that are backed up by consumers desire and ability to pay