Price Floor and Price Ceiling

Chapter3.pdf

Home >Business & Finance homework help >Economics homework help >Price Floor and Price Ceiling

p a r t 2

Markets and Government

Economics has a great deal to say about how both markets and governments allocate scarce resources. It gives us insight about the conditions under which each will likely work well (and each will likely work poorly). The next four chapters will focus on this topic.

Market allocation of resources

Business firms purchase resources like materials, labor services, tools, and machines from households in exchange for income, bidding the resources away from their alternate uses. The firms then transform the resources into products like shoes, automobiles, food products, and medical services and sell them to households. In a market economy, businesses will continue to supply a good or service only if the revenues from the sale of the product are sufficient to cover the cost of the resources required for its production.

GovernMent allocation of resources

Resource allocation by the government involves a more complex, three- sided exchange. In a democratic political setting, a legislative body levies taxes on voter–citizens, and these revenues are subdivided into budgets, which are allocated to government bureaus and agencies. In turn, the bureaus and agencies use the funds from their budgets to supply goods, services, and income transfers to voter–citizens. The legislative body is like a board of directors elected by the citizens. Legislators have an incentive to take action that will attract votes. Voters have an incentive to support legislators who provide them with goods, services, and transfers that are highly valued relative to their tax payments. When decisions are made democratically, political action will require the approval of a legislative majority.

This section will first analyze the operation of markets and then turn to the political process.

There are two primary methods of allocating scarce resources: markets and government.

fr an

ck re

po rt

er /E

+/ G

et ty

Im ag

53538_ch03_rev03.indd 41 17/12/13 5:02 PM

c h a p t e r 3 Demand, Supply, and the Market Process

fr an

ck re

po rt

er /E

+/ G

et ty

Im ag

F o c u s

●● What are the laws of demand and supply? ●● How do consumers decide whether to purchase a good? How do producers decide whether to supply it?

●● How do buyers and sellers respond to changes in the price of a good?

●● What role do profits and losses play in an economy? What must a firm do to make a profit?

●● How is the market price of a good determined? ●● How do markets adjust to changes in demand? How do they adjust to changes in supply?

●● What is the “invisible hand” principle?

I am convinced that if [the market system] were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind. —friedrich hayek, nobel laureate1

From the point of view of physics, it is a miracle that [7 million New Yorkers are fed each day] without any control mechanism other than sheer capitalism. —John h. holland, scientist, santa fe institute2

1Friedrich Hayek, “The Use of Knowledge in Society,” American Economic Review 35 (Sep- tember 1945): 519–30. 2As quoted by Russell Ruthen in “Adapting to Complexity,” Scientific American 268 (January 1993): 132.

53538_ch03_rev03.indd 42 17/12/13 5:02 PM

T o those who study art, the Mona Lisa is much more than a famous painting of a woman. Look- ing beyond the overall picture, they see and ap-

preciate the brush strokes, colors, and techniques em- bodied in the painting. similarly, studying economics can help you to gain an appreciation for the details behind many things in your everyday life. During your last visit to the grocery store, you probably noticed the fruit and vegetable section. Next time, take a moment to ponder how potatoes from Idaho, oranges from Florida, apples from Washington, bananas from Hon- duras, kiwi fruit from New Zealand, and other items from around the world got there. Literally thousands of different individuals, working independently, were involved in the process. Their actions were so well co- ordinated, in fact, that the amount of each good was just about right to fill exactly the desires of your lo- cal community. Furthermore, even the goods shipped from halfway around the world were fresh and reason- ably priced.

How does all this happen? The short answer is that it is the result of market prices and the incentives and coordination that flow from them. To the economist, the operation of markets—including your local grocery market—is like the brush strokes underlying a beauti- ful painting. Reflecting on this point, Friedrich Hayek speculates that if the market system had been deliber- ately designed, it would be “acclaimed as one of the greatest triumphs of the human mind.” similarly, com- puter scientist John H. Holland argues that, from the viewpoint of physics, the feeding of millions of New Yorkers day after day with very few shortages or surpluses is a miraculous feat (see the chapter- opening quotations).

Amazingly, markets coordinate the actions of millions of individuals without central plan- ning. There is no individual, political authority, or central planning committee in charge. considering that there are more than 300 million Americans with widely varying skills and desires, and roughly 28 million busi- nesses producing a vast array of products ranging from diamond rings to toilet paper, the coordination derived from markets is indeed an awesome achievement.

This chapter focuses on demand, supply, and the determination of market prices. For now, we will ana- lyze the operation of competitive markets—that is, markets in which buyers and sellers are free to enter and exit. We will also assume that the property rights are well defined. Later, we will consider what happens when these conditions are absent.

on eBay, sellers enter their reserve prices—the minimum prices they will accept for goods; buyers enter their maximum bids—the maximum prices they

are willing to pay for goods. The process works the same way when a person runs a newspaper ad

to sell a car. The seller has in mind a minimum price he or she will accept for the car. A po- tential buyer, on the other hand, has in mind a maximum price he or she will pay for the car.

If the buyer’s maximum price is greater than the seller’s minimum price, the exchange will occur at a

price somewhere in between. As these examples show, the buyers’ and sellers’ desires and incentives deter- mine prices and make markets work. We will begin with the demand (buyer’s) side, and then turn to the supply (seller’s) side of the market.

na to

ly T

ip ly

as hi

n/ Sh

ut te

rs to

ck .c

3-1 consuMer choice and the law of deMand Clearly, prices influence our decisions. As the price of a good increases, we have to give up more of other goods if we want to buy it. Thus, as the price of a good rises, its op- portunity cost increases (in terms of other goods that must be forgone to purchase it).

the produce section of your local grocery store is a great place to see economics in action. literally millions of indi- viduals from around the world have been involved in the process of getting these goods to the shelves in just the right quantities. Market prices underlie this feat.

to ck

ph ot

o. co

m /n

ic oo

la y

53538_ch03_rev03.indd 43 17/12/13 5:02 PM

44 part 2 Markets and GovernMent

This basic principle underlies the law of demand. The law of demand states that there is an inverse (or negative) relationship between the price of a good or service and the quantity of it that consumers are willing to purchase. This inverse relationship means that price and the quantity consumers wish to purchase move in opposite directions. As the price increases, buyers purchase less—and as the price decreases, buyers purchase more.

The availability of substitutes—goods that perform similar functions—helps ex- plain this inverse relationship. No single good is absolutely essential; everything can be replaced with something else. A chicken sandwich can be substituted for a cheeseburger. Wood, aluminum, bricks, and glass can take the place of steel. Going to the movies, playing tennis, watching television, and going to a football game are substitute forms of entertain- ment. When the price of a good increases, people cut back on their purchases of it and turn to substitute products.

3-1a the Market deMand schedule The lower portion of Exhibit 1 shows a hypothetical demand schedule for pizza delivery in a city. A demand schedule is simply a table listing the various quantities of something consumers are willing to purchase at different prices. When the price of a large pizza deliv- ery is $35, only 4,000 people per month order pizza delivery. As the price falls to $25, the quantity of pizza deliveries demanded rises to 8,000 per month; when the price falls to $10, the quantity demanded increases to 14,000 per month.

Law of demand a principle that states there is an inverse relationship between the price of a good and the quantity of it buyers are willing to purchase. as the price of a good increases, consumers will wish to purchase less of it. as the price decreases, consumers will wish to purchase more of it.

Substitutes Products that serve similar purposes. an increase in the price of one will cause an increase in demand for the other (examples are hamburgers and tacos, butter and margarine, Chevrolets and Fords).

ExHIBIT 1

Law of Demand

As the demand sched- ule shown in the table indicates, the number of people ordering pizza delivery (just like the consumption of other products) is inversely related to price. The data from the table are plotted as a demand curve in the graph. The inverse rela- tionship between price and amount demanded reflects the fact that consumers will substitute away from a good as it becomes more expensive.

PRICE QUANTITY (IN THOUSANDS PER MONTH)

$35 30 25 20 15 10 5

4 6 8

10 12 14 16

P ri ce

$35

Quantity (in thousands per month)

Demand

42 6 8 10 12 14 16

en ga

ge L

ea rn

in g

20 13

53538_ch03_rev03.indd 44 17/12/13 5:02 PM

chapter 3 deMand, suPPly, and the Market ProCess 45

The upper portion of Exhibit 1 shows what the demand schedule would look like if the various prices and corresponding quantities were plotted on a graph and connected by a line. This is called the demand curve. When representing the demand schedule graphically, economists measure price on the vertical or y-axis and the amount demanded on the horizontal or x-axis. Because of the inverse relationship between price and amount purchased, the demand curve will have a negative slope—that is, it will slope downward to the right. More of a good will be purchased as its price decreases. This is the law of demand.

Read horizontally, the demand curve shows how much of a particular good consumers are willing to buy at a given price. Read vertically, the demand curve shows how much consumers value the good. The height of the demand curve at any quantity shows the maximum price consumers are willing to pay for an additional unit. If consumers value highly an additional unit of a product, they will be willing to pay a large amount for it. Conversely, if they place a low value on the additional unit, they will be willing to pay only a small amount for it.

Because the amount a consumer is willing to pay for a good is directly related to the good’s value to them, the height of the demand curve indicates the marginal benefit (or value) consumers receive from additional units. (Recall that we briefly discussed marginal benefit in Chapter 1.) When viewed in this manner, the demand curve reveals that as consumers have more and more of a good or service, they value additional units less and less.

3-1b consuMer surplus Previously, we indicated that voluntary exchanges make both buyers and sellers better off. The demand curve can be used to illustrate the gains to consumers. Suppose you value a particular good at $50, but you are able to purchase it for only $30. Your net gain from buying the good is the $20 difference. Economists call this net gain of buyers consumer surplus. Consumer surplus is simply the difference between the maximum amount con- sumers would be willing to pay and the amount they actually pay for a good.

Exhibit 2 shows the consumer surplus for an entire market. The height of the demand curve measures how much buyers in the market value each unit of the good. The price indicates the amount they actually pay. The difference between these two—the triangular area below the demand curve but above the price paid—is a measure of the total consumer surplus generated by all exchanges of the good. The size of the consumer surplus, or

Consumer surplus the difference between the maximum price consumers are willing to pay and the price they actually pay. It is the net gain derived by the buyers of the good.

ExHIBIT 2

Consumer Surplus

consumer surplus is the area below the demand curve but above the actual price paid. This area represents the net gains to buyers from market exchange.

P ri

Quantity/time

Consumer surplus

Demand

en ga

ge L

ea rn

in g

20 13

53538_ch03_rev03.indd 45 17/12/13 5:02 PM

46 part 2 Markets and GovernMent

triangular area, is affected by the market price. If the market price for the good falls, more of it will be purchased, resulting in a larger surplus for consumers. Conversely, if the market price rises, less of it will be purchased, resulting in a smaller surplus (net gain) for consumers.

Because the value a consumer places on a particular unit of a good is shown by the corresponding height of the demand curve, we can use the demand curve to clarify the dif- ference between the marginal value and total value of a good—a distinction we introduced briefly in Chapter 1. Returning to Exhibit 2, if consumers are currently purchasing Q

1 units,

the marginal value of the good is indicated by the height of the demand curve at Q 1 —the last

unit consumed (or purchased). So at each quantity, the height of the demand curve shows the marginal value of that unit, which as you can see declines along a demand curve. The total value of the good, however, is equal to the combined value of all units purchased. This is the sum of the value of each unit (the heights along the demand curve) on the x-axis, out to and including unit Q

1 . This total value is indicated graphically as the entire area under the de-

mand curve out to Q 1 (the triangular area representing consumer surplus plus the unshaded

rectangular area directly below it). You can see that the total value to consumers of a good can be far greater than the

marginal value of the last unit consumed. When additional units are available at a low price, the marginal value of a good may be quite low, even though its total value to consumers is exceedingly high. This is usually the case with water. The value of the first few units of water consumed per day will be exceedingly high. The consumer surplus derived from these units will also be large when water is plentiful at a low price. As more and more units are con- sumed, however, the marginal value of even something as important as water will fall to a low level. When water is cheap, then, people will use it not only for drinking, cleaning, and cook- ing but also for washing cars, watering lawns, flushing toilets, and maintaining fish aquari- ums. Thus, although the total value of water is rather large, its marginal value is quite low.

Consumers will tend to expand their consumption of a good until its price and mar- ginal value are equal (which occurs at Q

1 in Exhibit 2 at a price of P

1 ). Thus, the price of

a good (which equals marginal value) reveals little about the total value derived from the consumption of it. This is the reason that the market price of diamonds (which reflects their high marginal value) is greater than the market price of water (which has a low marginal value), even though the total value of diamonds is far less than the total value of water. Think of it this way: Beginning from your current levels of consumption, if you were of- fered a choice between one diamond or one gallon of water right now, which would you take? You would probably take the diamond, because at the margin it has more value to you than additional water. However, if given a choice between giving up all of the water you use or all of the diamonds you have, you would probably keep the water over dia- monds, because water has more total value to you.

3-1c responsiveness of Quantity deManded to price chanGes: elastic and inelastic deMand curves As we previously noted, the availability of substitutes is the main reason why the demand curve for a good slopes downward. Some goods, however, are much easier than others to substitute away from. As the price of tacos rises, most consumers find hamburgers a rea- sonable substitute. Because of the ease of substitutability, the quantity of tacos demanded is quite sensitive to a change in their price. Economists would say that the demand for tacos is relatively elastic because a small price change will cause a rather large change in the amount purchased. Alternatively, goods like gasoline and electricity have fewer close sub- stitutes. When their prices rise, it is harder for consumers to find substitutes for these products. When close substitutes are unavailable, even a large price change may not cause much of a change in the quantity demanded. In this case, an economist would say that the demand for such goods is relatively inelastic.

53538_ch03_rev03.indd 46 17/12/13 5:02 PM

chapter 3 deMand, suPPly, and the Market ProCess 47

Graphically, this different degree of responsiveness is reflected in the steepness of the demand curve, as shown in Exhibit 3. The flatter demand curve (D

1 , left frame) is for a

product like tacos, for which the quantity purchased is highly responsive to a change in price. As the price increases from $2.00 to $4.00, the quantity demanded falls sharply from ten to four units. The steeper demand curve (D

2 , right frame) is for a product like gasoline,

for which the quantity purchased is much less responsive to a change in price. For gasoline, an increase in price from $2.00 to $4.00 results in only a small reduction in the quantity purchased (from ten to eight units). An economist would say that the flatter demand curve D

1 is “relatively elastic,” whereas the steeper demand curve D

2 is “relatively inelastic.” The

availability of substitutes is the main determinant of a product’s elasticity or inelasticity and thus how flat or steep its demand curve is.

What would a demand curve that was perfectly vertical represent? Economists refer to this as a “perfectly” inelastic demand curve, meaning that the quantity demanded of the product never changes—regardless of its price. Although it is tempting to think that the de- mand curves are vertical for goods essential to human life (or goods that are addictive), this is inaccurate for two reasons. First, in varying degrees, there are substitutes for everything. As the price of a good rises, the incentive increases for suppliers to invent even more substi- tutes. Thus, even for goods that currently have few substitutes, if the price were to rise high enough, alternatives would be invented and marketed, reducing the quantity demanded of the original good. Second, our limited incomes restrict our ability to afford goods when they become very expensive. As the price of a good rises to higher and higher levels, if we do not cut back on the quantity purchased, we will have less and less income to spend on other things. Eventually, this will cause us to cut back on our purchases of it. Because of these two reasons, the demand curve for every good will slope downward to the right.

3-2 chanGes in deMand versus chanGes in Quantity deManded The purpose of the demand curve is to show what effect a price change will have on the quan- tity demanded (or purchased) of a good. Economists refer to a change in the quantity of a good purchased in response solely to a price change as a “change in quantity demanded.” A change in quantity demanded is simply a movement along a demand curve from one point to another.

Changes in factors other than a good’s price—such as consumers’ income and the prices of closely related goods—will also influence the decisions of consumers to purchase

ExHIBIT 3

Elastic and Inelastic Demand Curves

The responsiveness of consumer purchases to a change in price is re- flected in the steepness of the demand curve. The flatter demand curve (D

1 ) for tacos shows a

higher degree of respon- siveness and is called relatively elastic, while the steeper demand curve (D

2 ) for gasoline

shows a lower degree of responsiveness and is called relatively inelasticGasoline

Quantity/time

Tacos

P ri

Quantity/time

P ri

en ga

ge L

ea rn

in g

20 13

53538_ch03_rev03.indd 47 17/12/13 5:02 PM

48 part 2 Markets and GovernMent

a good. If one of these other factors changes, the entire demand curve will shift inward or outward. Economists refer to a shift in the demand curve as a “change in demand.”

Failure to distinguish between a change in demand and a change in quantity demanded is one of the most common mistakes made by beginning economics students.3 A change in demand is a shift in the entire demand curve. A change in quantity demanded is a movement along the same demand curve. The easiest way to distinguish between these two concepts is the following: If the change in consumer purchases is caused by a change in the price of the good, it is a change in quantity demanded—a movement along the demand curve; if the change in consumer purchases is due to a change in anything other than the price of the good (a change in consumer income, for example), it is a change in demand—a shift in the demand curve.

Let us now take a closer look at some of the factors that cause a “change in demand”— an inward or outward shift in the entire demand curve.

1. changes in consumer income. An increase in consumer income makes it pos- sible for consumers to purchase more goods. If you were to win the lottery, or if your boss were to give you a raise, you would respond by increasing your spending on many products. Alternatively, when the economy goes into a recession, falling incomes and rising unem- ployment cause consumers to reduce their purchases of many items. A change in consumer income will result in consumers buying more or less of a product at all possible prices. When consumer income increases, in the case of most goods, individuals will purchase more of the good even if the price is unchanged. This is shown by a shift to the right—an outward shift—in the demand curve. Such a shift is called an increase in demand. A reduction in con- sumer income generally causes a shift to the left—an inward shift—in the demand curve, which is called a decrease in demand. Note that the appropriate terminology here is an in- crease or a decrease in demand, not an increase or a decrease in quantity demanded.

Exhibit 4 highlights the difference between a change in demand and a change in quantity demanded. The demand curve D

1 indicates the initial demand curve for tablet

Change in Demand versus Change in Quantity Demanded

Panel (a) shows a change in quantity de- manded, a movement along the demand curve D

1 , in response to a change in the price

of tablet computers. Panel (b) shows a change in demand, a shift of the entire curve, in this case due to an increase in consumer income.

ExHIBIT 4

P ri

Q1 Q3

$300

200

100

(a)

P ri

Quantity of tablet computers per month

Q1 Q2

D1 D2

$300

200

100

(b)

Quantity of tablet computers per month

Increase in demandIncrease in quantity demanded

en ga

ge L

ea rn

in g

20 13

3Questions designed to test the ability of students to make this distinction are favorites of many economics instruc- tors. A word to the wise should be sufficient.

53538_ch03_rev03.indd 48 17/12/13 5:02 PM

chapter 3 deMand, suPPly, and the Market ProCess 49

computers. At a price of $300, consumers will purchase Q 1 units. If the price were to decline

to $100, the quantity demanded would increase from Q 1 to Q

3 . The arrow in panel (a) indi-

cates the change in quantity demanded—a movement along the original demand curve D 1 in

response to the change in price. Now, alternatively suppose there were an increase in in- come that caused the demand for tablet computers to shift from D

1 to D

2 . As indicated by

the arrows in panel (b), the entire demand curve would shift outward. At the higher income level, consumers would be willing to purchase more tablet computers than before. This is true at a price of $300, $200, $100, and every other price. The increase in income leads to an increase in demand—a shift in the entire curve.

2. changes in the number of consumers in the market. Businesses that sell products in college towns are greatly saddened when summer arrives. As you might expect in these towns, the demand for many items—from pizza delivery to beer— falls during the summer. Exhibit 5 shows how the falling number of consumers in the market caused by students going home for the summer affects the demand for pizza delivery. With fewer customers, the demand curve shifts inward from D

1 to D

2 . There

is a decrease in demand; pizza stores sell fewer pizzas than before regardless of what price they originally charged. Had their original price been $20, then demand would fall from 200 pizzas per week to only 100. Alternatively, had their original price been $10, then de- mand would fall from 300 pizzas to 200. When autumn arrives and the students come back to town, there will be an increase in demand that will restore the curve to about its original position. As cities grow and shrink, and as international markets open up to domestic firms, changes in the number of consumers affect the demand for many products.

3. changes in the price of a related good. Changes in prices of closely related products also influence the choices of consumers. Related goods may be either substitutes or complements. When two products perform similar functions or fulfill similar needs, they are substitutes. Economists define goods as substitutes when there is a direct relationship between the price of one and the demand for the other—meaning an increase in the price of one leads to an increase in demand for the other (they move in the same direction). For example, margarine is a substitute for butter. If the price of butter rises, it will increase the demand for margarine as consumers substitute margarine for the more expensive butter. Conversely, lower butter prices will reduce the demand for margarine, shifting the entire demand curve for margarine to the left.

Gasoline and hybrid cars provide another example of a substitute relationship. As gasoline prices have risen in recent years, the demand for gas–electric hybrid cars has

A Decrease in Demand

In college towns, the demand for pizza delivery decreases substantially when stu- dents go home for the summer. A decrease in demand is a leftward shift in the entire demand curve. Fewer pizzas are demanded at every price.

ExHIBIT 5

P ri

Quantity of pizzas delivered per week

100 200 300

D2 D1

$20

en ga

ge L

ea rn

in g

20 13

53538_ch03_rev03.indd 49 17/12/13 5:02 PM

50 part 2 Markets and GovernMent

increased. Beef and chicken, pencils and pens, apples and oranges, and coffee and tea pro- vide other examples of goods with substitute relationships.

Other products are consumed jointly, so the demands for them are linked together as well. Examples of goods that “go together” include peanut butter and jelly, hot dogs and hot dog buns, and tents and other camping equipment. These goods are called com- plements. For complements, a decrease in the price of one will not only increase its quantity demanded; it will also increase the demand for the other good. The reverse is also true. As a complement becomes more expensive, the quantity demanded of it will fall, and so will the demand for its complements. For example, if the price of steak rises, grocery stores can expect to sell fewer bottles of steak sauce, even if the price of steak sauce remains unchanged.

4. changes in expectations. Consumers’ expectations about the future also can affect the current demand for a product. If consumers begin to expect that a major hur- ricane will strike their area, the current demand for batteries and canned food will rise. Expectations about the future direction of the economy can also affect current demand. If consumers are pessimistic about the economy, they start spending less, causing the cur- rent demand for goods to fall. Perhaps most important is how a change in the expected future price of a good affects current demand. When consumers expect the price of a product to rise in the near future, their current demand for it will increase. Gasoline is a good example. If you expect the price to increase soon, you’ll want to fill up your tank now before the price goes up. In contrast, consumers will delay a purchase if they expect the item to decrease in price. No doubt you have heard someone say, “I’ll wait until it goes on sale.” When consumers expect the price of a product to fall, current demand for it will decline.

5. demographic changes. The demand for many products is strongly influenced by the demographic composition of the market. An increase in the elderly population in the United States in recent years has increased the demand for medical care, retirement housing, and vacation travel. The demand curves for these goods have shifted to the right. During the 1980s, the number of people aged 15 to 24 fell by more than 5 million. Because young people are a major part of the U.S. market for jeans, the demand for jeans fell by more than 100 million pairs over the course of the decade.4 More recently, the increased use of cell phones and iPods among teenagers has led to a dramatic reduction in the demand for wristwatches.

6. changes in consumer tastes and preferences. Why do preferences change? Preferences change because people change and because people acquire new in- formation. Consider how consumers respond to changing trends in popular diet programs. The demand for high-carbohydrate foods like white bread has fallen substantially, whereas the demand for low-carbohydrate foods like beef has risen. This is a major change from the past, when the demand for beef fell because of the “heart-healthy” eating habits consumers preferred then. Trends in the markets for clothing, toys, collectibles, and entertainment are constantly causing changes in the demand for these products as well. Firms may even try to change consumer preferences for their own products through advertising and informa- tion brochures.

The accompanying Thumbnail Sketch summarizes the major factors that cause a change in demand—a shift of the entire demand curve—and points out that quan- tity demanded (but not demand) will change in response to a change in the price of a good.

Complements Products that are usually consumed jointly (for example, bread and butter, hot dogs and hot dog buns). a decrease in the price of one will cause an increase in demand for the other.

4These figures are from Suzanne Tregarthen, “Market for Jeans Shrinks,” The Margin 6, no. 3 (January–February 1991): 28.

53538_ch03_rev03.indd 50 17/12/13 5:02 PM

chapter 3 deMand, suPPly, and the Market ProCess 51

3-3 producer choice and the law of supply Now let’s shift our focus to producers and the supply side of the market. How does the mar- ket process determine the amount of each good that will be produced? To figure this out, we first have to understand what influences the choices of producers. Producers convert resources into goods and services by doing the following:

1. organizing productive inputs and resources, like land, labor, capital, natural resources, and intermediate goods;

2. transforming and combining these inputs into goods and services; and 3. selling the final products to consumers.

Producers have to purchase the resources at prices determined by market forces. Pre- dictably, the owners of these resources will supply the resources only at prices at least equal to what they could earn elsewhere. Put another way, each resource the producers buy to make their product has to be bid away from all other potential uses. Its owner has to be paid its opportunity cost. The sum of the producer’s cost of each resource used to produce a good will equal the opportunity cost of production.

There is an important difference between the opportunity cost of production and stan- dard accounting measures of cost. Accountants generally do not count the cost of assets owned by the firm when they calculate the firm’s cost. But economists do. Economists consider the fact that the assets owned by the firm could be used some other way—in other words, that they have an opportunity cost. Unless these opportunity costs are covered, the resources will eventually be used in other ways.

The opportunity cost of the assets owned by the firm is the earnings these assets could have generated if they were used in another way. Consider a manufacturer that invests $100 million in buildings and equipment to produce shirts. Instead of buying buildings and equipment,

Opportunity cost of production the total economic cost of producing a good or service. the cost component includes the opportunity cost of all resources, including those owned by the firm. the opportunity cost is equal to the value of the production of other goods sacrificed as the result of producing the good.

This factor changes the quantity demanded of a good:

1. The price of the good: A higher price decreases the quantity demanded; a lower price increases the quantity demanded.

These factors change the demand for a good:

1. consumer income: Lower consumer income will generally decrease demand; higher consumer income will generally increase demand.

2. Number of consumers in the market: Fewer consumers decreases demand; more consumers increases demand.

3a. Price of a substitute good: A decrease in the price of a substitute decreases the demand for the origi- nal good; an increase in the price of a substitute increases the demand for the original good.

3b. Price of a complementary good: An increase in the price of a complement decreases the demand for the original good; a decrease in the price of a complement increases the demand for the original good.

4. Expected future price of the good: If the price of a good is expected to fall in the future, the current demand for it will decrease; if the price of a good is expected to rise in the future, the current demand for it will increase.

5. Demographic changes: Population trends in age, gender, race, and other factors can increase or decrease demand for specific goods.

6. consumer preferences: changes in consumer tastes and preferences can increase or decrease demand for specific goods.

Thumbnail Sketch Factors That Cause Changes in Demand and Quantity Demanded

to ck

ph ot

o. co

m /b

ai an

lia ng

53538_ch03_rev03.indd 51 17/12/13 5:02 PM

52 part 2 Markets and GovernMent

the manufacturer could simply put the $100 million in the bank and let it draw interest. If the $100 million were earning, say, 5 percent interest, the firm would make $5 million on that money in a year’s time. This $5 million in forgone interest is part of the firm’s opportunity cost of producing shirts. Unlike an accountant, an economist will take that $5 million opportunity cost into account. If the firm plans to invest the money in shirt-making equipment, it had better earn more from making the shirts than the $5 million it could earn by simply putting the money in the bank. If the firm can’t generate enough to cover all of its costs, including the opportu- nity cost of assets owned by the firm, it will not continue in business. If the firm were earning only $3 million producing shirts, it might be earning profit on its accounting statement, but it would be suffering a $2 million economic loss relative to simply putting the money in the bank.

3-3a the role of profits and losses

to ck

ph ot

o. co

m /m

al er

ap as

Keys to econoMic ProsPerity

profits and losses Profits direct producers toward activities that increase the value of resources; losses impose a penalty on those who reduce the value of resources.

Firms earn a profit when the revenues from the goods and services that they supply exceed the opportunity cost of the resources used to make them. Consumers will not buy goods and services unless they value them at least as much as their purchase price. For example, Susan would not be willing to pay $40 for a pair of jeans unless she valued them by at least that amount. At the same time, the seller’s opportunity cost of supplying a good will reflect the value consumers place on other goods that could have been produced with those same resources. This is true precisely because the seller has to bid those resources away from other producers wanting to use them.

Think about what it means when, for example, a firm is able to produce jeans at a cost of $30 per pair and sell them for $40, thereby reaping a profit of $10 per pair. The $30 op- portunity cost of the jeans indicates that the resources used to produce the jeans could have been used to produce other items worth $30 to consumers (perhaps a denim backpack). In turn, the profit indicates that consumers value the jeans more than other goods that might have been produced with the resources used to supply the jeans.

The willingness of consumers to pay a price greater than a good’s opportunity cost indicates that they value the good more than other things that could have been produced with the same resources. Viewed from this perspective, profit is a reward earned by entre- preneurs who use resources to produce goods consumers value more highly than the other goods those resources could have produced. In essence, this profit is a signal that an entre- preneur has increased the value of the resources under his or her control.

Business decision makers will seek to undertake production of goods and services that will generate profit. However, things do not always turn out as expected. Sometimes business firms are unable to sell their products at prices that will cover their costs. Losses occur when the revenue derived from sales is insufficient to cover the opportunity cost of the resources used to produce a good or service. Losses indicate that the firm has reduced the value of the resources it has used. In other words, consumers would have been better off if those resources had been used to produce something else. In a market economy, losses will eventually cause firms to go out of business, and the resources they previously utilized will be directed toward other things valued more highly, or to other firms who can produce those same goods at a lower cost.

Profits and losses play a very important role in a market economy. They determine which products (and firms) will expand and survive and which will contract and be driven from the market. Clearly, there is a positive side to business failures. As our preceding dis- cussion highlights, losses and business failures free up resources being used unwisely so they can be put to use by other firms providing consumers with more value.

Profit an excess of sales revenue relative to the opportunity cost of production. the cost component includes the opportunity cost of all resources, including those owned by the firm. therefore, profit accrues only when the value of the good produced is greater than the value of the resources used for its production.

Loss a deficit of sales revenue relative to the opportunity cost of production. losses are a penalty imposed on those who produce goods even though they are valued less than the resources required for their production.

53538_ch03_rev03.indd 52 17/12/13 5:02 PM

chapter 3 deMand, suPPly, and the Market ProCess 53

3-3b supply and the entrepreneur Entrepreneurs organize the production of new products. In doing so, they take on significant risk in deciding what to produce and how to produce it. Their success or failure depends on how much consumers eventually value the products they de- velop relative to other products that could have been produced with the resources. Entrepreneurs figure out which projects are likely to be profitable and then try to persuade a corporation, a banker, or individual investors to invest the resources needed to give their new idea a chance. Studies indicate, however, that only about 55 to 65 percent of the new products introduced are still on the market five years later. Being an entrepreneur means you have to risk failing.

To prosper, entrepreneurs must convert and rearrange resources in a manner that will increase their value. A person who purchases 100 acres of raw land, puts in streets and a sewage- disposal system, divides the plot into 1-acre lots, and sells them for 50 percent more than the opportunity cost of all resources used is clearly an entrepreneur. This entre- preneur profits because the value of the resources has increased. Sometimes entrepreneur- ial activity is less complex, though. For example, a 15-year-old who purchases a power mower and sells lawn services to his neighbors is also an entrepreneur seeking to profit by increasing the value of his resources—time and equipment.

3-3c Market supply schedule How will producer–entrepreneurs respond to a change in product price? Other things con- stant, a higher price will increase the producer’s incentive to supply the good. Established producers will expand the scale of their operations, and over time new entrepreneurs, seeking personal gain, will enter the market and begin supplying the product, too. The law of supply states that there is a direct (or positive) relationship between the price of a good or service and the amount of it that suppliers are willing to produce. This direct relationship means that the price and the quantity producers wish to supply move in the same direction. As the price increases, producers will supply more—and as the price decreases, they will supply less.

Like the law of demand, the law of supply reflects the basic economic principle that incen- tives matter. Higher prices increase the reward entrepreneurs get from selling their products. The more profitable it is to produce a product, the more of it entrepreneurs will be willing to supply. Conversely, as the price of a product falls, so does its profitability and the incentive to supply it. Just think about how many hours of tutoring services you would be willing to supply for different prices. Would you be willing to spend more time tutoring students if instead of $8 per hour, tutoring paid $50 per hour? The law of supply suggests you would, and producers of other goods and services are no different.

Exhibit 6 illustrates the law of supply. The curve shown in the exhibit is called a supply curve. Because there is a direct relationship between a good’s price and the amount offered for sale by suppliers, the supply curve has a positive slope. It slopes upward to the right. Read horizontally, the supply curve shows how much of a particular good producers are willing to produce and sell at a given price. Read vertically, the supply curve reveals im- portant information about the cost of production. The height of the supply curve indicates both (1) the minimum price necessary to induce producers to supply that additional unit and (2) the opportunity cost of producing that additional unit. These are both measured by the height of the supply curve because the minimum price required to induce a supplier to sell a unit is precisely the marginal cost of producing it.

Law of supply a principle that states there is a direct relationship between the price of a good and the quantity of it producers are willing to supply. as the price of a good increases, producers will wish to supply more of it. as the price decreases, producers will wish to supply less.

Ba ro

n W

ol m

an /G

et ty

Im ag

entrepreneurs who buy raw land, put in streets and sewer lines, and divide up the land into lots for sale will earn a profit if the revenues derived from the lot sales exceed the opportunity cost of the project. profit is a reward for increasing the value of the resources.

53538_ch03_rev03.indd 53 17/12/13 5:02 PM

54 part 2 Markets and GovernMent

3-3d producer surplus We previously used the demand curve to illustrate consumer surplus, the net gains of buy- ers from market exchanges. The supply curve can be used in a similar manner to illustrate the net gains of producers and resource suppliers. Suppose that you are an aspiring musi- cian and are willing to perform a two-hour concert for $500. If a promoter offers to pay you $750 to perform the concert, you will accept, and receive $250 more than your minimum price. This $250 net gain represents your producer surplus. In effect, producer surplus is the difference between the amount a supplier actually receives (based on the market price) and the minimum price required to induce the supplier to produce the given units (their marginal cost). The shaded area of Exhibit 7 illustrates the measurement of producer surplus for an entire market.

It’s important to note that producer surplus represents the gains received by all par- ties contributing resources to the production of a good. In this respect, producer surplus is fundamentally different from profit. Profit accrues to the owners of the business firm producing the good, whereas producer surplus encompasses the net gains derived by all people who help produce the good, including those employed by or selling resources to the firm.

Producer surplus the difference between the price that suppliers actually receive and the minimum price they would be willing to accept. It measures the net gains to producers and resource suppliers from market exchange. It is not the same as profit.

ExHIBIT 7

Producer Surplus

Producer surplus is the area above the supply curve but below the actual sales price. This area represents the net gains to producers and resource suppliers from production and exchange.

P ri

Quantity/time

Producer surplus

Supply

en ga

ge L

ea rn

in g

20 13

Supply Curve

As the price of a product increases, other things constant, producers will increase the amount of the product supplied to the market.

ExHIBIT 6

Q2 Q3

Q1 Quantity/time

P ri

Supply

en ga

ge L

ea rn

in g

20 13

53538_ch03_rev03.indd 54 17/12/13 5:02 PM

chapter 3 deMand, suPPly, and the Market ProCess 55

3-3e responsiveness of Quantity supplied to price chanGes: elastic and inelastic supply curves Like the quantity demanded, the responsiveness of the quantity supplied to a change in price is different for different goods. The supply curve is said to be elastic when a modest change in price leads to a large change in quantity supplied. This is generally true when the additional resources needed to expand output can be obtained with only a small increase in their price. Consider the supply of soft drinks. The contents of soft drinks—primarily car- bonated water, sugar, and flavoring—are abundantly available. A sharp increase in the use of these ingredients by soft drink producers is unlikely to push up their price much. There- fore, as Exhibit 8 illustrates, if the price of soft drinks were to rise from $1 to $1.50, pro- ducers would be willing to expand output sharply from 100 million to 200 million cans per month. A 50 percent increase in price leads to a 100 percent expansion in quantity supplied. The larger the increase in quantity in response to a higher price, the more elastic the supply curve. The flatness of the supply curve for soft drinks reflects the fact that it is highly elastic.

In contrast, when the quantity supplied is not very responsive to a change in price, sup- ply is said to be inelastic. Physicians’ services are an example. If the earnings of doctors increase from $100 to $150 per hour, there will be some increase in the quantity of the ser- vices they provide. Some physicians will work longer hours; others may delay retirement. Yet, these adjustments are likely to result in only a small increase in the quantity supplied because it takes a long time to train a physician and the number of qualified doctors who are working in other occupations or who are outside of the labor force is small. Therefore, as Exhibit 8 (right frame) shows, a 50 percent increase in the price of physician services leads

ALfRED MARSHALL (1842–1924) British economist Alfred Marshall was one of the most influential economists of his era. Many con- cepts and tools that form the core of modern microeconomics originated with Marshall in his famous Principles of Economics, first published in 1890. Marshall introduced the concepts of supply and demand, equilibrium, elasticity, consumers’ and producers’ surplus, and the idea of distinguishing between short-run and long-run changes.

o u ts ta n d In G eCo n o M Is t

to ck

ph ot

o. co

m /s

or en

dl s

Th e

G ra

ng er

C ol

le ct

io n,

YC —

A ll

rig ht

s re

se rv

ed .

Elastic and Inelastic Supply Curves

Frame (a) illustrates a sup- ply curve that is relatively elastic and therefore the quantity supplied is highly responsive to a change in price. soft drinks provide an example. Frame (b) illus- trates a relatively inelastic supply curve, one in which the quantity supplied increases by only a small amount in response to a change in price. This is the case for physician services.

$150

P ri

$100

$1.50

P ri

100

200

Soft drinks (millions of cans per month)

Physician services (millions of hours per month)

(a) (b)

ExHIBIT 8

en ga

ge L

ea rn

in g

20 13

53538_ch03_rev03.indd 55 17/12/13 5:02 PM

56 part 2 Markets and GovernMent

to only a 20 percent expansion in the quantity supplied. Unlike soft drinks, higher prices for physician services do not generate much increase in quantity supplied. Economists would say that the supply of physician services is relatively inelastic.

3-4 chanGes in supply versus chanGes in Quantity supplied Like demand, it is important to distinguish between a change in the quantity supplied and a change in supply. When producers change the number of units they are willing to supply in response to a change in price, this movement along the supply curve is called a “change in quantity supplied.” A change in any factor other than the price shifts the supply curve and is called a “change in supply.”

As we previously discussed, profit-seeking entrepreneurs will produce a good only if its sales price is expected to exceed its opportunity cost of production. Therefore, changes that affect the opportunity cost of supplying a good will also influence the amount of it produc- ers are willing to supply. These other factors, such as the prices of resources used to make the good and the level of technology available, are held constant when we draw the supply curve. The supply curve itself reflects quantity changes only in response to price changes. Changes in these other factors shift the supply curve. Factors that increase the opportunity cost of providing a good will discourage production and decrease supply, shifting the entire curve inward to the left. Conversely, changes that lower the opportunity cost of producers will encourage production and increase supply, shifting the entire curve outward to the right.

Let us now take a closer look at the primary factors that will cause a change in supply and shift the entire curve right or left.

1. changes in resource prices. How will an increase in the price of a resource, such as wages of workers or the materials used to produce a product, affect the supply of a good? Higher resource prices will increase the cost of production, reducing the profitability of firms supplying the good. The higher cost will induce firms to reduce their output. With time, some may even be driven out of business. As Exhibit 9 illustrates, higher resource prices will reduce the supply of the good, causing a shift to the left in the supply curve from S

1 to S

2 . Alternatively, a reduction in the price of a resource used to produce a good will

cause an increase in supply—a rightward shift in the supply curve—as firms expand output in response to the lower costs and increased profitability of supplying the good.

2. changes in technology. Like lower resource prices, technological improvements—the discovery of new, lower-cost production techniques—reduce production costs, and there- by increase supply. Technological advances have affected the cost of almost everything.

A Decrease in Supply

crude oil is a resource used to produce gasoline. When the price of crude oil rises, it increases the cost of producing gasoline and results in a decrease in the supply of gasoline.

ExHIBIT 9

P ri

Quantity of gasoline

S2 S1

en ga

ge L

ea rn

in g

20 13

53538_ch03_rev03.indd 56 17/12/13 5:02 PM

chapter 3 deMand, suPPly, and the Market ProCess 57

Before the invention of the printing press, books had to be handwritten. Just imagine the massive reduction in cost and increase in the supply of books caused by this single inven- tion. Similarly, improved farm machinery has vastly expanded the supply of agricultural products through the years. The field of robotics has reduced the cost of producing air- planes, automobiles, and other types of machinery. Better computer chips have drastically reduced the cost of producing electronics. Forty years ago, a simple calculator cost more than $100 and a microwave oven almost $500. When introduced in the mid-1980s, a cel- lular telephone cost more than $4,000. You have probably noticed that the prices of flat- screen computer monitors and plasma-screen televisions have fallen substantially in recent years. Again, technological advances explain these changes.

3. elements of nature and political disruptions. Natural disasters and chang- ing political conditions can also alter supply, sometimes dramatically. In some years, good weather leads to “bumper crops,” increasing the supply of agricultural products. At other times, freezes or droughts lead to poor harvests, reducing supply. War and political unrest in the Middle East region have had a major impact on the supply of oil several times during the past few decades. Factors such as these will alter supply.

4. changes in taxes. If the government increases the taxes on the sellers of a product, the result will be the same as any other increase in the cost of doing business. The added tax that sellers have to pay will reduce their willingness to sell the product at any given price. Each unit must now be sold for a price that covers not only the opportunity cost of produc- tion, but also the tax. For example, a special tax is levied on commercial airline tickets, partially to cover the cost of airport security. This tax increases the cost of air travel and thereby reduces the supply (a shift to the left in the supply curve.)

The accompanying Thumbnail Sketch summarizes the major factors that change supply (a shift of the entire supply curve) and quantity supplied (a movement along the supply curve).

3-5 how Market prices are deterMined: deMand and supply interact Consumer–buyers and producer–sellers make decisions independent of each other, but mar- ket prices coordinate their choices and influence their actions. To the economist, a market is not a physical location but an abstract concept that encompasses the forces generated

Market an abstract concept encompassing the forces of demand and supply and the interaction of buyers and sellers with the potential for exchange to occur.

This factor changes the quantity supplied of a good:

1. The price of the good: A lower price decreases the quantity supplied; a higher price increases the quantity supplied.

These factors change the supply of a good:

1. Resource prices (the prices of things used to make the good): Lower resource prices increase supply; higher resource prices decrease supply.

2. Technological change: A technological improve- ment increases supply; a technological setback decreases supply.

3. Weather or political conditions: Favorable weather or good political conditions increase supply; ad- verse weather conditions or poor political condi- tions decrease supply.

4. Taxes imposed on the producers of a good: Lower taxes increase supply; higher taxes decrease supply.

Thumbnail Sketch Factors That Cause Changes in Supply and Quantity Supplied

to ck

ph ot

o. co

m /b

ai an

lia ng

53538_ch03_rev03.indd 57 17/12/13 5:02 PM

58 part 2 Markets and GovernMent

by the decisions of buyers and sellers. A market may be quite narrow (for example, the market for grade A jumbo eggs), or it may be quite broad like when we lump diverse goods into a single market, such as the market for all “consumer goods.” There is also a wide range of sophistication among markets. The New York Stock Exchange is a highly formal, computerized market. Each weekday, buyers and sellers, who seldom meet, electronically exchange corporate shares they own worth billions of dollars. In contrast, a neighborhood market for babysitting services or tutoring in economics may be highly informal, bringing together buyers and sellers primarily by word of mouth.

Equilibrium is a state in which the conflicting forces of demand and supply are in balance. When a market is in equilibrium, the decisions of consumers and producers are brought into harmony with one another, and the quantity demanded will equal the quantity supplied. In equilibrium, it is possible for both buyers and sellers to realize their choices simultaneously. What could bring these diverse interests into harmony? We will see that the answer is market prices.

3-5a Market eQuilibriuM As we have learned, a higher price will reduce the quantity of a good demanded by consum- ers. Conversely, a higher price will increase the quantity of a good supplied by producers. The market price of a good will tend to change in a direction that will bring the quantity of a good consumers want to buy into balance with the quantity producers want to sell. If the price is too high, the quantity supplied by producers will exceed the quantity demanded. Producers will be unable to sell as much as they would like unless they reduce their price. Alternatively, if the price is too low, the quantity demanded by consumers will exceed the quantity supplied. Some consumers will be unable to get as much as they would like, unless they are willing to pay a higher price to bid some of the good away from other potential customers. Thus, there will be a tendency for the price in a market to move toward the price that brings the two into balance.

People have a tendency to think of consumers wanting lower prices and producers wanting higher prices. Although this is true, price changes frequently trend toward the middle of the two extremes. When a local store has an excess supply of a particular item, how does it get rid of it? By having a sale or otherwise lowering its price. Firms often lower their prices in order to get rid of excess supply.

In contrast, excess demand is solved by consumers bidding up prices. Children’s toys around Christmas provide a perfect example. When first introduced, items such as the Nintendo Wii, Webkinz, and the video game Rock Band were immediate successes. The firms producing these products had not anticipated the overwhelming demand; every child wanted one for Christmas. Some stores raised their prices, but the demand was so strong that lines of parents were forming outside stores before they even opened. Often, only the first few in line were able to get the toys (a sure sign that the store had set the price below equilibrium). Out in the parking lots, in the classified ads, and on eBay, parents were offer- ing to pay even higher prices for these items. If stores were not going to set the prices right, parents in these informal markets would! These examples show that rising prices are often the result of consumers bidding up prices when excess demand is present. A similar phe- nomenon can be seen in the market for tickets to a World Series game or a popular music group’s upcoming concert, as the immediate value of a ticket on the resale market can be much higher than the original retail price if, at that price, the original quantity supplied is not adequate to meet the quantity demanded.

As these examples illustrate, whenever quantity supplied and quantity demanded are not in balance, there is a tendency for price to change in a manner that will correct the imbalance. It is possible to show this process graphically with the supply and demand curves we have developed in this chapter. Exhibit 10 shows the supply and demand curves in the market for a basic calculator. At a high price—$12, for example—producers will plan to supply 600 cal- culators per day, whereas consumers will choose to purchase only 450. An excess supply of 150 calculators (shown by distance ab in the graph) will result. Unsold calculators will push the inventories of producers upward. To get rid of some of their calculators in inventory, some producers will cut their price to increase their sales. Other firms will have to lower their price,

Equilibrium a state in which the conflicting forces of demand and supply are in balance. When a market is in equilibrium, the decisions of consumers and producers are brought into harmony with one another, and the quantity demanded will equal the quantity supplied.

53538_ch03_rev03.indd 58 17/12/13 5:02 PM

chapter 3 deMand, suPPly, and the Market ProCess 59

too, as a result, or sell even fewer calculators. This lower price will make supplying calcula- tors less attractive to producers. Some of them will go out of business. Others will reduce their output or perhaps produce other products. How low will the price of calculators go? As the figure shows, when the price has declined to $10, the quantity supplied by producers and the quantity demanded by consumers will be in balance at 550 calculators per day. At this price ($10), the quantity demanded by consumers just equals the quantity supplied by producers, and the choices of the two groups are brought into harmony.

What will happen if the price per calculator is lower—$8, for example? In this case, the amount demanded by consumers (650 units) will exceed the amount supplied by pro- ducers (500 units). An excess demand of 150 units (shown by the distance cd in the graph) will be the result. Some consumers who are unable to purchase the calculators at $8 per unit because of the inadequate supply would be willing to pay a higher price. Recogniz- ing this fact, producers will raise their price. As the price increases to $10, producers will expand their output and consumers will cut down on their consumption. At the $10 price, equilibrium will be restored.

3-5b efficiency and Market eQuilibriuM When a market reaches equilibrium, all the gains from trade have been fully realized and economic efficiency is present. Economists often use economic efficiency as a standard to measure outcomes under alternative circumstances. The central idea of efficiency is a cost-versus-benefit comparison. On the one hand, undertaking an economic action will be efficient only if it generates more benefit than cost. On the other hand, undertaking an action that generates more cost than benefit is inefficient. For a market to be efficient, all trades that generate more benefit than cost need to be undertaken. In addition, economic efficiency requires that no trades creating more cost than benefit be undertaken.

Economic efficiency a situation in which all of the potential gains from trade have been realized. an action is efficient only if it creates more benefit than cost. With well-defined property rights and competition, market equilibrium is efficient.

Supply and Demand

The table indicates the supply and demand conditions for calculators. These conditions are also illustrated by the graph. When the price exceeds $10, an excess supply is present, which places downward pressure on price. In contrast, when the price is less than $10, an excess demand results, which causes the price to rise. Thus, the market price will tend toward $10, at which point the quantity demanded will be equal to the quantity supplied.

ExHIBIT 10

PRICE OF CALCULATORS

(DOLLARS)

QUANTITY SUPPLIED (PER DAY)

QUANTITY DEMANDED (PER DAY)

CONDITION IN THE

MARKET

DIRECTION OF PRESSURE

ON PRICE

Excess supply

P ri

ce (

d o

lla rs

)

Quantity/time

350 450 550 650 750

Excess demand

$13 12 11 10 9 8 7

625 600 575 550 525 500 475

400 450 500 550 600 650 700

Excess supply Excess supply Excess supply Balance Excess demand Excess demand Excess demand

Downward Downward Downward Equilibrium Upward Upward Upward

a b

c d

en ga

ge L

ea rn

in g

20 13

53538_ch03_rev03.indd 59 17/12/13 5:02 PM

60 part 2 Markets and GovernMent

A closer look at the way that markets work can help us understand the concept of efficiency. The supply curve reflects producers’ opportunity cost. Each point along the supply curve indicates the minimum price for which the units of a good could be produced without a loss to the seller. Assuming no other third parties are affected by the production of this good, then the height of the supply curve represents the opportu- nity cost to society of producing and selling the good. On the other side of the market, each point along the demand curve indicates how consumers value an extra unit of the good—that is, the maximum amount the consumer is willing to pay for the extra unit. Again assuming that no other third parties are affected, the height of the demand curve represents the benefit to society of producing and selling the good. Any time the con- sumer’s valuation of a unit (the benefit) exceeds the producer’s minimum supply price (the cost), producing and selling the unit is consistent with economic efficiency. The trade will result in mutual gain to both parties. When property rights are well defined and only the buyers and sellers are affected by production and exchange, competitive market forces will automatically guide a market toward an equilibrium level of output that satisfies economic efficiency.

Exhibit 11 illustrates why this is true. Suppliers of bicycles will produce additional bi- cycles as long as the market price exceeds their opportunity cost of production (shown by the height of the supply curve). Similarly, consumers will continue to purchase additional bikes as long as their benefit (shown by the height of the demand curve) exceeds the market price. Eventually, market forces will result in an equilibrium output level of Q and a price of P. At this point, all the bicycles providing benefits to consumers that exceed the costs to suppliers will be produced. Economic efficiency is met because all of the potential consumer and producer gains from exchange (shown by the shaded area) have occurred. As you can see, the point of market equilibrium is also the point where the combined area showing consumer and producer surplus is the greatest.

When fewer than Q bicycles are produced, some bicycles valued more by consumers than the opportunity cost of producing them are not being produced. This is not consistent with economic efficiency. On the other hand, if output is expanded beyond Q, inefficiency will also result because some of the bicycles cost more to produce than consumers are will- ing to pay for them. Prices in competitive markets eventually guide producers and consum- ers to the level of output consistent with economic efficiency.

Economic Efficiency

When markets are com- petitive and property rights are well defined, the equilibrium reached by a market satisfies economic efficiency. All units that create more benefit (the buyer’s valuation shown by the height of the demand curve) than cost (oppor- tunity cost of production shown by the height of the supply curve) are pro- duced. This maximizes the total gains from trade, the combined area repre- sented by consumer and producer surplus.

ExHIBIT 11

P ri

Bicycles per month

Entire shaded area is net gains to buyers and

sellers

Consumer surplus

Producer surplus

en ga

ge L

ea rn

in g

20 13

53538_ch03_rev03.indd 60 17/12/13 5:02 PM

chapter 3 deMand, suPPly, and the Market ProCess 61

3-6 how Markets respond to chanGes in deMand and supply How will a market adjust to a change in demand? Exhibit 12 shows the market adjustment to an increase in the demand for eggs around Easter. Demand D

1 and

supply S are typical throughout much of the year. Dur- ing the two weeks before Easter, however, consumer demand for eggs rises because people purchase them to decorate, too. This shifts egg demand from D

1 to D

during that time of year. As you can see, the increase in demand pushes the price upward from P

1 to P

2 (typically

by about 20 cents per dozen) and results in a larger equi- librium quantity traded (Q

2 rather than Q

1 —an increase

of typically around 600 million eggs). There is a new equilibrium at point b around Easter (versus point a dur- ing the rest of the year).

Although consumers may not be happy about paying a higher price for eggs around Easter, the higher price serves two essential purposes. First, it encourages consumers to conserve on their usage of eggs. Some consumers may purchase only two dozen eggs to color, rather than three; other consumers may skip having an omelet for breakfast and have yogurt instead. These steps on the consumer side of the market help make the eggs that are available around Easter go further. Second, the higher price is precisely what re- sults in the additional 600 million eggs being supplied to the market to satisfy this in- creased consumer demand. Without the price increase, excess demand would be present, and many consumers would simply be unable to find eggs to purchase around Easter. If the price remained at P

1 (the equilibrium price throughout most of the year), consumers at

Easter-time would want to purchase more eggs than producers would be willing to supply. At the higher P

2 price, however, the quantity suppliers are willing to sell is again in balance

with the quantity consumers wish to purchase. Why were suppliers unwilling to supply the additional 600 million eggs at the origi-

nal price of P 1 ? Because at the original equilibrium price of P

1 , suppliers were already

Market Adjustment to Increase in Demand

Here, we illustrate how the market for eggs adjusts to an increase in demand such as generally occurs around Easter. Initially (before the Easter sea- son), the market for eggs reflects demand D

1 and

supply S. The increase in demand (shift from D

1 to

D 2 ) pushes price up and

leads to a new equilibrium at a higher price (P

2 rather

than P 1 ) and larger quan-

tity traded (Q 2 )

ExHIBIT 12

P ri

Eggs per week

en ga

ge L

ea rn

in g

20 13

the tradition of coloring and hunting for eggs causes an increase in demand for eggs around easter. as exhibit 12 illustrates, this leads to higher egg prices and costly actions by producers to supply a larger quantity during this period.

ub .-W

ilh . D

om rö

se /S

hu tt

er st

oc k.

co m

53538_ch03_rev03.indd 61 17/12/13 5:02 PM

62 part 2 Markets and GovernMent

producing and selling all the eggs that cost less to produce than that price. The additional eggs desired by consumers around Easter all cost more to produce than the old market price of P

1 . The higher price of P

2 is what allows suppliers to cover their higher produc-

tion costs associated with these extra eggs. Around Easter, farmers take costly steps to avoid having the hens molt because hens lay fewer eggs when they are molting. They do this by changing the quantity and types of feed and by increasing the lighting in the birds’ sheds—both of which mean higher production costs. Farmers also try to build up larger than normal inventories of eggs before Easter. Eggs are typically about two days old when consumers buy them at the store, but can be up to seven days old around Easter time. Building up and maintaining this additional inventory are costly, too.

In a market economy, when the demand for a good increases, its price will rise, which will (1) motivate consumers to search for substitutes and cut back on additional purchases of the good and (2) motivate producers to supply more of the good. These two forces will eventually bring the quantity demanded and quantity supplied back into balance.

It’s important to note that this response on the supply side of the egg market is not a shift in the supply curve. The supply curve remains unchanged. Rather, there is a movement along the original supply curve—a change in quantity supplied. The only reason suppliers are will- ing to alter their behavior (produce more eggs) is because the increased demand has pushed up the price of eggs. Notice that it is the change in demand (a shift of the demand curve) that leads to the change in quantity supplied (a movement along the supply curve). Producers are simply responding to the price movement caused by the change in demand. A movement along one curve (a change in quantity supplied or a change in quantity demanded) happens in response to a shift in the other curve (a change in demand or a change in supply).

When the demand for a product declines, the adjustment process sends buyers and sellers just the opposite signals. Take a piece of paper and see if you can diagram a decrease in demand and how it will affect price and quantity in a market. If you’ve done it correctly, a decline in demand (a shift to the left in the demand curve) will lead to a lower price and a lower quantity traded. What’s going on in the diagram is that the lower price (caused by lower consumer demand) is reducing the incentive of producers to supply the good. When consumers no longer want as much of a good, falling market prices signal producers to cut back production. The reduced output allows these resources to be freed up to go into the production of other goods consumers want more.

How will markets respond to changes in supply? Exhibit 13 shows the market’s ad- justment to a decrease in the supply of lemons, such as happened during January 2007 when freezing temperatures in California destroyed a large portion of the lemon crop. A reduction

Market Adjustment to a Decrease in Supply

Here, using lemons as an example, we illustrate how a market adjusts to a decrease in supply. Assume adverse weather conditions substantially reduce the supply (shift from S

1 to S

2 ) of lemons.

The reduction in supply leads to an increase in the equilibrium price (from P

to P 2 ) and a reduction in

the equilibrium quantity traded (from Q

1 to Q

2 ).

ExHIBIT 13

P ri

Lemons (quantity per week)

Q2 Q1

en ga

ge L

ea rn

in g

20 13

53538_ch03_rev03.indd 62 17/12/13 5:02 PM

chapter 3 deMand, suPPly, and the Market ProCess 63

in supply (shift from S 1 to S

2 ) will cause the price of lemons to increase sharply (P

1 to P

2 ).

Because of the higher price, consumers will cut back on their consumption of lemons (the movement along the demand curve from a to b). Some will switch to substitutes—in this case, probably other varieties of citrus. The higher price also encourages the remaining lemon suppliers to take additional steps—like more careful harvesting techniques or using more fertilizer—that allow them to produce more lemons than otherwise would be the case. The higher prices will rebalance the quantity demanded and quantity supplied.

As the lemon example illustrates, a decrease in supply will lead to higher prices and a lower equilibrium quantity. How do you think the market price and quantity would adjust to an increase in supply, as might be caused by a breakthrough in the technology used to harvest the lemons? Again, try to draw the appropriate supply and demand curves to illustrate this case. If you do it correctly, the graph you draw will show an increase in supply (a shift to the right in the supply curve) leading to a lower market price and a larger equilibrium quantity.

The accompanying Thumbnail Sketch summarizes the effect of changes—both in- creases and decreases—in demand and supply on the equilibrium price and quantity. The cases listed in the sketch, however, are for when only a single curve shifts. But sometimes market conditions simultaneously shift both demand and supply. For example, consumer income might increase at the same time that a technological advance in production occurs. These two changes will cause both demand and supply to increase at the same time—both curves will shift to the right. The new equilibrium will definitely be at a larger quantity, but the direction of the change in price is indeterminate. The price may either increase or decrease, depending on whether the increase in demand or increase in supply is larger— which curve shifted the most, in other words.

What will happen if supply increases but demand falls at the same time? Price will definitely fall, but the new equilibrium quantity may either increase or decrease. Draw the supply and demand curves for this case and make sure that you understand why.

3-6a invisible hand principle

Keys to econoMic ProsPerity invisible hand principle Market prices coordinate the actions of self-interested individuals and direct them toward activities that promote the general welfare.

to ck

ph ot

o. co

m /m

al er

ap as

changes in demand 1. An increase in demand—shown by a rightward shift

of the demand curve—will cause an increase in both the equilibrium price and the equilibrium quantity.

2. A decrease in demand—shown by a leftward shift of the demand curve—will cause a decrease in both the equilibrium price and the equilibrium quantity.

changes in supply 1. An increase in supply—shown by a rightward shift of

the supply curve—will cause a decrease in the equilib- rium price and an increase in the equilibrium quantity.

2. A decrease in supply—shown by a leftward shift of the supply curve—will cause an increase in the equilib- rium price and a decrease in the equilibrium quantity.

Thumbnail Sketch How Changes in Demand and Supply Affect Market Price and Quantity

to ck

ph ot

o. co

m /b

ai an

lia ng

53538_ch03_rev03.indd 63 17/12/13 5:03 PM

64 part 2 Markets and GovernMent

More than 235 years ago, Adam Smith, the father of economics, stressed that personal self-interest when directed by market prices is a powerful force promoting economic prog- ress. In a famous passage in his book An Inquiry into the Nature and Causes of the Wealth of Nations, Smith put it this way:

Every individual is continually exerting himself to find out the most advan- tageous employment for whatever [income] he can command. It is his own advantage, indeed, and not that of the society which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society. . . . He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.5

The “invisible hand” to which Smith referred was the pricing system––prices deter- mined by the forces of supply and demand. Smith’s fundamental insight was that market prices tend to bring the self-interest of individuals into harmony with the betterment of society. Moreover, when it is directed by market prices, personal self-interest is a powerful force promoting growth and prosperity.

The tendency of market prices to channel the actions of self-interested individuals into activities that promote the prosperity of the society is now known as the invisible hand principle. Let’s take a closer look at this important principle.

3-6b prices and Market order The invisible hand principle can be difficult to grasp because there is a natural tendency to asso- ciate order with central direction and control. Surely some central authority must be in charge. But this is not the case. The pricing system, reflecting the choices of literally millions of con- sumers, producers, and resource owners, provides the direction. Moreover, the market process works so automatically that most of us give little thought to it. We simply take it for granted.

Perhaps an example from your everyday life will help you better understand the invis- ible hand principle. Visualize a busy retail store with 10 checkout lanes. No one is assign- ing shoppers to checkout lanes. Shoppers are left to choose for themselves. Nonetheless, they do not all try to get in the same lane. Why? Individuals are always alert for adjustment opportunities that offer personal gain. When the line at one lane gets long or is held up by a price check, some shoppers will shift to other lanes and thereby smooth out the flow among the lanes. Even though central planning is absent, this process of mutual adjustment by self-interested individuals results in order and social cooperation. A similar phenomenon occurs on busy interstate highways as drivers switch between lanes for personal gain, with the end result being the quickest flow of traffic for everyone and for the group as a whole.

The incentive structure generated by markets is a lot like that accompanying the check- out at a busy retail store or driving on the freeway. Like the number of people in a lane, profits and losses provide market participants with information about the advantages and disadvantages of different economic activities. Losses indicate that an economic activity is congested, and, as a result, producers are unable to cover their costs. In such a case, successful market participants will shift their resources away from such activities toward other, more valuable uses. Conversely, profits are indicative of an open lane, the opportu- nity to experience gain if one shifts into an activity in which the price is high relative to the per-unit cost. As producers and resource suppliers shift away from activities characterized by congestion and into those characterized by the opportunity for profit, they enlarge the flow of economic activity.

Consider the following three vitally important functions performed by market prices.

Invisible hand principle the tendency of market prices to direct individuals pursuing their own interests to engage in activities promoting the economic well-being of society.

5Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (New York: Modern Library, 1937), 423.

53538_ch03_rev03.indd 64 17/12/13 5:03 PM

chapter 3 deMand, suPPly, and the Market ProCess 65

1. Market prices communicate information to both buyers and sellers that will promote efficient use of resources and proper response to changing conditions. Prices provide producers with up-to-date information about which goods consumers most in- tensely desire and with important information about the abundance of the resources used in the production process. The cost of production, driven by the opportunity cost of resources, tells the business decision-maker the relative importance others place on the alternative uses of those resources. A boom in the housing market might cause lumber prices to rise. In turn, furniture-makers seeing these higher lumber prices will utilize substitute raw materials such as metal and plastic in their production processes. Because of market prices, furniture-makers will conserve on their use of lumber, just as if they had known that lumber was now more urgently needed for constructing new housing.

Consider another example. Suppose a drought in Brazil severely reduces the supply of coffee. Coffee prices will rise. Even if consumers do not know about the drought, the higher prices will provide them with all the information they need to know—it’s time to cut back on coffee consumption. Market prices register information derived from the choices of millions of consumers, producers, and resource suppliers, and provide them with everything they need to know to make wise decisions.

2. Market prices coordinate the actions of market participants. Market prices also coordinate the choices of buyers and sellers, bringing their decisions into line with each other. Excess supply will lead to falling prices, which discourage production and encourage consumption until the excess supply is eliminated. Alternatively, excess demand will lead to price increases, which encourage consumers to economize on their uses of the good and suppliers to produce more of it, eliminating the excess demand. Changing market prices induce responses on both sides of the market that will correct imbalances.

3. Market prices motivate economic players. Market prices establish a reward– penalty (profit–loss) structure that encourages people to work, cooperate with others, use efficient production methods, supply goods that are intensely desired by others, and invest for the future. Self-interested entrepreneurs will seek to produce only the goods consumers value enough to pay a price sufficient to cover production cost. Self-interest will also encourage pro- ducers to use efficient production methods and adopt cost-saving technologies because lower costs will mean greater profits. Firms that fail to do so will be unable to compete successfully in the marketplace.

At the beginning of this chapter, we asked you to reflect on why the grocery stores in your local community generally have on hand about the right amount of milk, bread, vegetables, and other goods. Likewise, how is it that refrigerators, automobiles, and CD players, produced at different places around the world, make their way to stores near you in approximately the same numbers that they are demanded by consumers? The invisible hand principle provides the answer, and it leads to an amazing degree of social cooperation.

Is the concept of the invisible hand really valid? Next time you sit down to have a nice dinner, think about all the people who help make it possible. It is unlikely that any of them, from the farmer to the truck driver to the grocer, was motivated by a concern that you have an enjoyable meal. Market prices, however, bring their interest into harmony with yours. Farmers who raise the best beef or turkeys receive higher prices, truck drivers and grocers earn more money if their products are delivered fresh and in good condition, and so on. An amazing degree of cooperation and order is created by market exchanges—all without the central direction of any government official.

3-6c coMpetition and property riGhts As we noted earlier in this chapter, our focus so far has been on markets in which rival firms can freely enter and exit, and private-property rights are clearly defined and enforced. The efficiency of market organization is, in fact, dependent upon these two things: (1) competitive markets and (2) well-defined and enforced private-property rights.

53538_ch03_rev03.indd 65 17/12/13 5:03 PM

66 part 2 Markets and GovernMent

●● The law of demand states that there is an inverse (or negative) rela- tionship between the price of a good or service and the quantity of it that consumers are willing to purchase. The height of the demand curve at any quantity shows the maximum price that consumers are willing to pay for that unit.

●● The degree of responsiveness of consumer purchases to a change in price is shown by the steepness of the demand curve. The more responsive buyers are to a change in price, the flatter, or more elastic, the demand curve will be. Conversely, the less re- sponsive buyers are to a change in price, the steeper, or more inelastic, the demand curve will be.

●● A movement along a demand curve is called a change in quantity demanded. A shift of the entire curve is called a change in demand. A change in quantity demanded is caused by a change in the price of the good (generally in response to a shift of the supply curve). A change in demand can be caused by several things, including a change in consumer income or a change in the price of a closely related good.

●● The opportunity cost of producing a good is equal to the cost incurred by bidding the required resources away from alternative uses. Profit indicates that the producer has increased the value of the resources used, whereas a loss indicates that the producer has reduced the value of the resources used.

●● The law of supply states that there is a direct (or positive) relation- ship between the price of a good or service and the quantity of it that producers are willing to supply. The height of the supply curve at any quantity shows the minimum price necessary to induce suppli- ers to produce that unit—that is, the opportunity cost of producing it.

●● A movement along a supply curve is called a change in quantity supplied. A change in quantity supplied is caused by a change in the price of the good (generally in response to a shift of the de- mand curve). A shift of the entire supply curve is called a change in supply. A change in supply can be caused by several factors, such as a change in resource prices or an improvement in technology.

●● The responsiveness of supply to a change in price is shown by the steepness of the supply curve. The more willing producers are to alter the quantity supplied in response to a change in price, the flatter, or more elastic, the supply curve. Conversely, the less willing producers are to alter the quantity supplied in response to a change in price, the steeper, or less elastic, the supply curve.

●● Prices bring the conflicting forces of supply and demand into bal- ance. There is an automatic tendency for market prices to move toward the equilibrium price, at which the quantity demanded equals the quantity supplied.

●● Consumer surplus represents the net gain to buyers from market trades. Producer surplus represents the net gain to producers and re- source suppliers from market trades. In equilibrium, competitive mar- kets maximize these gains, a condition known as economic efficiency.

●● Changes in the prices of goods are caused by changes in sup- ply and demand. An increase in demand will cause the price and quantity supplied to rise. Conversely, a decrease in demand will cause the price and quantity supplied to fall. An increase in sup- ply, however, will cause the price to fall and quantity demanded to rise. Conversely, a decrease in supply will cause the price to rise and quantity demanded to fall.

k e y p o i n t s

Competition, the great regulator, can protect both buyer and seller. It protects consum- ers from sellers who would charge a price substantially above the cost of production or withhold a vital resource for an exorbitant amount of money. Similarly, it protects employ- ees (sellers of their labor) from the power of any single employer (the buyers of labor). When markets are competitive, both buyers and sellers have alternatives and these alterna- tives provide them with protection against ill treatment by others.

When property rights are well defined, secure, and tradable, suppliers of goods and services have to pay resource owners for their use. They will not be permitted to seize and use scarce resources without compensating the owners. Neither will they be permitted to use violence (for example, to attack or invade the property of another) to get what they want. The efficiency of markets hinges on the presence of property rights—after all, people can’t easily exchange or compete for things they don’t have or can’t get property rights to. Without well-defined property rights, markets simply cannot function effectively.

LooKing AHeAd Although we incorporated numerous examples designed to enhance your understanding of the supply-and-demand model throughout this chapter, we have only touched the surface. in various modified forms, this model is the central tool of economics. The next chapter will explore several specific applications and extensions of this important model.

53538_ch03_rev03.indd 66 17/12/13 5:03 PM

chapter 3 deMand, suPPly, and the Market ProCess 67

c r i t i c a l a n a l y s i s Q u e s t i o n s

1. *Which of the following do you think would lead to an in- crease in the current demand for beef?

a. higher pork prices

b. higher consumer income

c. higher prices of feed grains used to feed cattle

d. widespread outbreak of mad cow or hoof-and-mouth disease

e. an increase in the price of beef

2. What is being held constant when a demand curve for a spe- cific product (shoes or apples, for example) is constructed? Explain why the demand curve for a product slopes down- ward to the right.

3. What is the law of supply? How many of the following “goods” do you think conform to the general law of supply? Explain your answer in each case.

a. gasoline

b. cheating on exams

c. political favors from legislators

d. the services of heart specialists

e. children

f. legal divorces

4. *Are prices an accurate measure of a good’s total value? Are prices an accurate measure of a good’s marginal value? What’s the difference? Can you think of a good that has high total value but low marginal value? Use this concept to ex- plain why professional wrestlers earn more than nurses, de- spite the fact that it is virtually certain that nurses create more total value for society than do wrestlers.

5. What is being held constant when the supply curve is con- structed for a specific good like pizza or automobiles? Ex- plain why the supply curve for a good slopes upward to the right.

6. Define consumer surplus and producer surplus. What is meant by economic efficiency, and how does it relate to the gains of consumers and producers?

7. How is the market price of a good determined? When the mar- ket for a product is in equilibrium, how will consumers value an additional unit compared to the opportunity cost of producing that unit? Why is this important?

8. *“The future of our industrial strength cannot be left to chance. Somebody has to develop notions about which in- dustries are winners and which are losers.” Is this statement by a newspaper columnist true? Who is the “somebody”?

9. What factors determine the cost of producing a good or ser- vice? Will producers continue to supply a good or service if consumers are unwilling to pay a price sufficient to cover the cost?

10. *“Production should be for people and not for profit.” Answer the following questions concerning this statement:

a. If production is profitable, are people helped or harmed? Explain.

b. Are people helped more if production results in a loss than if it leads to profit? Is there a conflict between production for people and production for profit?

11. What must an entrepreneur do to earn a profit? How do the actions of firms earning profits influence the value of resources? What happens to the value of resources when losses are pres- ent? If a firm making losses goes out of business, is this bad? Why or why not?

12. *What’s wrong with this way of thinking? “Economists claim that when the price of something goes up, producers increase the quantity supplied to the market. But last year, the price of oranges was really high and the supply of them was really low. Economists are wrong!”

13. What is the invisible hand principle? Does it indicate that self-interested behavior within markets will result in actions that are beneficial to others? What conditions are necessary for the invisible hand to work well? Why are these conditions important?

14. What’s wrong with this way of thinking? “Economists argue that lower prices will result in fewer units being supplied. However, there are exceptions to this rule. For example, in 1972, a very simple 10-digit electronic calculator sold for $120. By 2000, the price of the same type of calculator had declined to less than $5. Yet business firms produced and sold many more calculators in 2000 than they did in 1972. Lower prices did not result in less production or in a decline in the number of calculators supplied.”

15. What is the difference between substitutes and comple- ments? Indicate two goods that are substitutes for each other. Indicate two goods that are complements.

16. Do business firms operating in competitive markets have a strong incentive to serve the interest of consumers? Are they motivated by a strong desire to help consumers? Are “good intentions” necessary if individuals are going to engage in actions that are helpful to others? Discuss.

*Asterisk denotes questions for which answers are given in Appendix B.

●● Market prices communicate information, coordinate the ac- tions of buyers and sellers, and motivate decision makers to act. As the invisible hand principle indicates, market prices are generally able to bring the self-interest of individuals into

harmony with the general welfare of society. The efficiency of the system is dependent upon two things, however: (1) com- petitive market conditions and (2) well-defined and secure property rights.

53538_ch03_rev03.indd 67 17/12/13 5:03 PM