3: Instructor's Commentary

The Market Economy

For many people, life is good and getting better, but we all face costs and must choose what we think is best for us. This lesson sharpens the concepts of scarcity and opportunity cost, introduces the idea of economic efficiency, and explains how we can expand production by accumulating capital and specializing and trading with each other.

Introduction

This chapter summarizes basic facts about the market. There are a few essential facts that we have to grapple with. First, there is a tradeoff involved in any decision to produce or consume more of one good. Consuming more of good x necessarily means consuming less of some other good. The production possibilities frontier shows the tradeoffs made in producing two goods for a firm or society. Individuals make similar tradeoffs when choosing to consume more of one good than another, which you will learn about in Lessons 4, 8, and 9 when you study marginal benefit, utility, and indifference curves.

Second, some firms, people, or countries can produce a good more efficiently than others. This is the idea of comparative advantage. Comparative advantage explains why people, firms, and countries specialize and engage in trade.

Economists define trade very generally to mean any transaction between two individuals, firms, or countries.

Third, resources are used efficiently when marginal cost is equal to marginal benefit. A firm uses more of an input up until the point when the benefit from using one more of the input is the same as the cost of using one more of the input. Later, you will see that a consumer consumes more of a good up until the point where the benefit of consuming one dollar more is the same as the opportunity cost of spending a dollar more on the alternative good. You compare the benefit and cost of one extra unit to make a decision, not of the total amount. For example, if you are studying in a café, you will order an additional cup of coffee if that cup is worth more to you than the price of the coffee, regardless of how much coffee you've had before. This is called making decisions at the margin.

How is this efficient equilibrium reached? If we had an economy of only one person, or an omniscient ruler deciding what was best for us, it is easy to see how this person could arrange things so that marginal cost equals marginal benefit. However, under certain assumptions, competitive markets of many individual firms and consumers reach the same result. How does this happen?

You will review this later. In case you are curious, the assumptions are as follows:

1. that there is a complete market in all goods, including insurance and future markets
2. the market is competitive—anyone can enter the market and buy or sell
3. there are no public goods or externalities, that is, only one person can use the good and its use influences no one else
4. there are no informational asymmetries, that is, the seller can't know something about the good the buyer doesn't know.

How the Market Works

What do economists mean by "the market"? It may be useful to think of a physical market. Originally, a market was a place where many people gathered to buy or sell goods. This type of market still exists in many countries. These markets usually have stalls with many vendors selling their goods. Buyers can easily go from one vendor to another and compare prices. Vendors, on the other hand, see what their competitors are selling, for what price, and in what volume.

In economics, the term market refers to a larger network where transactions (buying or selling) take place. However, the key characteristics are still many participants conducting many transactions and the quick exchange of information in a decentralized way.

In the physical market every individual is free to make whatever deals he or she wants. A vendor can ask whatever price she wants for her goods. A buyer can offer as little as he wants for some good, but transactions only occur when sellers and buyers can agree about the price of an object. (The seller must value the object less than the agreed on price, and the buyer more). A vendor can ask $20 for a glass of water, but it's unlikely anyone will buy. Similarly, I can offer a vendor 10 cents for a gold ring, but he is unlikely to sell. (Logging on to Priceline.com and bidding $75 for a flight to New York is similar. You're free to bid whatever you what, but if you set a price too low you're wasting your time). Every person may differ in how much they value, or are willing to pay for, an object.

In the physical market, everyone is trying to get the best deal possible. Vendors want the highest price. Buyers try to find the lowest price. Obviously, if a buyer has information on all the prices offered, he will choose the lowest one. Therefore, identical goods should not sell at different prices.

What happens when a good is very useful or beneficial? People value it more and are willing to spend more for it. What happens when a good is costly to make? Then sellers will only produce it if it is highly valued.

What happens when goods are scarce? The vendor may not know, and will sell at any price higher than what his value of the good. But once the good sells out, people who still want the good can then offer to buy it from those who did manage to buy. If the price they offer is higher than how much the first buyer values the good, the first buyer will sell. Eventually, the people who are willing to spend the most to get the good—who value it the most, relative to money—will buy it. The price goes higher and higher until no one is left who will give the person who has one and is least attached to it more than that person's valuation of it. Notice that when all transactions have ended, those who value the item the most (in other words, are willing and able to pay the most for it) end up with it.

The price of one unit at this point is how much the last seller is willing to sell it for and how much the last buyer is just willing to pay for it. The price is the marginal benefit from the item—if the price were any lower, the seller would get more benefit from keeping the object; if it were any higher, the last buyer would get more benefit from buying something else.

In modern markets, we can't see every transaction taking place or run after someone who has bought the last of something we want, to try to buy it from them. So how is information transmitted? The answer is the price. The price of a good is a signal that tells buyers and sellers how scarce a good is, relative to how much it is demanded. How does the price regulate? Sellers do not see the number of people who want to buy the type of good they are selling. However, they do notice if at a given price their goods are not selling. This induces them to reduce the price. If goods sell well, they can raise the price.

Information signals are weakened when prices are set, not by the market but by individual companies or the government, perhaps through subsidies, taxes, legislation or monopolies. We call this a price distortion.

How do people specialize so that each produces exactly what he has comparative advantage in? A producer doesn't know how good everyone else is at producing goods, but she knows what their relative price is. Therefore, she can calculate what is most advantageous to produce herself and sell, and what it is cheaper to buy on the market.

For example, you probably buy most of the clothes you wear rather than make them yourself. Imagine if there were only one place in town that made clothes, and a generic outfit cost a thousand dollars. You might start taking sewing lessons. You might even start a store of your own, if you could produce clothes cheaper and undersell the other store. As more people started selling clothes, the price would come down, until only those who were most efficient would find it profitable to sell clothes.

This apparent coordination of the action of many persons is called the invisible hand, a term coined by Adam Smith, the first great economist. His book, Wealth of Nations, written in 1776, is remarkably insightful and easy to read, even today. Look it up and leaf through some of the chapters. Smith discusses how rational self-interest of all ensures goods are available in the largest quantities for all, the crucial role of competition and the danger of monopolies, or giving one group special power, and the benefits of specialization and trade.