Chapter 2 The market mechanism

Economic Systems Classifying economic systems – methods of classification – classification by degree of government control command economies free-market economies mixed economies

Economic Systems The command economy – features of a command economy – planning consumption and investment matching of inputs and outputs distribution of output Advantages of a command economy – high investment, high growth – stable growth – social goals pursued – low unemployment

Economic Systems Problems of a command economy – problems of gathering information – inefficient allocation of resources – expensive to administer – inappropriate incentives – shortages and surpluses

Economic Systems The free-market economy – demand and supply decisions – the price mechanism shortages and surpluses equilibrium price response to change in demand and supply – interdependence of markets

The Free-market Economy Advantages of a free-market economy – transmits information between buyers and sellers – no need for costly bureaucracy – incentives to be efficient – competitive markets respond to consumer wishes Problems of a free-market economy – competition may be limited – inequality – environment and social goals may be ignored The mixed economy – areas where the government might intervene

A.Demand Theory 1. What is Demand? The demand for a good is a relationship between its price and the quantity an individual consumer wants to buy over a certain period of time, assuming other things being constant (ceteris paribus).

2.What is Quantity Demanded? It is the quantity bought by the individual consumer at a particular price.

3.How to derive a demand schedule ? Price ($)Quantity demanded It shows the relationship between quantity demanded and price. Example:

Diagram which plots the demand curve from the demand schedule P 0Q D

4.What is Law of Demand The lower the price at which one can buy a good, the greater the quantity demanded, other things being constant (ceteris paribus).

5.Movements along Demand and Shiftiness of Demand D1 D2 0 P Q 0 P Q

6.Factors affecting quantity demanded. It will be changed by changing the good’s price, other things being constant.

7.Factors affecting Demand 1. Real income of consumers Superior or normal goods Inferior goods 2. Prices of related goods Substitutes Complements 3. Taste or preferences

4. Expectation of future price changes 5. Size and composition of the population 6. Derived demand 7. Other factors

B.Supply Theory 1. What is supply? The supply of a good is a relationship between its price and the quantity an individual firm offers for sale, over a certain period, assuming other things being constant.

2.What is Quantity supplied It is the quantity of a good that the firm is willing to produce for sale in the market at specific price.

3.How to desire a supply schedule? Price ($)Quantity demanded It shows the relationship between quantity demanded and price. Example:

P 0Q Diagram which plots the supply curve from the supply schedule S 10 20

4.Law of Supply The higher the price at which one can buy a good, the greater the quantity supply, other things being constant (ceteris paribus).

5.Movement along Supply and shiftiness of Supply 0 P Q P 0 Q S1 S2 S1

C.Market Equilibrium The price indicated by the intersection of the curves is called the equilibrium price/ market-clearing price.

P 0Q S D Pe Qe * E

At equilibrium point (E): – Quantity Demand = Quantity Supply  No excess Supply or Demand

D.How does the market mechanism work? It works if the price system or the market mechanism is the way in which resources are allocated, according to changes in price. Any prices different from Pe, implies disequilibrium in the market  under free economy, the market will automatically adjust to Pe.

1. If price is higher than Pe (i.e.At P1)  Adjustment process At P1  excess supply exists  P has to  As P On consumer side   P  Qd  On producer side  P  Qs

Hence, accordingly, this adjustment process will continue until demand intersect Supply at Pe is restored.

Any price below Pe  excess demand exists (or shortage) Excess Demand  on the consumer side, there is a pressure for the price to rise As P  Qd On the producer side As PQs

Hence, both Demand and Supply faces will adjust automatically until the market equilibrium is restored at Pe.

P 0Q P1 P2 Excess Demand and Excess Supply Pe Qe S D Excess supply Excess demand

Change in Demand and Supply vs equilibrium price CasesDiagramResult D, SPe and Qe P 0Q S D2 D1

S, DPe and Qe P 0Q D S2 S1

D and S Pe uncertain and Qe P 0Q S2 S1 D2 D1

D and S Pe uncertain and Qe P 0Q S2 S1 D1 D2

D and SPe and Qe uncertain P 0Q S2 S1 D2 D1

Thus, if both D and S change together, the new equilibrium Pe and Qe will depend on the relative extent of changes of D and S curves.

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