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Chapter 14 The Case for Free Markets I: The Price System If there existed the universal mind that . . . would register simultaneously all the processes of nature and of society, that could forecast the results of their inter-reactions, such a mind . . . could . . . draw up a faultless and an exhaustive economic plan. . . . in truth, the bureaucracy often conceives that just such a mind is at its disposal; that is why it so easily frees itself from the control of the market. LEON TROTSKY, A LEADER OF THE RUSSIAN REVOLUTION
Efficient Resource Allocation & Pricing • Efficient allocation of resources • Takes advantage of every opportunity • Make some individuals better off • Not worsening lot of anyone else • Low prices • May not always serve the public interest
Figure 1 Production possibilities frontier and efficiency 500 700 600 Billions of Quarts of Milk 400 C D E G F B 300 400 500 200 0 100 200 300 100 Motor boats
Figure 2 Toll bridges of the San Francisco bay area
The market strikes back • Keep price low • When a price increase is appropriate • Consequences • Worsen effects of shortages • Nationwide chaos in gasoline distribution • After sudden decline in Iranian oil exports, 1979 • In times of war - surrender of cities under siege • Deterrent - smuggling food supplies • Discouraged housing construction • Rent controls
The market strikes back • Keep price low • When a price increase is appropriate • Appropriate to resist price increases • Unrestrained monopoly • Taxes - capriciously and inappropriately • Rising prices - fall heavily on poor people • Potentially serious & tragic consequences • Artificial restrictions on prices
Scarcity & Need to Coordinate Decisions • Three basic questions - resource allocation • Output selection • Product planning • Distribution • Laissez-faire • Minimal government interference • People - left alone in carrying out their economic affairs
Scarcity & Need to Coordinate Decisions • Laissez-faire / free markets • Output selection • Law of supply & demand • Consumer preferences • Production costs • Product planning • Inputs – assigned to firms • Most productive use • Distribution • Price mechanism
Trade-off: efficiency & equality • Price system • Carries out - distribution process • Rations goods • Preferences & relative incomes • Favor the rich – problem • Equality • Tax system - equalize incomes • Market mechanism
Scarcity & Need to Coordinate Decisions • Central planning • Planners decide • Output selection • Product planning • Distribution • Industry interdependence • Output required from any one industry • Depends on outputs from many other industries • Taken into account by planners
Scarcity & Need to Coordinate Decisions • Input-output analysis • Mathematical procedure • Accounts – industries interdependence • Determines - amount of output • Each industry must provide • As inputs to other industries
Scarcity & Need to Coordinate Decisions • Full, rigorous central-planning solution • To production problem • Tremendous task • Overwhelming quantity of information • Incredibly difficult calculations • Carried out automatically & unobtrusively • Price mechanism – free-market economy
Scarcity & Need to Coordinate Decisions • Price mechanism • Other things being equal • Ranks potential consumers • Order: intensity of preference for good • Amount willing to spend • Consumers • Want a scarce commodity the most • Will receive it • Sellers • Supply it most efficiently
Figure 3 Supply-demand graph showing that price excludes only buyers and sellers who care the least 50 S’ S D $70 60 40 Price F C E A G b g a f c B 30 4 5 20 0 1 2 3 S’ S 10 Quantity (in thousands) D 6 7 8
How Perfect Competition Achieves Efficiency • Consumer’s surplus from a purchase • Difference • Maximum amount • Consumer – willing to pay • Price – charged by market • Producer’s surplus from a sale • Difference • Market price • Lowest price • Supplier - willing to sell
Table 1 Consumer’s & producer’s surplus in the swimming lesson market (dollars)
Figure 4 (a) Producer’s and consumer’s surplus: two swimmers D 100 $140 R S 120 T 50 30 -30 20 P 90 -10 P 20 80 D Consumer’s and Producer’s Surplus 40 60 60 U 4 5 40 V S 1 2 3 0 20 Number of Students or Instructors
Figure 4 (b) Producer’s & consumer’s surplus and optimal output D 100 $140 R S 120 T 50 30 -30 20 P 90 -10 P 20 80 D Consumer’s and Producer’s Surplus 40 60 60 U 4 5 40 V S 1 2 3 0 20 Number of Students or Instructors
How Perfect Competition Achieves Efficiency • Maximize net surplus / public interest • Both buyers & sellers • Output quantity • Intersection of supply & demand curves • Consumer & producer surplus • Maximized • Perfect competition • Optimal resource allocation • Optimal output
How Perfect Competition Achieves Efficiency • Smaller output than in perfect competition • Monopoly forces output to be smaller • Public interest – damaged • Less than optimal resource allocation • Larger output than in perfect competition • Government tax reduction • Misallocation of resources • Public welfare – damaged
Perfect Competition – Optimal Output • Rule for efficient output selection • Marginal analysis: MC=MU • MC - Marginal cost of last unit produced • MU - Marginal utility of last unit consumed • Price system • Producers: MC=Price • Consumers: MU=Price
Perfect Competition – Optimal Output • Perfect competition • Producers & consumers • Uncoordinated decisions • Automatically • Produce quantity of each good • MC=MU • Market mechanism • No government intervention • No planning • Allocates society’s scarce resources efficiently
Perfect Competition – Optimal Output • Prices = Marginal costs • Price system • Correct cost signals to consumers • Consumers • Best use of society’s resources • Prices • Guide resource allocation • Influence distribution of income • Buyers & sellers • Efficient solutions – may seem unfair
Table 2 Replies to a questionnaire
Toward Assessment of Price Mechanism • Free market, price mechanism • Not perfect • Room for improvement • Serious shortcomings • Accomplishments • Allocative efficiency
