The Case for Free Markets: The Price System

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The Case for Free Markets: The Price System

● Efficient Resource Allocation and Pricing

● Scarcity and the Need to Coordinate Economic Decisions

● How Perfect Competition Achieves Efficiency

● Efficient Resource Allocation and Pricing

● Scarcity and the Need to Coordinate Economic Decisions

● How Perfect Competition Achieves Efficiency

OutlineOutline

Copyright© 2006 Southwestern/Thomson Learning All rights reserved.

Three Coordination Tasks in the EconomyThree Coordination Tasks in the Economy

● Recall: since resources are scarce, society must use them efficiently.

● Society must choose:1. How much of each good to produce.

2. What input quantities to use in production.

3. How to distribute goods to consumers.

● Here we examine how 3 tasks are achieved by market system under perfect competition.

● Recall: since resources are scarce, society must use them efficiently.

● Society must choose:1. How much of each good to produce.

2. What input quantities to use in production.

3. How to distribute goods to consumers.

● Here we examine how 3 tasks are achieved by market system under perfect competition.

FIGURE 1. Toll Bridges of the San Francisco Bay Area

FIGURE 1. Toll Bridges of the San Francisco Bay Area

80

BerkeleyA

Palo AltoB

DumbartonBridge

San Mateo–HaywardBridge

Fremont

Oakland

SanRafael

SanFrancisco

San Francisco–Oakland Bay

Bridge

GoldenGate

Bridge

Richmond–San Rafael

Bridge

92

84

101

71

84

92

17

101

SanPabloBay


Real World PuzzleReal World Puzzle

● How much should P be to cross the SF-Oakland Bay Bridge?♦ Bay Bridge is very congested.

♦ Enormous volume of toll-paying traffic has long ago paid the cost of building it.

♦ Yet, economists argue that P Bay Bridge > P San Mateo-Hayward or Dumbarton Bridges –which are less crowded.

♦ Why?

● How much should P be to cross the SF-Oakland Bay Bridge?♦ Bay Bridge is very congested.

♦ Enormous volume of toll-paying traffic has long ago paid the cost of building it.

♦ Yet, economists argue that P Bay Bridge > P San Mateo-Hayward or Dumbarton Bridges –which are less crowded.

♦ Why?


Efficient Resource Allocation and PricingEfficient Resource Allocation and Pricing

● Scarcity limits # of goods that can be produced.● PPF used to illustrate concept of scarcity.● Recall: PPF (in Fig. 2) shows all combos of missiles and

milk that an economy can produce given available resources and technology.

● Pt D –if 300 missiles are produced, then economy has enough resources left to produce 500b milk.

● Pt G is inefficient –could produce 200b more milk without giving up any missiles.

● Scarcity limits # of goods that can be produced.● PPF used to illustrate concept of scarcity.● Recall: PPF (in Fig. 2) shows all combos of missiles and

milk that an economy can produce given available resources and technology.

● Pt D –if 300 missiles are produced, then economy has enough resources left to produce 500b milk.

● Pt G is inefficient –could produce 200b more milk without giving up any missiles.


Efficient Resource Allocation and PricingEfficient Resource Allocation and Pricing

● Points below PPF → resources are wasted● Efficient allocation of resources: it is impossible to make

some people better off without making others worse off.● Pt G –can move to E and produce more of both goods

with available S of inputs. So it’s possible to make some people better off without harming anyone.

● All points below PPF are inefficient.● All points on PPF are efficient → cannot get more of 1

good without giving up some of other.

● Points below PPF → resources are wasted● Efficient allocation of resources: it is impossible to make

some people better off without making others worse off.● Pt G –can move to E and produce more of both goods

with available S of inputs. So it’s possible to make some people better off without harming anyone.

● All points below PPF are inefficient.● All points on PPF are efficient → cannot get more of 1

good without giving up some of other.

FIGURE 2. PPF and EfficiencyFIGURE 2. PPF and Efficiency

Bill

ion

s o

f

Qu

arts

of

Milk

Missiles

C

F

E

B

D

G

500 400 300 200 100 0

100

200

300

400

500

600

700

● Use puzzle to see how P can guide efficient choices.● Higher tolls for Bay Bridge can ↓commute time →

↑efficiency.● 3 routes from Berkeley to Palo Alto:

1. Richmond-San Rafael Bridge, cross Golden Gate Bridge, through SF and south on HWY 101

2. Bay Bridge and south on HWY 101

3. San Mateo-Hayward Bridge or Dumbarton

● Which route uses resources (commuter time and gas) most efficiently?

● Use puzzle to see how P can guide efficient choices.● Higher tolls for Bay Bridge can ↓commute time →

↑efficiency.● 3 routes from Berkeley to Palo Alto:

1. Richmond-San Rafael Bridge, cross Golden Gate Bridge, through SF and south on HWY 101

2. Bay Bridge and south on HWY 101

3. San Mateo-Hayward Bridge or Dumbarton

● Which route uses resources (commuter time and gas) most efficiently?

Pricing to Promote Efficiency: An ExamplePricing to Promote Efficiency: An Example


Pricing to Promote Efficiency: An ExamplePricing to Promote Efficiency: An Example

● ↑ efficiency if a driver who is indifferent between routes would pick least crowded bridges → ↓travel time for everyone.

● Routes 1 and 2 are not socially desirable because of added delays for everyone.

● Route 3 is best from public interest.

● ↑ efficiency if a driver who is indifferent between routes would pick least crowded bridges → ↓travel time for everyone.

● Routes 1 and 2 are not socially desirable because of added delays for everyone.

● Route 3 is best from public interest.

BridgeCars

per day

1.Bay 270,000

2. Golden Gate 125,000

3. San Mateo 85,000

4. Dumbarton 65,000

Key: Helps if ↑P to cross most crowded bridges and ↓P to cross less crowded bridges. Then more drivers use less crowded bridges.

● Price increases can be useful when they lead people to economize on use of scarce goods and resources.

● Low prices do NOT always serve the public interest. ♦ E.g., if P crossing a crowded bridge is too low → drivers

crowd bridge even more. Or if P gas is too low → drivers do not conserve gas and further damage the climate/environment.

● Price increases can be useful when they lead people to economize on use of scarce goods and resources.

● Low prices do NOT always serve the public interest. ♦ E.g., if P crossing a crowded bridge is too low → drivers

crowd bridge even more. Or if P gas is too low → drivers do not conserve gas and further damage the climate/environment.

Can Price Increases Ever Serve the Public Interest?Can Price Increases Ever Serve the Public Interest?


● 10 yrs before great potato famine, Economics Professor Longfield (at University of Dublin) stated:

● “Suppose the crop of potatoes in Ireland was to fall short in some year –say, 1/6th of the usual consumption. If there were no increase in price, the whole supply of the year would be exhausted in 10 months, and for the remaining two months, a scene of misery and famine beyond description would ensue. But when prices increase, the sufferers often believe that it is not caused by scarcity. They suppose that there are provisions enough, but that the distress is caused by the insatiable greed of the possessors and they have generally succeeded in obtaining laws against price increases, which alone can prevent provisions from being entirely consumed long before a new supply can be obtained.”

● 10 yrs before great potato famine, Economics Professor Longfield (at University of Dublin) stated:

● “Suppose the crop of potatoes in Ireland was to fall short in some year –say, 1/6th of the usual consumption. If there were no increase in price, the whole supply of the year would be exhausted in 10 months, and for the remaining two months, a scene of misery and famine beyond description would ensue. But when prices increase, the sufferers often believe that it is not caused by scarcity. They suppose that there are provisions enough, but that the distress is caused by the insatiable greed of the possessors and they have generally succeeded in obtaining laws against price increases, which alone can prevent provisions from being entirely consumed long before a new supply can be obtained.”



● If potato crop fails → potatoes are scarce → consumers need to use resources efficiently –stretching out current C until next crop arrives.

● Society must ↓C which happens automatically if ↑P.● Yet, if P potato is too low → consumers will use

resources inefficiently, resulting in hunger.● Higher prices can serve the public interest better than

lower ones. ♦ E.g., Rent controls reduce housing quality and availability in

NY City.

● If potato crop fails → potatoes are scarce → consumers need to use resources efficiently –stretching out current C until next crop arrives.

● Society must ↓C which happens automatically if ↑P.● Yet, if P potato is too low → consumers will use

resources inefficiently, resulting in hunger.● Higher prices can serve the public interest better than

lower ones. ♦ E.g., Rent controls reduce housing quality and availability in

NY City.



The Need to Coordinate Economic DecisionsThe Need to Coordinate Economic Decisions

● Entire economy is very complex with millions of different decision makers.

● I may buy a pint of Chunky Monkey today; along with 1,000s of other consumers all over U.S. But I don’t know or care about their purchasing decisions.

● Yet, scarcity requires that these individual demands be coordinated with production, so that Qd = Qs.

● Massive coordination task involving: consumers, supermarkets, wholesalers, shippers, and dairy farmers. All of whom must somehow agree on their decisions.

● Entire economy is very complex with millions of different decision makers.

● I may buy a pint of Chunky Monkey today; along with 1,000s of other consumers all over U.S. But I don’t know or care about their purchasing decisions.

● Yet, scarcity requires that these individual demands be coordinated with production, so that Qd = Qs.

● Massive coordination task involving: consumers, supermarkets, wholesalers, shippers, and dairy farmers. All of whom must somehow agree on their decisions.


The Need to Coordinate Economic DecisionsThe Need to Coordinate Economic Decisions

● Planned economy: producers are told how much to produce and consumers are told what to purchase.

● Market economy: prices coordinate economic activity.♦ High P→ discourage C of scarce resources and encourage

more production.

♦ Low P → encourage C of abundant resources and discourage further production.

● Planned economy: producers are told how much to produce and consumers are told what to purchase.

● Market economy: prices coordinate economic activity.♦ High P→ discourage C of scarce resources and encourage

more production.

♦ Low P → encourage C of abundant resources and discourage further production.

1. Output selection is solved by forces of S and D.♦ Shortage: ↑P → more production and less consumption

♦ Surplus: ↓P → more consumption and less production

● If ↑D ice cream → Qd > Qs (temporary shortage) → ↑P ice cream → ↑production ice cream.

● How does production rise?♦ Initially milk that would have been used to make cheese or

sour cream is used to make ice cream instead.

♦ If high P ice cream persists, then dairy farmers begin buying more cows, more dairy milking equipment, etc.

1. Output selection is solved by forces of S and D.♦ Shortage: ↑P → more production and less consumption

♦ Surplus: ↓P → more consumption and less production

● If ↑D ice cream → Qd > Qs (temporary shortage) → ↑P ice cream → ↑production ice cream.

● How does production rise?♦ Initially milk that would have been used to make cheese or

sour cream is used to make ice cream instead.

♦ If high P ice cream persists, then dairy farmers begin buying more cows, more dairy milking equipment, etc.

Three Coordination Tasks: Mix of OutputThree Coordination Tasks: Mix of Output


● ∆D shifts the allocation of resources. ♦ If more ice cream is wanted, then more resources are devoted

to ice cream production.

● No government official or planner determines resource allocation.

♦ Lure of profits and signal of prices guides dairy farmers to raise their output when ice cream is in greater demand.

● ∆D shifts the allocation of resources. ♦ If more ice cream is wanted, then more resources are devoted

to ice cream production.

● No government official or planner determines resource allocation.

♦ Lure of profits and signal of prices guides dairy farmers to raise their output when ice cream is in greater demand.

Three Coordination Tasks: Mix of OutputThree Coordination Tasks: Mix of Output

2. Usage of inputs: inputs are assigned to firms that can make the most profitable use of them.

● Firms that cannot make sufficiently productive use of an input will be priced out of the market for that input.♦ E.g., if ↑D cars → ↑P cars → ↑D steel → ↑P steel → ↓steel

use by appliance manufactures who cannot use the steel as profitably as the carmakers.

● Input prices signal the appropriate usage of inputs in production.

2. Usage of inputs: inputs are assigned to firms that can make the most profitable use of them.

● Firms that cannot make sufficiently productive use of an input will be priced out of the market for that input.♦ E.g., if ↑D cars → ↑P cars → ↑D steel → ↑P steel → ↓steel

use by appliance manufactures who cannot use the steel as profitably as the carmakers.

● Input prices signal the appropriate usage of inputs in production.

Three Coordination Tasks: Efficient Usage of InputsThree Coordination Tasks: Efficient Usage of Inputs


● Example where input prices are not allowed to provide proper signals to producers:

♦ 2 ways to ↑egg production: (1) ↑ feed , or (2) ↑ heat from blowers powered by natural gas.

♦ Steel mills also use natural gas in production and there are no economical substitutes. So a mill would have to seriously ↓prod if natural gas is unavailable.

♦ Vs. egg farmers could switch from natural gas to feed for a few pennies more.

● Example where input prices are not allowed to provide proper signals to producers:

♦ 2 ways to ↑egg production: (1) ↑ feed , or (2) ↑ heat from blowers powered by natural gas.

♦ Steel mills also use natural gas in production and there are no economical substitutes. So a mill would have to seriously ↓prod if natural gas is unavailable.

♦ Vs. egg farmers could switch from natural gas to feed for a few pennies more.



● When P natural gas was capped in 1970’s, egg farmers consumed large and socially inefficient Q of natural gas. When P ceiling was lifted, farmers went back to using more feed.

● How would a central planner know to allocate more natural gas to steel mills and less to egg farmers?

● Free markets allow input prices to signal the appropriate (most efficient) usage of inputs in production.

● When P natural gas was capped in 1970’s, egg farmers consumed large and socially inefficient Q of natural gas. When P ceiling was lifted, farmers went back to using more feed.

● How would a central planner know to allocate more natural gas to steel mills and less to egg farmers?

● Free markets allow input prices to signal the appropriate (most efficient) usage of inputs in production.


3. Distribution of goods among consumers: consumers purchase what they like best given their income.

● Previous example: ↑P ice cream → consumers who are lukewarm about ice cream ↓Qd. So ↑P rations available ice cream among consumers who are willing to pay the most for it.

● Rationing by P is better than distribution under central planning where every consumer would get 2 pints per week –even if someone hates it.

3. Distribution of goods among consumers: consumers purchase what they like best given their income.

● Previous example: ↑P ice cream → consumers who are lukewarm about ice cream ↓Qd. So ↑P rations available ice cream among consumers who are willing to pay the most for it.

● Rationing by P is better than distribution under central planning where every consumer would get 2 pints per week –even if someone hates it.

Three Coordination Tasks: Distribution to ConsumersThree Coordination Tasks: Distribution to Consumers


● Rationing by P does favor the wealthy because they can afford more. However, concerns about poverty doesn’t mean we should eliminate P system.

● Tax wealthy and give to poor and continue to let P system allocate goods to those who value them most.

● Rationing by P does favor the wealthy because they can afford more. However, concerns about poverty doesn’t mean we should eliminate P system.

● Tax wealthy and give to poor and continue to let P system allocate goods to those who value them most.

Three Coordination Tasks: Distribution to ConsumersThree Coordination Tasks: Distribution to Consumers

● The price mechanism ensures that: ♦ Consumers who want a scarce commodity most will receive it.

♦ Sellers who can produce it most efficiently will get to supply the commodity.

● In Fig. 3, DG –6,000 customers with different preferences. Pt A 1,000 customers willing to pay $70; pt B next 1,000 are only willing to pay $60, etc.

● In equilibrium: P = $40 and buyers at pt A, B, C, and E will buy the book. But consumers at F and G won’t.

● Book goes to consumers who value it most.

● The price mechanism ensures that: ♦ Consumers who want a scarce commodity most will receive it.

♦ Sellers who can produce it most efficiently will get to supply the commodity.

● In Fig. 3, DG –6,000 customers with different preferences. Pt A 1,000 customers willing to pay $70; pt B next 1,000 are only willing to pay $60, etc.

● In equilibrium: P = $40 and buyers at pt A, B, C, and E will buy the book. But consumers at F and G won’t.

● Book goes to consumers who value it most.

Which Buyers and Which Sellers Get Priority?Which Buyers and Which Sellers Get Priority?

FIGURE 3. Price Excludes Buyers and Sellers Who Care Least

FIGURE 3. Price Excludes Buyers and Sellers Who Care Least

0

10

20

30

40

50

60

$70

7 8

S

S

a

b

c

e

g

f

D

D

G

F

E

C

A

B

1 2 3 4 5 6

Pri

ce

Quantity in thousands

Demand curve, DD, reflects consumers’ marginal utilities.

LR Supply curve, SS, reflects firm’s LR average costs.

Best-selling book

● SS is LR industry S curve.● Pt g: Qs by firms whose AC < $20 and pt f is Qs by

firms whose AC < $30, etc.● As we move up the S curve, increasingly inefficient

firms are included among suppliers.● In equilibrium: P = $40 and only those suppliers with

AC < $40 (pts g, f, and e) get to sell the good. But less efficient suppliers (like pts c and b) won’t.

● SS is LR industry S curve.● Pt g: Qs by firms whose AC < $20 and pt f is Qs by

firms whose AC < $30, etc.● As we move up the S curve, increasingly inefficient

firms are included among suppliers.● In equilibrium: P = $40 and only those suppliers with

AC < $40 (pts g, f, and e) get to sell the good. But less efficient suppliers (like pts c and b) won’t.

Which Buyers and Which Sellers Get Priority?Which Buyers and Which Sellers Get Priority?


How Perfect Competition Achieves Efficient Output SelectionHow Perfect Competition Achieves Efficient Output Selection

● Efficient production of any good requires MU = MC.● This max difference between TU and TC to society of

producing the quantities chosen.♦ E.g., MU beef = $8 and MC = $5 → cost of producing 1 more

lb is less than consumers are willing to pay for it, so ↑Q beef by 1 lb would ↑ welfare.

♦ Or if MU = $3 and MC = $5 → cost of producing 1 more lb is greater than consumers are willing to pay for it, so ↓Q beef by 1 lb would ↑ welfare.

● Producing Q beef where MU = MC ensures society allocates correct amount of resources to beef production.

● Efficient production of any good requires MU = MC.● This max difference between TU and TC to society of

producing the quantities chosen.♦ E.g., MU beef = $8 and MC = $5 → cost of producing 1 more

lb is less than consumers are willing to pay for it, so ↑Q beef by 1 lb would ↑ welfare.

♦ Or if MU = $3 and MC = $5 → cost of producing 1 more lb is greater than consumers are willing to pay for it, so ↓Q beef by 1 lb would ↑ welfare.

● Producing Q beef where MU = MC ensures society allocates correct amount of resources to beef production.


How Perfect Competition Achieves Efficient Output SelectionHow Perfect Competition Achieves Efficient Output Selection

● Recall, under perfect competition MU = MC. ♦ Firms max profit by selecting Q where P = MC.

♦ Consumers max CS by selecting Q where P = MU.

● Without any central planning or government interference, perfect competition ensures that correct amount of resources are allocated to produce goods so that society’s welfare is maximized.

● Recall, under perfect competition MU = MC. ♦ Firms max profit by selecting Q where P = MC.

♦ Consumers max CS by selecting Q where P = MU.

● Without any central planning or government interference, perfect competition ensures that correct amount of resources are allocated to produce goods so that society’s welfare is maximized.


Fairness versus EfficiencyFairness versus Efficiency

● Economists often offer efficient solutions that are deemed inequitable.♦ E.g., economist favor “peak-load” pricing to encourage less

use of public transportation during rush hours. A train seat is more scarce during rush hour. So efficiency demands that seats be more expensive during peak usage to discourage consumers with flexible schedules from using trains during rush hour.

♦ Public thinks it’s unfair to make low-wage workers pay higher train ticket fares.

● Economists often offer efficient solutions that are deemed inequitable.♦ E.g., economist favor “peak-load” pricing to encourage less

use of public transportation during rush hours. A train seat is more scarce during rush hour. So efficiency demands that seats be more expensive during peak usage to discourage consumers with flexible schedules from using trains during rush hour.

♦ Public thinks it’s unfair to make low-wage workers pay higher train ticket fares.

● Efficient bridge use requires higher tolls on more crowded bridges.

● Same toll charged for all bridges ($4) even though Bay Bridge is most crowded.

● Why does least crowded bridge (Dumbarton) have same toll as most crowded?♦ Many feel it is fair to have those who travel on a particular

bridge pay for its costs. Thus, it would be unfair for those who use the crowded Bay Bridge to pay more.

● Efficient bridge use requires higher tolls on more crowded bridges.

● Same toll charged for all bridges ($4) even though Bay Bridge is most crowded.

● Why does least crowded bridge (Dumbarton) have same toll as most crowded?♦ Many feel it is fair to have those who travel on a particular

bridge pay for its costs. Thus, it would be unfair for those who use the crowded Bay Bridge to pay more.

Resolve Bay Bridge Pricing PuzzleResolve Bay Bridge Pricing Puzzle


● Economics alone cannot decide the appropriate trade-off between fairness and efficiency.

● Economics cannot judge whether a pricing scheme is fair or unfair.

● Economics can indicate that a particular pricing decision (sought for its fairness) will impose heavy inefficiency costs on commuters.

● Economics alone cannot decide the appropriate trade-off between fairness and efficiency.

● Economics cannot judge whether a pricing scheme is fair or unfair.

● Economics can indicate that a particular pricing decision (sought for its fairness) will impose heavy inefficiency costs on commuters.

Resolve Bay Bridge Pricing PuzzleResolve Bay Bridge Pricing Puzzle


Market System Generates GrowthMarket System Generates Growth

● Markets are unsurpassed in their ability to produce goods efficiently but also in their ability to create wealth.

● Today, average American can afford 10 times the quantity of goods and services that an individual’s income would have bought 100 years ago.

● Ultimately, the failure to achieve growth and create wealth helped to end communism in Eastern Europe and to promote market reforms in China.

● Markets are unsurpassed in their ability to produce goods efficiently but also in their ability to create wealth.

● Today, average American can afford 10 times the quantity of goods and services that an individual’s income would have bought 100 years ago.

● Ultimately, the failure to achieve growth and create wealth helped to end communism in Eastern Europe and to promote market reforms in China.

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The Case for Free Markets: The Price System

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