Chapter 3 – Free Markets at Work zFree markets – how choices of consumers and firms become trade and transactions. zModeling behavior in a free market: Demand and Supply. z What a free market does effectively, and what it can’t do. zHow free markets can get messed up.

Essentials of a Free Market zConsumers -- choosing a variety of goods and services based upon maximizing utility subject to the budget constraint. zFirms -- specialization into producing different types of goods, based upon maximizing profits. zA high degree of competition among different firms producing the same good, with no single firm having an advantage over another firm in the industry (Perfect Competition).

More Essentials of a Free Market zA price for a good or service which is known to buyers and sellers. zMutually Beneficial Exchange – trade or purchasing something takes place only if it serves to benefit both the buyers and the sellers. zApplications: buying goods, hiring labor, world trade.

The Role of Money in Free Markets zMoney – primary role is as a Facilitator of Trade, to serve as a lubricant to make trade take place as smoothly as possible. z“Engine Oil” to the engine of trade in free markets.

Specific Roles of Money as a Facilitator of Trade zMedium of Exchange -- Money is exchanged for goods and services. zStandard of Value -- Value is measured in dollars (the “price tag”). zStore of Value -- People can use money when they wish, present versus future.

Modeling the Free Market: Demand and Supply zEvery good or service (e.g. coffee) has consumers who wish to buy it (Demand), along with firms who wish to sell it (Supply). zA theory and model which predicts: (1) how much of the good will ultimately be sold, (2) the price it will sell for, and (3) how these conditions change due to specific events.

Demand zDemand, or Quantity Demanded, (Q D ) -- the amount of a given good or service (e.g. coffee) that one or more people intend to purchase.

Demand for Coffee: Causes zThe Price of Coffee (P) P  (ceteris paribus)  Q D  zA Whole Bunch of Other Causes (e.g. Tastes) Tastes  (ceteris paribus)  Q D 

Formalizing the Theory of Demand zGraph Q D versus one of its causes -- the price of coffee (P). zInverse relationship implies that the curve is downward sloping. zChanges in P are described as a movement along the curve. zGraph is drawn assuming that Tastes (and any other causes) are constant (ceteris paribus).

Describing Changes in One of the “Other Causes” zA Change in Tastes (or a change in any cause other than the price) is described by a shift of the Demand curve. zContrast this with a change in P -- movement along the curve. zDifferent descriptions occur only because P is the cause that appears on the graph.

Shifting the Demand Curve zA change -- other than P -- that makes Q D increase is described as a rightward shift of the curve, or an Increase in Demand. zA change -- other than P -- that makes Q D decrease is described as a leftward shift of the curve, or a Decrease in Demand.

Supply zSupply, or Quantity Supplied, (Q S ) -- the amount of a given good or service (e.g. coffee) that firms intend to produce and sell.

Supply of Coffee -- Causes zPrice of Coffee (P) P  (ceteris paribus)  Q S  zA Whole Bunch of Other Causes (e.g. Price of Energy) Price of Energy  (ceteris paribus)  Q S 

Formalizing the Theory of Supply zGraph Q S against one of its causes -- the price level (P). zPositive relationship implies that the curve is upward sloping. zChanges in P are described as a movement along the curve. zGraph is drawn assuming that the Price of Energy and all other causes are constant.

Describing Changes in One of the “Other Causes” zA Change in the Price of Energy (or a change in any cause other than the price) is described by a shift of the Supply curve. zContrast this with a change in P -- movement along the curve. zDifferent descriptions occur only because P is the cause that appears on the graph.

Shifting the Supply Curve zA change -- other than P -- that makes Q S increase is described as a rightward shift of the curve, or an Increase in Supply. zA change -- other than P -- that makes Q S decrease is described as a leftward shift of the curve, or a Decrease in Supply.

Equilibrium: The Market in Action zEquilibrium (P* and Q*) -- The values where the price of coffee and quantity traded of coffee will ultimately settle, given that the strategies of demands and suppliers play out.

Properties of Equilibrium zIf the price of coffee is anywhere other than P*, natural market forces bring it to equilibrium. zIf P > P*, there exists excess supply, and pressure for the price to fall.  If P < P*, there exists excess demand, and pressure for the price to rise.

More Properties of Equilibrium zP*and Q* represent the price and quantity traded as predicted by the theory and model. zIn general, we observe the equilibrium. zShifts in either the Demand or Supply curves change the equilibrium.

Shifts and Changing the Equilibrium -- Applications zExample 1 – Coffee is found to be more attractive to drink (e.g. medical finding), which affects Tastes. zTastes   Q D  zIncrease in Tastes increases Q D, described by shifting the Demand curve rightward. zDraw the picture and evaluate the answer.

Another Application zExample 2 -- The price of energy (P E ) increases. zP E  hinders production, therefore reduces Q S. zThis behavior is described as a leftward shift of the Supply curve. zDraw the graphs and evaluate.

Demand and Supply in a Competitive Economy zIn an economy with perfect competition throughout: yThere exists a market, i.e, Demand and Supply, for each good and service. yThere exists a market, i.e. Demand and Supply, for each factor or input (labor, materials, physical capital) used to produce each good or service.

The Circular Flow zConsumers – Demand goods and services, Supply inputs (e.g. labor). zFirms – Supply goods and services, Demand inputs (e.g. labor). zThe Circular Flow – the web of connections between the various goods and input markets in the economy that determine quantities traded and prices, connected by income generated by production and used for purchasing.

General Competitive Equilibrium zGeneral Competitive Equilibrium (GCE)– the situation in which all perfectly competitive markets are in equilibrium simultaneously. zMost efficient, optimal type of overall economy, specifics later. zVery possible to have economy in general equilibrium without GCE, sub- optimal with distortions.

The “Nice Assumptions” zThe “Nice Assumptions” – ideal conditions in all markets that lead to General Competitive Equilibrium. 1.No Market Power. 2.No Market Failure.

Nice Assumption #1 -- No Market Power zNo Market Power -- advantages in the market are transitory and can be eliminated by competition. -- equal access to information -- equal access to markets

Nice Assumption #2 -- No Market Failure zNo Market Failure -- markets form quickly and function smoothly and efficiently to coordinate choices of individuals and firms. -- markets form quickly when needed -- markets function smoothly and efficiently to coordinate choices

The Roles of Government in a Free Market Economy zTry to eliminate market power when it exists -- enforce laws. zTry to eliminate market failure when it exists -- regulate externalities, provide for public goods. zAbove are ideal roles. In practical terms, how much should government to intervene, possibly create additional distortions?