1. 9 9 The Price System and the Case for Free Markets 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; they is why it so easily frees itself from the control of the market. LEON TROTSKY, A LEADER OF THE RUSSIAN REVOLUTION The Price System and the Case for Free Markets 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; they is why it so easily frees itself from the control of the market. LEON TROTSKY, A LEADER OF THE RUSSIAN REVOLUTION

2. ●Efficient Resource Allocation and Pricing ●Scarcity and the Need to Coordinate Economic Decisions ●How Perfect Competition Achieves Efficiency ●Toward Assessment of the Price Mechanism ●Efficient Resource Allocation and Pricing ●Scarcity and the Need to Coordinate Economic Decisions ●How Perfect Competition Achieves Efficiency ●Toward Assessment of the Price Mechanism Contents Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

3. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Efficient Resource Allocation and Pricing ●Efficiency exists when it is not possible to make some people better off without making others worse off.

4. FIGURE 9-1 PPF and Efficiency Billions of Quarts of Milk Missiles C F E B D G 500400300200100 0 200 300 400 500 600 700 Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

5. ●The example of San Francisco Bay bridges shows that it is possible to reduce congestion and traffic delays by charging higher tolls on more heavily used bridges Pricing to Promote Efficiency: An Example Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

6. FIGURE 9-2 Toll Bridges of the San Francisco Bay Area 71 84 92 17 101 San Pablo Bay Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

7. ●Price increases can be useful when they lead people to economize on the use of scarce goods and resources. Can Price Increases Ever Serve the Public Interest? Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

8. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Need to Coordinate Economic Decisions ●The invisible hand of the price system automatically coordinates millions of interconnected economic activities. ●High prices discourage consumption of scarce resources. ●Low prices encourage consumption of abundant resources. ●The invisible hand of the price system automatically coordinates millions of interconnected economic activities. ●High prices discourage consumption of scarce resources. ●Low prices encourage consumption of abundant resources.

9. ●What to produce? (output selection) ●How to produce it? (production planning) ●Who gets it? (distribution of products among consumers) ●What to produce? (output selection) ●How to produce it? (production planning) ●Who gets it? (distribution of products among consumers) Three Coordination Tasks in the Economy Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

10. ●Output selection: the allocation of society’s resources among different products depends on ♦consumer preferences (demands). ♦production costs of the goods demanded. ●Output selection: the allocation of society’s resources among different products depends on ♦consumer preferences (demands). ♦production costs of the goods demanded. Three Coordination Tasks in the Economy Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

11. ●Production planning: inputs are assigned to the firms that can make the most productive (most profitable) use of them. ●Distribution of products among consumers: the price system carries out the distribution process by rationing goods on the basis of ♦preferences; ♦ relative incomes. ●Production planning: inputs are assigned to the firms that can make the most productive (most profitable) use of them. ●Distribution of products among consumers: the price system carries out the distribution process by rationing goods on the basis of ♦preferences; ♦ relative incomes. Three Coordination Tasks in the Economy Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

12. ●Planners cannot carry out the coordination tasks of the economy due to ♦lack of necessary data; ♦computational complications. ●Planners cannot carry out the coordination tasks of the economy due to ♦lack of necessary data; ♦computational complications. Input-Output Analysis: The Near Impossibility of Central Planning Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

13. ●The price mechanism ensures that ♦Those consumers who want a scarce commodity most will receive it. ♦Those sellers who can supply it most efficiently will get to supply the commodity. ●The price mechanism ensures that ♦Those consumers who want a scarce commodity most will receive it. ♦Those sellers who can supply it most efficiently will get to supply the commodity. Which Buyers and Which Sellers Get Priority? Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

14. FIGURE 9-3 Price Excludes Buyers & Sellers Who Care Least 0 10 20 30 40 50 60 $70 78 S S a b c e g f D D S' S' G F E C A B 123456 Price Quantity in thousands Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

15. ●The price mechanism ranks potential consumers of a good in the order of the intensity of their preference for the good, as indicated by the amount they are willing to spend for it. Which Buyers and Which Sellers Get Priority? Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

16. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. How Perfect Competition Achieves Efficiency ●Perfect competition  efficiency ●Marginal utility = marginal cost ●Rule for efficient output selection ●Perfect competition  efficiency ●Marginal utility = marginal cost ●Rule for efficient output selection

17. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. How Perfect Competition Achieves Efficiency ●Firms produce according to the rule:MC = P ●Consumers purchase according to the rule: MU = P ●Consequently MC = MU ●Firms produce according to the rule:MC = P ●Consumers purchase according to the rule: MU = P ●Consequently MC = MU

18. ●When all prices are set equal to marginal costs, the price system gives correct cost signals to consumers and producers. ●Consumers use society’s resources with the same care they devote to watching their own money. ●The same is true for producers. ●When all prices are set equal to marginal costs, the price system gives correct cost signals to consumers and producers. ●Consumers use society’s resources with the same care they devote to watching their own money. ●The same is true for producers. The Invisible Hand at Work Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

19. ●Prices have an impact on equity as well as efficiency. ●If a trade-off must be made between equity and efficiency, economics alone cannot give much guidance. ●Prices have an impact on equity as well as efficiency. ●If a trade-off must be made between equity and efficiency, economics alone cannot give much guidance. Other Roles of Prices: Income Distribution and Fairness Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

20. TABLE 9-1 Replies to a Questionnaire Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

21. ●In addition to producing efficient solutions, free markets are a tremendous engine of economic growth. Yet Another Free-Market Achievement Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

22. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Toward Assessment of the Price Mechanism ●The free enterprise system is not flawless, but it accomplishes tasks that no other economic system can.