1. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko “The Economic Way of Thinking” 11 th Edition Chapter 5: Supply and Demand: A Process of Cooperation

2. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 2 of 42 Chapter 5 Outline Introduction The Market is a Process of Competing Bids and Offers Transaction Costs, Again Property Rights and Institutions The Coordinating Role of Money Prices The Basic Process

3. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 3 of 42 Chapter 5 Outline Competition, Cooperation and Market Clearing Changing Market Conditions The Market for Credit Competition Results From Scarcity Surpluses and Scarcity

4. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 4 of 42 Chapter 5 Outline Market Processes Versus Central Planning Appendix: Time Preference and Interest Rates –Why is Interest Paid? –Time Preference –The Risk Factor in Interest Rates –Real and Nominal Interest Rates

5. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 5 of 42 Introduction Specialization is what distinguishes every wealthy society the world has ever known. Adam Smith observed: “It is the great multiplication of the productions of all the different arts, ‘in consequence of the division of labor’ which occasions, in well governed society, that universal opulence which extends itself to the lowest ranks of the people”

6. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 6 of 42 Introduction How do wealthy highly specialized commercial societies know to take the actions necessary to wind up producing the myriad of goods and services they enjoy? –Answer Massive ignorance, since specialists by their very nature don’t know how to do anything. The miracle of the market is that millions of people globally manage to cooperate together to produce the goods and services that we enjoy.

7. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 7 of 42 Introduction The role of government in these societies is to: Monitor property rights. Enforce property rights. Enforce contracts

8. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 8 of 42 The Market is a Process of Competing Bids and Offers Markets are not necessarily physical places. –They are mechanisms which bring together buyers and sellers, demanders and suppliers. A market can be formal, but many markets are informal. A market is not a person, place or thing. –It is a process of competing bids and offers.

9. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 9 of 42 The Market is a Process of Competing Bids and Offers When economists use the term supply and demand they are describing the market as a process of competing bids and offers or continual on-going negotiations among individuals.

10. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 10 of 42 Transaction Costs, Again Transaction costs are the costs of arranging contracts or transaction agreements between demanders and suppliers. –It isn’t enough that demanders are willing to do what suppliers would require. –Someone needs to arrange the actual transaction.

11. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 11 of 42 Transaction Costs, Again Questions –Why does broken glass stay on a bicycle trail even if each bicyclist would pay someone to clean it up? –Why don’t commuters in no hurry clear the way for those who are? –Why does even the most environmentally aware person contribute to its degradation? –Why did food rot in the fields in the USSR when people were starving?

12. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 12 of 42 Transaction Costs, Again Answer –When transaction costs are high, the result will be a failure of cooperation. All of these questions illustrate a failure of cooperation because the cost of arranging the transaction is too high.

13. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 13 of 42 Property Rights and Institutions Private Ownership –People have the incentive to take control of resources. –Resources will quickly and cheaply come together. Low Transaction Costs –Allow negotiations necessary to produce goods and services to succeed.

14. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 14 of 42 Property Rights and Institutions Questions –Why are the countries that are attempting to move to a market system facing high transaction costs? –Can they design an efficient system? –Can they do it quickly?

15. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 15 of 42 Property Rights and Institutions Answer –The success of market reform projects in many nations depends on overcoming the problem of high transaction cost rapidly.

16. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 16 of 42 The Coordinating Role of Money Prices Question –Why is money used in exchanges instead of barter? Answer –Money is a general medium of exchange.

17. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 17 of 42 The Coordinating Role of Money Prices The advantages of money –Lowers transaction costs –Acceptability –Provides signals quickly –Because it is easily adjusted

18. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 18 of 42 The Basic Process D S 1000 $500 1,200 $700 800 $300 Supply and Demand in the Acoustic Guitar Market Quantity of Acoustic Guitars Price

19. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 19 of 42 The Basic Process D S 1000 $500 1,200 $700 800 $300 Supply and Demand in the Acoustic Guitar Market Quantity of Acoustic Guitars Price The Market clears at $500

20. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 20 of 42 The Basic Process D S 1000 $500 1,200 $700 800 $300 Supply and Demand in the Acoustic Guitar Market Quantity of Acoustic Guitars Price A shortage of 400 guitars at $300

21. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 21 of 42 The Basic Process D S 1000 $500 1,200 $700 800 $300 Supply and Demand in the Acoustic Guitar Market Quantity of Acoustic Guitars Price A surplus of 400 guitars at $700

22. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 22 of 42 Competition, Cooperation and Market Clearing Competition, like cooperation, is rampant throughout the market process. Rather than competition between buyer and seller: –Buyers tend to compete with other buyers –Sellers tend to compete with other sellers.

23. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 23 of 42 Competition, Cooperation and Market Clearing In the case of a shortage, buyers compete with one another by offering higher prices, and the bidding process eliminates the shortage. In the case of a surplus, sellers compete amongst themselves by trying to attract customers and move excess inventories. –Each seller would compete with lower prices until the surplus disappears.

24. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 24 of 42 Competition, Cooperation and Market Clearing With individual buyers bidding up prices when there are shortages and sellers reducing prices when there are surpluses, the market system, through forces of supply and demand, settles on a market clearing price. The clearing price is the equilibrium quantity and price.

25. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 25 of 42 Competition, Cooperation and Market Clearing To say the market is clear is to say that there is neither a shortage nor a surplus. The plans of buyers have become fully coordinated with the plans of sellers.

26. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 26 of 42 Competition, Cooperation and Market Clearing Free markets for any good or service show a tendency to clear. A commercial society does not require economists to clear markets. It requires effective rules of the game for people to buy, sell and trade (i.e. to coordinate their own plans).

27. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 27 of 42 Changing Market Conditions Supply and demand curves shift. Overall supply and demand will change. A new market clearing price will be established.

28. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 28 of 42 The Market for Credit As for any scarce good, the demand curve for credit is downward sloping. –A lower interest rate to borrow will tend to increase the quantity of credit demanded. –A higher interest rate to borrow will tend to reduce the quantity of credit demanded.

29. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 29 of 42 The Market for Credit The supply curve for credit is upward sloping. –A lower the interest rate to borrow will tend to reduce the quantity of credit supplied. –A higher the interest rate to borrow will tend to increase the quantity of credit supplied.

30. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 30 of 42 The Market for Credit The market for credit clears when –The plans of the lenders are coordinated with the plans of the borrowers. If borrowers and lenders expect interest rates to change, credit supply and demand will be affected.

31. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 31 of 42 Competition Results from Scarcity Scarcity is a relationship between desirability and availability or between demand and supply. Scarcity is not rarity. Something is rare if it is only available in relatively small quantities

32. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 32 of 42 Competition Results from Scarcity Scarce Goods –When people cannot obtain as much of a good as they would like without being required to sacrifice something else of value. Rationing –Prices ration scarce goods. Competition –A result of scarcity –Occurs when people strive to meet the criteria that is being used to ration scarce goods.

33. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 33 of 42 Surpluses and Scarcity Surplus –Occurs when quantity supplied exceeds quantity demanded at some implied price. Surplus of Physicians –Decreasing wages motivates people to look at different careers. Question –What would a surplus of physicians do to wages and prices?

34. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 34 of 42 Market Processes Versus Central Planning A socialist economy would be run like one huge non-profit organization –Socialists utilize a system of central planners to perform the functions that we take for granted and which occur automatically in a market system. There is no way possible to effectively and efficiently produce and distribute the massive array of goods and services desired by millions of citizens.

35. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 35 of 42 Appendix – Why is Interest Paid? Interest is not a payment for use of money. Interest is a price people pay to obtain resources now rather than to wait until they have earned the purchasing power with which to buy the resources. Could interest exist in an economy that functioned without money?

36. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 36 of 42 Appendix – Time Preference Due to human mortality and contingencies of life… –People display a positive rate of time preference –They place a higher value on present enjoyment than on future enjoyment. Thus, current resources are more valuable than future resources.

37. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 37 of 42 Appendix – The Risk Factor of Interest Rates Ordinarily it would cost an individual more per dollar to borrow from a commercial bank than it would cost a large corporation. This is a risk factor –Investigations –Bookkeeping –“Insurance premium”

38. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 38 of 42 Appendix – Real and Nominal Interest Rates Nominal Interest Rate = the quoted rate (i.e. the rate on the contract). Real Interest Rate – the nominal rate minus the rate of inflation (any expected decrease in the purchasing power of money).

39. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 39 of 42 Once Over Lightly Society is characterized by extensive division of labor. The market is a process of competing bids and contracts. Intermediaries facilitate exchange and reduce transaction cost. Money is used as a medium to facilitate exchange.

40. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 40 of 42 Once Over Lightly The market clears when quantity demanded equals quantity supplied. Exchange is a cooperative activity. Scarce goods must be rationed in some fashion. Surpluses and shortages arise when the market price is above or below the equilibrium price.

41. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 41 of 42 Once Over Lightly Interest is the cost of obtaining resources now. Nominal interest rate is the quoted rate. Real interest rate is the nominal rate minus the expected rate of inflation. People generally find present goods more valuable than future goods. Scarcity is a relationship between supply and demand. Scarcity is not rarity.

42. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 42 of 42 End of Chapter 5