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A market economy is an economic system controlled,
regulated, and directed by markets alone; order in the production
and distribution of goods is entrusted to this self-regulating
mechanism. An economy of this kind derives from the expectation
that human beings behave in such a way as to achieve maximum money
gains.
- Karl Polanyi |
The market mechanism, the operation of the forces of supply and demand, is the very heart of the market system. This chapter explores the logic behind using the market mechanism to set prices and output. It explores the method by which the market system maintains micro-order. This was one of the questions that intrigued the early economists. How can society be certain that the 'right' amount of bread and other commodities will be produced? How can society be certain that the bread and other commodities will be sold at the 'right' price?
The market mechanism can only operate fully when people follow certain 'market' behavioral norms. The sellers of goods and services must be motivated by profit. The buyers must be motivated by wanting to get the most for their money. While there is little dispute among economists about the logic of the market mechanism, there is a fundamental disagreement about whether the market mechanism is based on 'human nature' or represents learned behavior. Neoclassical economists believe such behavior to be an inherent part of human nature. Institutionalists believe that such behavior was learned as the market system slowly came into being and might be 'unlearned' under different conditions. [1 Note]
Even in our own advanced industrial economy we can find businesses and consumers who do not always behave according to market norms. Many small businesses are a combination of hobby and livelihood and the proprietor would not go into another line of business even if the profits were much higher. Antiquarian book stores, tropical fish and aquarium supply stores, florists and many other businesses are often owned by people who are simply trying to make livings out of their hobbies. Consumers may also respond to criteria other than price. We might refuse to patronize a business because we find its labor or environmental policies distasteful, even though it offers the best combination of quality and price.
Since consumption is presumably the fundamental purpose of the material side of life, our investigation of the market mechanism can start with the consumer. As a consumer you will respond to changes in prices. When the price of some item that you normally purchase increases, you will buy less of it. There are two reasons for this. First, an increase in the price of something you want to buy makes you poorer. It will now require a larger portion of your income to purchase the same amount you used to buy at the lower price. You just can't afford as much steak when it is $10.00/lb. as you can when it is $6.50/lb. Note that in this case you are responding to the price in relationship to your income. Second, you respond to the price of an item in relationship to other items. At $6.50/lb. you bought two pounds of steak per week; At $10.00/lb. you figure you might as well buy lobster instead.
Note that your purchases will move in the opposite direction if prices fall. You will now be effectively richer and able to afford more steak. You will also buy more steak because it now seems cheaper relative to other things you might buy instead (chicken, perhaps, or less desirable cuts of beef). So we have now identified a regularity of human behavior: when the price of something increases we purchase less of it; when the price of something decreases we purchase more of it.
Economists find this response to price changes so pervasive that we call it the Law of Demand: When the price of something increases, we buy less of it; when the price of something falls, we buy more of it. But don't memorize it yet. This statement of the law of demand is still incomplete.
At this point, some caution is in order. There are clearly other things besides the price of steak that might get you to buy more or less of it. You might buy more steak because you got a raise, or less because your workhours were reduced. You might buy less steak because you found a good deal on lobster. Or, if you always eat your steak with lobster, you might buy more steak because you found a good deal on lobster. Or, the mouth-watering TV ads by the Beef Council might change your tastes and get you to buy more steak (after all, that is what they are designed to do). Or you just learned that your cholesterol is dangerously high and have cut out red meats entirely.
So the price of an item is just one of many things that affect your consumer behavior. Your purchases will also be affected by changes in your income, your tastes, or in the prices of other goods. This leads to our more complete (and more cautious) statement of the law of demand: All other things remaining the same, when the price of something increases we will buy less of it and when the price of something decreases we will buy more of it.
Your demand for any specific good is related to your tastes, your income, the price of the good, and the prices of related goods. Note that the law of demand is only a statement about the relationship of the amount of the good that we purchase to the price of that good.
There are a number of reasons that economists focus on price when we examine demand. The most important reason is that price also influences the supplier. This will be expanded upon later in this chapter when we examine the supply side of the market. Additionally, we believe price changes usually have a powerful, predictable and, sometimes, measurable effect on the quantity demanded. This is not always true of the other factors affecting demand.
Changes in taste certainly affect demand. But they are not even remotely quantifiable. We do not have any units with which to measure changes in tastes. Changes in the prices of related goods also affect demand. Sometimes the relationship between two different goods is so straightforward that we can even measure the result. If the price of charcoal briquettes falls, sales of fire-starter will increase. But most cases are not so clear. Perhaps a great bargain on air fare to Jamaica reduces your demand for new furniture. Both are in a sense substitutes when it comes to spending our discretionary income.
Income is itself a special case. Certainly our demand for consumer
goods in general will increase or decrease with income. But what
can we say about our demand for any particular good? Perhaps
a promotion and significant raise will increase your demand for
fine French and Italian red wines. Might the raise also decrease
your demand for the basic California reds that you have been purchasing?
When you purchase more of something as your income increases,
we call it a normal good. When you purchase less of something
as your income increases, we call it an inferior good.
But normality or inferiority is not a characteristic of the good
itself: a fairly poor family may purchase more hamburger as their
income rises; a middle-class family may purchase less hamburger
as their income rises.
Elasticity of Demand
By itself, the law of demand does not tell us very much. It expresses a qualitative, but not a quantitative, relationship between price and demand. Business executives trying to find the 'right' price for a product will certainly want to know more than just that sales will decrease if the price is increased and sales will increase if the price is decreased. They will want to know by how much sales will increase or decrease in response to any particular price decrease or increase. Consumers react quite differently to price changes for different products. A 30% increase in the price of tangerines might lead consumers to cut their purchases by 70% as they buy other fruit instead. On the other hand, if gasoline prices increase by 50%, the amount purchased might fall by less than 10%. Economists have developed a numerical measure, which we call elasticity, to express the different degrees of response consumers make to price changes of different products. When the price changes a lot but the amount we purchase only changes a little (as in the gasoline example), we say the demand is inelastic. When the price changes a little but the amount we purchase changes a lot (as in the tangerine example), we say the demand is elastic. [2 Note]
Demand for a good or service will tend to be inelastic if it has few or no good substitutes and elastic if it has many close substitutes. Demand for a good or service will tend to be inelastic if expenditure on it makes up a tiny part of the consumer's budget and elastic if it makes up a large part of the consumer's budget. For example, the demand for table salt is extremely inelastic - there is not much you can buy instead if its price goes up and the total amount you spend on table salt is such an insignificant part of your budget that you aren't really going to feel poorer.
Although difficult to measure, elasticity has much practical significance. We can use this concept to explain why an oil cartel has more power than a banana cartel, or why cigarette taxes are so popular with governments. If a seller can raise the price of a good or service for which demand is inelastic, total revenue (price times quantity sold) will go up; but raising the price when demand is elastic will reduce total revenue. That is why bumper crops are generally bad for farmers. The demand for wheat is inelastic. If the wheat crop is 10% larger than normal, the price may have to fall by 20% or more in order to sell it all. So the average farmer will sell more wheat but take in less revenue.
The law of demand is generally applicable when we are purchasing goods or services in order to use them: either as final consumers or as businesses using them as inputs to produce the goods and services we hope to sell to our customers. But sometimes we buy things in the hopes of selling them at a higher price and have no intention of actually using them. Where such speculation is involved, the law of demand is not very useful. A rising price might be taken by buyers as a sign that prices will continue to rise, leading to increased sales; a falling price might be taken as a sign that prices will continue to fall, and buyers will defer their purchases to a later time.
Additionally, the law of demand does not hold for the types of goods and services that people buy primarily to show how rich or sophisticated they are. Lowering the prices on a particular line of designer clothing might make them appear more 'common' and sales might actually fall; raising the price of a particular wine might get people to think it is better and purchase more. These peculiar cases are called Veblen Goods or snob goods. [3 Note] While Veblen goods only make up a small part of the total market for goods and services, this type of behavior - reducing consumption of something when the price falls - should serve to remind us that the law of demand is an expression of human behavior under certain circumstances, and is not a 'law' in quite the same sense as the law of gravity.
There is another interesting case called Giffen's Paradox. Some extremely poor people might spend a large amount of their income, perhaps 60%, on whatever the cheapest source of calories is in their economy (potatoes, corn, manioc flour, etc.). They don't buy so much of it because they like it, they buy it because they are poor and it is all they can afford. Some of the rest of their income will be used to buy small amounts of food commodities that they actually prefer (perhaps chicken, pork, or beans). What happens if the price of the cheap food goes up a bit, say by 16%? First, they will find that they are now even poorer. But there is no cheaper foodstuff to switch to, and they can't live and work on fewer calories. Buying the same amount of the cheap food they bought before will now take up 70% of their income. With the little left over, they can no longer afford as much of the preferable foods. Yet they will still need to replace the calories that came from the chicken, pork or beans. The only solution is to buy even more of what is still the cheapest food available. So here we have a case in which a rising price causes purchases to increase.
Now we can turn to the sellers, the suppliers of goods and services. Their goal is assumed to be simply to earn the highest profits possible given the conditions they face. They will produce whatever it is profitable to produce. In Adam Smith's words:
It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. [4 Source]
If the price they can get increases, there will be higher profits. They can increase production because previously unprofitable production methods (such as putting workers on overtime) or adding a night shift will now be profitable. Other business people will also consider entering that line of business. On the other hand, lower prices will force some firms to cut back production and force others out of business entirely.
Of course any individual businessperson would usually prefer to
keep output stable and enjoy the higher profits coming from a
price increase. But the greed for profits is held in check by
competition. If one firm does not increase output when prices
rise, others will recognize a profit opportunity and increase
their production.
The General Rule of Supply
Note that supply is similar to but opposite from demand. A rising price decreases the quantity purchased but increases the quantity supplied. A lower price increases the quantity purchased but decreases the quantity supplied. However, the relationship between price and the amount of a good supplied is not as certain as the relationship between price and the amount of a good purchased. The qualifications and exceptions are both more numerous and more important when we are examining the supply relationship. Therefore economists are not as universally willing to state a 'law' of supply as we are to state a law of demand.
None the less, there is a powerful tendency for the production of a good or service to increase when the price goes up and to decrease when the price goes down. As with demand, we have to add the qualification all other things remaining the same. But in the case of supply, the other things that have to remain the same are things that affect the cost of production: these include the prices the supplier has to pay for labor, raw materials and other inputs and the technologies that are used to transform these inputs into the goods and services that the producer will sell.
The general rule of supply is strongest where there is the most competition and weakest where there is the least competition. The way in which firms will respond to price changes is influenced by the degree of competition within their industry. Markets may range from those in which nothing an individual firm does will alter the product price to those in which the firm has considerable leeway in setting the price. Economists have coined several terms which we use to identify various positions on the spectrum from no control over price to complete control over price:
Note that perfect competition does not actually exist. Economists invented this concept so that we could more easily explore the logic of supply and demand, just as physicists need to explore what would occur at absolute zero even though they cannot produce absolute zero in their laboratories. But some markets are very close. Egg ranching would be a good example. There is a large number of small firms. It is an easy business to enter or exit. Consumers really don't care which farm their eggs come from. But a small number of supermarket chains and large food processing firms buy most of the eggs, so this isn't quite perfect competition. Many other types of farming are also close - but family farmers will often keep farming even though they are losing money. As farmers like to say, "Its not a business, its a way of life." When money-losing firms continue to produce a commodity, the market price cannot go back up to 'normal' and we don't quite have perfect competition. Ease of exit is just as important as ease of entry.
Another qualification to the general rule of supply must be made with respect to time. In some industries it may be impossible to produce very much more of a product until new factories or other production facilities are built. In such cases, supply will be extremely inelastic in the short run, even though the supply might increase significantly over a period of time long enough for firms to respond to higher prices by building new factories. If the price of coconuts goes up, there is very little that coconut plantation owners can do in the short run. They can plant more trees, but the resulting increase in supply will not hit the markets for another fifteen to twenty years. On the other hand, manufacturers of some goods may be able to increase output quite a bit in the short run by adding a second or third shift to their factory. Of course they will only do this as long as the price of the product they sell is high enough to pay for the more expensive (and less productive) swing shift and/or graveyard shift labor.
Labor markets can sometimes present an important exception to the general rule of supply. If average wage rates decrease, workers might try to work more hours per week in order to maintain their previous weekly incomes; conversely, rising wage rates often induce workers to try to work fewer hours as they become rich enough to afford more leisure. The implications of such patterns in labor markets will be developed in later chapters.
It is the combination of the supply response - price and output going up or down together - with the demand response - price and output moving in opposite directions - that allows price-setting through supply and demand to be one of the foundations of an economic system.
Let us start with a surplus of a particular good. More felt-tip pens are being produced than can be sold at the prevailing price. As the sellers try to get rid of the extra pens, they will drive the price down. Fortunately, the falling price affects buyers and sellers in opposite ways. Buyers respond by buying more pens; manufacturers no longer find it profitable to produce as many pens and reduce their production. If more are purchased and fewer produced, the surplus disappears. You can test your own understanding of this process by tracing the steps that would occur if there were a shortage of felt-tip pens rather than a surplus.
Note the way in which economists use the terms surplus and shortage. There is a surplus when supply exceeds demand at the prevailing price. There is a shortage when all demand is not met at the prevailing price. This is very different than the way in which the general public uses these terms. If a severe frost in the Brazilian states of Sao Paulo and Parana reduces the size of the coffee crop, prices will increase until the quantity of coffee demanded falls into balance with the supply of coffee. At this price, perhaps $10.00/lb. for basic coffee, economists will say there is no shortage, since everyone willing and able to pay $10.00/lb. is getting all the coffee they demand at that price.
Market forces, then, will push prices toward an equilibrium price. The equilibrium price is the price at which buyers will be willing to buy the same quantity that suppliers are willing to supply. The equilibrium price will only change when the conditions of either supply or demand change. These conditions are the 'all other things' that we mentally held constant when we stated the law of demand or described the supply response to prices.
By way of example, we could start with two markets in equilibrium: the markets for turkeys and geese. In both markets, the price is such that it balances the amount produced with the amount purchased. Moreover, if this equilibrium price or something close to it has been in effect for enough time for turkey and goose ranchers to expand or contract their flocks or even to start new poultry ranches (or to leave poultry ranching altogether), it will be a price just high enough that both turkey and goose ranchers can cover their costs and earn 'normal' profits. We know this to be the case because if profits were higher than normal, new ranches would be founded and if profits were lower than normal some ranchers would leave the business.
Now let us introduce a factor that will change either the underlying demand conditions (tastes, incomes or the prices of related goods) or the underlying supply conditions (costs of inputs or production technologies). Imagine that a number of highly visible celebrities start serving goose rather than turkey on Thanksgiving, Christmas and other festive occasions. The effect might be to change the public's tastes. We will want more goose and less turkey. Since the suppliers will not be able to foresee or prepare for our changing tastes, the higher demand for geese will drive up the price of goose while the lower demand for turkey will push down the price of turkey. This is competition in action. Buyers are competing for the available supply of goose and driving up the prices. Sellers are competing to get rid of their excess turkey and driving down the price.
Goose ranchers will enjoy higher than normal profits just as turkey ranchers will suffer from losses. But not for long. Some turkey ranchers will be driven to bankruptcy. New goose ranches will be established. Some turkey ranchers will switch to raising geese. The market will eventually reach a new equilibrium, with prices that allow both goose and turkey ranchers to earn normal profits. And the quantities produced of each will have adjusted to the changing tastes of the buyers. Again, you can test your understanding of this process by changing another one of the underlying conditions and projecting what will happen step by step.
In the example above, the market system has automatically brought about a change in the production of particular goods in response to the changing tastes of the consumers. This is the sort of thing the market does best. Rising prices - and thus profits - lead firms to increase production and thereby both meet the increased demand and eventually bring prices back down to normal levels. Falling prices - and thus profits - lead firms to decrease production to a level at which the price will once again allow them to earn just enough profit to want to stay in business but not so much profit that they will want to increase production. In this sense, the market system is functional. The rising price from a temporary shortage both gets some of the buyers to do without or to do with less and spurs the producers to increase their output.
But there are many situations in which the output will not or cannot increase no matter how high the price goes. [5 Note] If, for example, the original manuscript of The Wealth of Nations were to be sold, the bids, no matter how high they went, would not induce another one to be produced. In this case, the market system would simply assure that the manuscript went to the highest bidder, but would not affect supply at all. That is a silly example, but there are many markets that are similar, in the sense that the supply is restricted. Urban land markets are in this category. Increasing demand will lead to rising prices, but not lead to an expanded supply. In cases such as this, the market forces are only fulfilling half - the demand half - of their functions.
Although our terminology has changed since Adam Smith wrote The Wealth of Nations, our basic concept of the market adjustment process has not. Smith used the term "natural price" to describe all costs of producing a good or service, including enough profit to get the capitalist to keep sufficient capital in that line of business. The day to day price, the "market price" in Smith's words, might bounce about, but could not for long drift very far from the natural price:
The actual price at which any commodity is commonly sold is called its market price. It may either be above, or below, or exactly the same with its natural price. The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market, and the demand of those who are willing to pay the natural price of the commodity, or the whole value of the rent, labour, and profit, which must be paid in order to bring it thither. Such people may be called the effectual demanders, and their demand the effectual demand; since it may be sufficient to effectuate the bringing of the commodity to market. It is different from the absolute demand. A very poor man may be said in some sense to have a demand for a coach and six; he might like to have it; but his demand is not an effectual demand, as the commodity can never be brought to market in order to satisfy it.When the quantity of any commodity which is brought to market falls short of the effectual demand, all those who are willing to pay the whole value of the rent, wages, and profit, which must be paid in order to bring it thither, cannot be supplied with the quantity which they want. Rather than want it altogether, some of them will be willing to give more. A competition will immediately begin among them, and the market price will rise more or less above the natural price, according as either the greatness of the deficiency, or the wealth and wanton luxury of the competitors, happen to animate more or less the eagerness of the competition. Among competitors of equal wealth and luxury the same deficiency will generally occasion a more or less eager competition, according as the acquisition of the commodity happens to be of more or less importance to them. Hence the exorbitant price of the necessaries of life during the blockade of a town or in a famine.
When the quantity brought to market exceeds the effectual demand, it cannot be all sold to those who are willing to pay the whole value of the rent, wages, and profit, which must be paid in order to bring it thither. Some part must be sold to those who are willing to pay less, and the low price which they give for it must reduce the price of the whole. The market price will sink more or less below the natural price, according as the greatness of the excess increases more or less the competition of the sellers, or according as it happens to be more or less important to them to get immediately rid of the commodity. The same excess in the importation of perishable, will occasion a much greater competition than in that of durable commodities; in the importation of oranges, for example, than in that of old iron.
When the quantity brought to market is just sufficient to supply the effectual demand, and no more, the market price naturally comes to be either exactly, or as nearly as can be judged of, the same with the natural price. The whole quantity upon hand can be disposed of for this price, and cannot be disposed of for more. The competition of the different dealers obliges them all to accept of this price, but does not oblige them to accept of less. [6 Source]
Now we can lay out the basic argument for the advantages of the market system over social systems based on tradition or command. First, the motivation mechanism is very basic: self-interest with respect to the material side of life. The consumer is simply trying to get the most satisfaction out of a limited income; the worker is trying to get the most income for the least work; and the capitalist is trying to get the most profit possible. At the heart of Adam Smith's understanding of the market system is the seeming contradiction that while each individual
... intends only his own gain, ... he is in this,
as in many other cases, led by an invisible hand to promote an
end which was no part of his intention.
Nor is it always the
worse for the society that it was no part of it. By pursuing
his own interest he frequently promotes that of the society more
effectually than when he really intends to promote it. [7 Source]
While self-interest may or may not be a universal part of human nature, it is certainly a powerful motivating force.
Second, the end result of competing producers and competing consumers all looking out for themselves is that prices should reflect the actual costs of production. Over the long run, businesses will simply earn a 'normal' rate of profit - just enough profit to get them to stay in that business.
Third, there is no need for an order from the village council or the Secretariat of Iron and Steel to increase or decrease production. The 'orders' come from price changes which in turn come from actual shortages or surpluses of a particular good or service relative to demand. This is what economists mean when we refer to the market system as "self-adjusting." In short, the opposing forces of self-interest and competition (which is due to the self-interest of others) work together to provide micro-order. To Smith, these forces comprised an "invisible hand" by which society's material interests were served without a visible set of rules and regulations.
This brief investigation of the market mechanism has shown how the market forces of supply and demand - as long as there is sufficient competition - can play an all-important organizing role in the material life of a society. Profit seeking firms will produce the goods and services on which they expect to earn the most profit. If there is a shortage of a particular good or service, the rising price will act as a lure to firms which will expand production of that item. It is in this way that the market answers the 'what to produce" question. The same holds true for the factors of production. If a shortage of labor drives up wages, firms will shift to production technologies that use less labor but more capital. It is in this way that the market answers the 'how to produce it' question.
The market mechanism is also the heart of the distributional principle in a market system. Your income will determine how much of the total output of society you can claim. But your income is itself determined by the market value of the factors of production under your control. If you own several thousand acres of good farmland and farm commodity prices are high, the rental value of your land will also be high. If you can only sell unskilled labor and the supply of unskilled labor is high relative to the demand for unskilled labor, your income and consequent ability to consume will be quite low. It is in this way that the market answers the 'for whom' question. This may seem to be unfair. In fact, we often perceive the prices set by the market as unfair or otherwise unacceptable and set many prices through a political rather than market process. The inherent conflict between social values such as fairness, equity and democracy and the operation of the market will be examined in Chapter 5.
In a market system, micro-order is maintained by self-adjusting market forces. Consumers and producers all follow their material self-interest. If there is too little of something relative to demand, the competition of consumers to purchase it will force prices up. Higher prices will provide the producers with higher profits. The higher prices will also convince some consumers to not purchase as much of that commodity. The higher profits will lure more capital into that line of business, as existing capitalists expand and new capitalists enter the business. Prices will eventually drop to just enough to allow 'normal' profits.
If there is too much of something relative to demand, the competition of producers to get rid of it brings prices down. Some consumers will then purchase more of that good or service. As price falls, so does profit. Some producers will be driven to bankruptcy. Others will switch to some other product. Prices will eventually be able to rise just enough to once again allow normal profits.
But there are many exceptions and qualifications. There must be enough consumers and producers for effective competition to occur. Producers must be able to enter and leave the business as profit opportunities improve or as losses accumulate. Some market behavior cannot be explained in this framework. Short-term movements in purely speculative markets (the stock market, or the market for precious metals, for example) cannot be explained by the law of demand and/or the general rule of supply. In labor markets, supply may go the 'wrong' way as falling wages drive families to work even more hours. Yet, as long as we keep the exceptions and qualifications in mind, the law of demand and the general rule of supply can be useful tools.
1. Imagine a society in which consumers respond to rising prices by purchasing more of the good or service and respond to falling prices by purchasing less; and suppliers respond to rising prices by producing less and to falling prices by producing more. Can there be an equilibrium price under such conditions?
2. Is labor a commodity in the same sense that an egg or an automobile tire or a haircut is a commodity? What about land?
3, Why is there sometimes a "shortage" (for example,
of coffee, gasoline, or housing) according to the public
when no shortage exists according to economists?
Parallel Readings
History of Economic Thought - The Worldly Philosophers, Chapter iii, "The Wonderful World of Adam Smith."
Economic Theory - Economics Explained, Chapter 14, "How Markets Work," and Chapter 15, "Where Markets Fail."
Economic History of the Western World - The Making of Economic
Society, Chapter 3, "The Emergence of Market Society."
Further Reading
The Wealth of Nations
(entire text) is available electronically.