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Principles of Macroeconomics

v9.0 John B. Taylor and Akila Weerapana
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1.3 Market Economies and the Price System

Every economy, whether it is a small island economy or a large economy like the United States, must find a way to solve three essential questions or problems.

  1. What is to be produced: movies, computers, guns, butter, greeting cards, Rollerblades, health care, or something else? In other words, where on the production possibilities curve should an economy be?

  2. How are these goods to be produced? In other words, how can an economy use the available resources so that it is not at an inefficient point inside the production possibilities curve?

  3. For whom are the goods to be produced? We know from the hat versus sunglasses example that the allocation of goods in an economy affects people’s well-being. An economy in which Maria could not trade her sunglasses for a hat would not work as well as one in which such trades and reallocations are possible. Moreover, an economy in which some people get everything and others get virtually nothing also is not working well.

Figure 1.6 Three Fundamental Questions for Any Economic System

Any economic system has to answer three questions: What goods and services should be produced—cars, movies, or something else? How should these goods or services be produced—in what type of factory, and with how much equipment and labor? And for whom should these goods be produced?

There are three photographs representing the three questions “What”, “How” and “For Whom”.

Source: MikeDotta/Shutterstock.com

Long Description

The first image shows “What” is being produced - cars - while the second image shows the “How” - an image of a factory building a motor. The third image shows the “For Whom” - a couple buying a car at a dealer showroom.

Broadly speaking, the and the are two alternative approaches to answering these questions. In a market economy, most decisions about what, how, and for whom to produce are made by individual consumers, firms, governments, and other organizations interacting in markets. In a command, or centrally planned, economy, most decisions about what, how, and for whom to produce are made by those who control the government, which, through a central plan, commands and controls what people do.

Command economies are much less common in the twenty-first century than they were in the mid-twentieth century, when nearly half the world’s population, including the residents of Eastern Europe, the Soviet Union, and China, lived in centrally planned economies. After many decades of struggling to make this system work, leaders of the command economies gradually grew disillusioned with the high degree of inefficiency resulting from the planned approach, which required that the state, or central planners, make critical detailed production decisions; this often resulted in shortages or surplus of products and, as a by-product, in political unrest. Since 1990, most command economies have, with varying degrees of success, tried to convert from a command to a market system. The difficulties with converting these systems are partly due to the fact that these economies have none or few of the social, legal, or political fixtures critical to the market system. China has been by far the most successful of these economies at making the transition, developing a model that the Chinese term “socialism with Chinese characteristics.” Beginning in the 1970s, elements of both the command and market economies coexisted in China; in the mid-1990s, market mechanisms grew more dominant. In the twenty-first century, while its political system is still highly centralized, China’s economy is much more decentralized. Many people credit China’s rapid economic growth in recent years to its successful transition away from a centralized economic system.

Key Elements of a Market Economy

Let’s take a closer look at some of the ingredients critical to a market economy.

Freely Determined Prices

In a market economy, most prices—such as the price of computers—are freely determined by individuals and firms interacting in markets. These are an essential characteristic of a market economy. In a command economy, most prices are set by government, and this leads to inefficiencies in the economy. For example, in the former Soviet Union, the price of bread was set so low that farmers fed bread to the cows. Feeding bread to livestock is an enormous waste of resources. Livestock could eat plain grain. By feeding the cows bread, farmers added the cost of the labor to bake the bread and the fuel to heat the bread ovens to the cost of livestock feed. This is inefficient, like point I in Figure 1.3.

In practice, not all prices in market economies are freely determined. For example, some cities control the price of rental apartments. We will look at these exceptions later. But the vast majority of prices are free to vary.

Property Rights and Incentives

Property rights are another key element of a market economy. give individuals the legal authority to keep or sell property, whether land or other resources. Property rights are needed for a market economy because they give people the ability to buy and sell goods. Without property rights, people could take whatever they wanted without paying. People would have to devote time and resources to protecting their earnings or goods.

Moreover, by giving people the rights to the earnings from their work, as well as letting them suffer some of the consequences or losses from their mistakes, property rights provide an . For example, if an inventor could not get the property rights to an invention, then the incentive to produce the invention would be low or even nonexistent. Hence, there would be few inventions, and we all would be worse off. If property rights did not exist, people would not have incentives to specialize and reap the gains from the division of labor. Any extra earnings from specialization could be taken away.

Freedom to Trade at Home and Abroad

Economic interaction is a way to improve economic outcomes, as the examples in this chapter indicate. Allowing people to interact freely is thus another necessary ingredient of a market economy. Freedom to trade can be extended beyond national borders to other economies.

International trade increases the opportunities to gain from trade. This is especially important in small countries, where it is impossible to produce everything. But the gains from exchange and comparative advantage also exist for larger countries.

A Role For Government

Just because prices are freely determined and people are free to trade in a market economy does not mean that there is no role for government. For example, in virtually all market economies, the government provides defense and police protection. The government also helps establish property rights. But how far beyond that should it go? Should the government also address the “for whom” question by providing a safety net—a mechanism to deal with the individuals in the economy who are poor, who go bankrupt, who remain unemployed? Most would say yes, but what should the government’s role be? Economics provides an analytical framework to answer such questions. In certain circumstances—called —the market economy does not provide good enough answers to the “what, how, and for whom” questions, and the government has a role to play in improving on the market. However, the government, even in the case of market failure, may do worse than the market, in which case economists say there is .

The Role of Private Organizations

It is an interesting feature of market economies that many economic interactions between people take place in organizations—firms, families, charitable organizations—rather than in markets. Some economic interactions that take place in an organization also take place in a market. For example, many large firms employ lawyers as part of their permanent staff. Other firms simply purchase the services of such lawyers in the market; if the firm wants to sue someone or is being sued by someone, it hires an outside lawyer to represent it.

Economic interactions in firms differ from those in the market. Staff lawyers inside large firms are usually paid annual salaries that do not depend directly on the number of hours worked or their success in the lawsuits. In contrast, outside lawyers are paid an hourly fee and a contingency fee based on the number of hours worked and how successful they are.

Incentives within an organization are as important as incentives in markets. If the lawyers on a firm’s legal staff get to keep some of the damages the firm wins in a lawsuit, they will have more incentive to do a good job. Some firms even try to create market-like competition between departments or workers in order to give more incentives.

Why do some economic interactions occur in markets and others in organizations? Ronald Coase of the University of Chicago won the Nobel Prize for showing that organizations such as firms are created to reduce market transaction costs, the costs of buying and selling, which include finding a buyer or a seller and reaching agreement on a price. When market transaction costs are high, we see more transactions taking place within organizations. For example, a firm might have a legal staff rather than outside lawyers because searching for a good lawyer every time there is a lawsuit is too costly. In a crisis, a good lawyer may not be available.

The Price System

The previous discussion indicates that in market economies, freely determined prices are essential for determining what is produced, how, and for whom. For this reason, a market economy is said to use the price system to solve these problems. In this section, we show that prices do a surprising amount of work: (1) Prices serve as signals about what should be produced and consumed when there are changes in tastes or changes in technology, (2) prices provide incentives to people to alter their production or consumption, and (3) prices affect the distribution of income, or who gets what in the economy.

Let’s use an example. Suppose that there is a sudden new trend for college students to ride bicycles more and drive cars less. How do prices help people in the economy decide what to do in response to this new trend?

The Information in Prices

Crop prices incentivize farmers to adjust their production by signaling which crops are in need.

Signals

First, consider how the information about the change in tastes is signaled to the producers of bicycles and cars. As students buy more bicycles, the price of bicycles rises. A higher price will signal that it is more profitable for firms to produce more bicycles. In addition, some bicycle components, like lightweight metal, will also increase in price. Increased lightweight metal prices signal that production of lightweight metal should increase. As the price of metal rises, wages for metalworkers may increase. Thus, prices are a signal all the way from the consumer to the metalworkers that more bicycles should be produced. This is what is meant by the expression “prices are a signal.”

It is important to note that no single individual knows the information that is transmitted by prices. Any economy is characterized by limited information, where people cannot know the exact reasons why prices for certain goods rise or fall. Hence, it is rather amazing that prices can signal this information.

Incentives

Now let’s use this example to consider how prices provide incentives. A higher price for bicycles will increase the incentives for firms to produce bicycles. Because they receive more for each bicycle, they produce more. If there is a large price increase that is not merely temporary, new firms may enter the bicycle business. In contrast, the reduced prices for cars signal to car producers that production should decrease. 

Distribution

How do prices affect the distribution of income? On the one hand, workers who find the production of the good they make increasing because of the higher demand for bicycles will earn more. On the other hand, income will be reduced for those who make cars or who have to pay more for bicycles. Local delivery services that use bicycles will see their costs increase.

Financial Crises and Recessions

Economies are sometimes hit by . When the World Trade Center was destroyed by terrorists in September 2001, the financial markets in New York had to close down because trading rooms and electronic networks for making trades were destroyed. However, backup facilities were soon made operational and the markets reopened after only a few days. Fortunately, the financial crisis was over soon after it began.

In August 2007 another financial crisis began, but this one lasted much longer. A fall in home prices in 2006 and 2007 following a prior rapid rise caused people to stop making payments on their home loans; banks and other financial institutions then became reluctant to lend. As a result people throughout the economy had trouble getting loans, and they reduced their purchases of goods and services. This meant that firms had to cut production of these goods and services and they laid off people who were employed producing them. A —a period of declining production and employment—thus began in December 2007 and ended in June 2009.

Economies have been subject to financial crises and recessions for hundreds of years. By far the worst in the United States was the Great Depression of the 1930s, but comparably serious financial crises have occurred in other regions and countries, most recently in Latin America, Asia, and Russia in the 1990s. The 1980s and 1990s in the United States was a period of unusual financial calm with few recessions. There is a great debate about whether financial crises are inevitable—a kind of market failure where the market economy does not work well—and government has a role to play in trying to prevent them and mitigate them, or whether the crises are due to government actions which make things worse—a kind of government failure.

The Price System during National Disasters

Periodically, regions of the country are hit by natural disasters such as hurricanes, earthquakes, fires, or blizzards. In the aftermath of a disaster, or sometimes even during the buildup (for a foreseeable event), certain goods become scarce in the economy. Examples of genuine shortages of necessary goods include fuel, food, medicine, or water in a hurricane-zone or hand sanitizers, masks, and gloves during the COVID-19 crisis. Another reason for scarcity of goods is speculative buying, sometimes in anticipation of future shortages but other times just out of overreaction. Good examples of the latter include the panicked buying of toilet paper, bottled water, and canned food during the COVID-19 crisis when there was little reason to believe that the supply of these goods would be disrupted. Even when there was a potential explanation for increased purchases of some goods—for instance more people were using toilet paper at home because they were not going to work—the increase in purchases dwarfed the actual need for use of those goods.

When such a scarcity occurs, the price system has a critical role to play in allocating resources. Prices of scarce goods will rise, often quite substantially. As you will soon learn, this increase in price plays an important role in allocating the now-scarce resources but the resulting outcomes often lead to disgruntlement with the price system. When prices of essentials rise, those who are most willing and able to pay will have access to those goods whereas those who need the goods but are unable to pay the high prices will have to do without. When consumers see firms selling bottled water at prices that are ten times higher than prices during normal times, or see sellers on Amazon charging $50 for a bottle of hand sanitizer that usually sells for $4, they feel that they are being taken advantage of. Calls for investigations of price gouging behavior and the imposition of limits on price rises typically increase along with calls for suspending the use of the price system as a method of allocation and using an alternative method of allocation such as rationing. 

By the time you finish this course in Economics, you will be able to better understand the complexity of this topic. For now, you should know that the price system has both advantages and disadvantages in allocating resources in the aftermath of a national disaster. For certain goods, higher prices can act as a signal that encourages firms to supply more to the affected region or for stores to stock up their inventories, for example adding more sandbags, bottled water, and camping stoves before a hurricane arrives. Price increases can also discourage hoarding and speculative buying by consumers, so for example, the people who bought what effectively will be 8 months-worth of toilet paper supply for their household may not have done so in the face of a price increase, leaving more available for others to buy. On the other hand, for goods where the production lags are long or supply chains complicated, there will be a limited supply response in response to price increases. This means that under-resourced buyers who genuinely need goods will not be able to access them. Examples of this include ventilators, N95 masks, and personal protective equipment (PPE) during the COVID-19 crisis. Worldwide demand for these goods spiked, prices rose sharply (news reports suggested that mask prices increased six-fold), and well-resourced, well-connected hospitals in rich areas were able to access these goods much more easily than poorer, rural hospitals were able to. Another example would be rationing of staple foods during World War II where people with no access to land for growing food or jobs for earning money were not able to pay the higher prices for food to meet their basic nourishment needs, but were able to do so with ration cards.

Artificial Intelligence, Economics, and the Price System

Artificial intelligence is a branch of computer science that focuses on building and using machines that react like humans, and often react much better than humans do in recognizing, for example, speech or faces. With machine learning, computers can also adapt automatically and change as circumstances change; for example, as people develop different speaking accents within the same language. Amazing improvements in artificial intelligence and machine learning have been made in recent years. Computers can quickly identify people, and they match them in giant data sets based only on photos. These advancements raise questions about economics—the study of people making purposeful choices with scarcity and interacting with other people when they make such choices. Students ask, perhaps after taking some computer science courses, “Do we really need economics anymore? Can’t fast artificial intelligence examine preferences and allocate resources and people more efficiently than markets can and thus determine what, how, and for whom to produce?”

No. It’s the opposite. Economics is more important now than ever as the world becomes more computerized and quantified. The price system itself becomes more valuable because prices of goods and services incorporate enormous amounts of relevant information that no one person, no one computer, can possibly incorporate. Prices convey information about what is happening throughout the world, they provide incentives to millions of people to act in various ways, and they affect the distribution of income. A central computer cannot possibly allocate people or resources efficiently without this information, certainly not in a way that takes account of the shifting preferences of millions of consumers and a technology that moves forward every day. Ignoring economics as we apply the latest in artificial intelligence and machine learning is a recipe for disaster.

At the same time, it’s possible—as never before in history—to make economic ideas work better in practice to improve people’s lives by using the latest advances in computer science. One way to understand this idea is to distinguish between prediction and causation or the question “what happens if something else happens?” Artificial intelligence is very good at predicting whether a picture is a cat or a dog or a person, or at predicting whether a person with certain characteristics will “click” on an advertisement on the computer screen. But the computer—without the aid of economics and the decentralized price system—is not good at answering such causal “what if” questions, such as “What will happen to sales of an item if the price is increased or decreased?” Nor is it good at developing or dealing with entirely new products that will exist tomorrow or next year that do not exist today. These same issues came up years ago when central planning was still used around much of the world, including in Russia and China. That experience helped people learn about the magic of the price system, and so central planning was abandoned in much of the world. Currently there is a renewed interest in alternatives to market economics, whether you call it socialism or more simply highly interventionist government economic policy. With the demise of the Soviet Union, old case studies that showed the harms of central planning are forgotten, and they do not seem so relevant. It was helpful then to discuss how Soviet production plants could fulfill centrally imposed plans by producing, for example, one 500-pound nail rather that 500 one-pound nails, even though the giant nail was useless. The examples are different today when more modern examples of clicking or using search engines are relevant and we can deal with huge quantities of data. But they are as relevant as ever and you will see such examples throughout this text.

Benefits of Understanding Economic Principles

Watch this video for an explanation of the importance of following basic economic principles for everyone.

Review

  1. The market economy and the command economy are two alternative systems for addressing the questions any economy must face: what to produce, how to produce, and for whom to produce.

  2. A market economy is characterized by several key elements, such as freely determined prices, property rights, and freedom to trade at home and abroad.

  3. For a market economy to work well, markets should be competitive and the government should play a role when there is a market failure.

  4. Prices are signals, they provide incentives, and they affect the distribution of income.

  5. Market economies are sometimes hit by financial crises and recessions, creating another role for government in preventing or alleviating them.