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
Contents
● Efficient Resource Allocation and Pricing
● Scarcity and the Need to Coordinate
Economic Decisions
● How Perfect Competition Achieves
Efficiency
● Toward Assessment of the Price Mechanism
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.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
9-1 PPF and Efficiency
700
B
600
D
500
Billions of
Quarts of Milk
FIGURE
400
E
G
300
200
F
100
0
C
100
200
300
400
500
Missiles
Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.
Pricing to Promote Efficiency: An
Example
● 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
Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.
9-2 Toll Bridges of the
San Francisco Bay Area
FIGURE
San
Pablo
Bay
San
Rafael
Richmond–
San Rafael
Bridge
71
Golden
Gate
Bridge
A
Berkeley
101
San
Francisco
80
Oakland
San Francisco–
Oakland Bay
Bridge
17
101
San Mateo–Hayward
Bridge
92
92
Fremont
Dumbarton
Bridge
84
84
B
Palo Alto
Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.
Can Price Increases Ever Serve
the Public Interest?
● Price increases can be useful when they lead
people to economize on the use of scarce
goods and resources.
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.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
Three Coordination Tasks in the
Economy
● What to produce? (output selection)
● How to produce it? (production planning)
● Who gets it? (distribution of products
among consumers)
Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.
Three Coordination Tasks in the
Economy
● Output selection: the allocation of society’s
resources among different products depends
on
♦ consumer preferences (demands).
♦ production costs of the goods demanded.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Three Coordination Tasks in the
Economy
● 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.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Input-Output Analysis: The Near
Impossibility of Central Planning
● Planners cannot carry out the coordination
tasks of the economy due to
♦ lack of necessary data;
♦ computational complications.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Which Buyers and Which Sellers
Get Priority?
● 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.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
9-3 Price Excludes
Buyers & Sellers Who Care Least
FIGURE
D
S
A
$70
a
B
60
b
S'
C
Price
50
c
E
40
e
f
F
30
g
20
10
G
S
D
S'
0
1
2
3
4
5
6
7
8
Quantity in thousands
Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.
Which Buyers and Which Sellers
Get Priority?
● 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.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
How Perfect Competition
Achieves Efficiency
● Perfect competition  efficiency
● Marginal utility = marginal cost
● Rule for efficient output selection
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
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
The Invisible Hand at Work
● 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.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
Other Roles of Prices: Income
Distribution and Fairness
● 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.
Copyright© 2003 South-Western/Thomson Learning. All rights reserved.
9-1 Replies to a
Questionnaire
TABLE
Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.
Yet Another Free-Market
Achievement
● In addition to producing efficient solutions,
free markets are a tremendous engine of
economic growth.
Copyright© 2003 South-Western/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.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.