Economic Activity and Markets
Gary Santoni
Grade Levels: 9,10,11,12
Document Type: Instructional Unit; Supplementary Materials
Description:
Relates how the nation's economic activity is coordinated in producing the goods
and services the country demands.(free)
This document may be printed.
ECONOMIC
ACTIVITY
AND MARKETS
Economic Activity
Some Initial Observations
National Income, a measure of the value of all goods and services produced in
the United States, was $2,646,700,000,000 in 1983(1). Included in this total are the
values of literally hundreds of thousands of different types of goods and services,
ranging from bubble gum and houses to plumbers and surgeons. These goods and
services were produced by 100,834,000(2) individuals of whom over 43 percent were
female, 14.6 percent were black or of Hispanic origin and 6.6 percent were
teenagers(3). These individuals used a great variety of raw materials, equipment,
machinery, land and sources of power in the production process. For their activity,
these individuals were paid amounts which, when totaled, were roughly equivalent in
value to the goods and services they produced. In 1983, wages and salaries totaled
$1,984,900,000,000(4) which was 75 percent of National Income. The remaining 25
percent was paid to the owners of rental property ($58,300,000,000 or 2.2 percent of
National Income), business proprietors ($121,700,000,000 or 4.6 percent of National
Income), owners of corporations ($203,189,000,000 or 7.7 percent of National Income)
and net interest ($256,600,000,000 or 9.7 percent of National Income)(5).
As these numbers suggest, the U.S. economy is very complex. Millions of
individuals cooperate in producing hundreds of thousands of separate goods and
services. As complex as this system is, many individuals take into account your
specific desires when making production decisions. Although this statement may seem
improbable, it is nonetheless true and can be demonstrated by a simple example.
When you go to a local restaurant with the idea in mind of buying a hamburger, your
experience tells you that you will, in fact, be able to obtain the hamburger when you
order it. Clearly, the owner of the restaurant anticipated your wants and the wants of
others like you when he or she decided upon the number of hamburgers to produce.
this is true not only of hamburgers, but also of other goods you buy. It is true for you
and for everyone else. Generally speaking, producers make available the kinds and
quantities of goods that individuals want to buy.
Of course, there have been exceptions to this general proposition, such as the
1979 gasoline shortage in the United States. While such exceptions are rare in the
U.S., they are common in some other countries. Later in this pamphlet, we will
examine why there are occasional shortages of some goods and surpluses of others.
What This Pamphlet Is About
This pamphlet is intended to help you understand how the economic activity of
individuals is coordinated in producing the goods and services we all want. Some
specific topics that will be discussed include scarce goods and choice, production and
cooperation, specialization and coordination, markets, prices and profits.
Scarce Goods, Choice, and Cost
If wishes were horses then beggers would ride." You may have heard this from
your father when you told him you wanted your own record player, scuba equipment or
new dress, etc. His response reflects a fundamental problem that all people must
confront––the problem of relative scarcity. This problem refers to the fact that if you (or
anyone) want to obtain more of a particular good, you must necessarily give up some
of another desirable good.
To extend the example given above, your father might say to you, "If you really
want that record player, you will have to earn enough to buy it." Suppose you really do
want it and you get a job after school in order to buy it. Your job will prevent you from
doing other things that you would have enjoyed doing had your afternoon been free.
You will not be able to play baseball, go swimming or enjoy the company of your
friends. The enjoyable things that you would have done had you not been working are
the goods you have to give up to obtain the record player. In other words, they are the
true cost of the record player to you. The cost of obtaining any good is the value you
associate with the other goods you would have obtained but necessarily gave up.
Why must you earn the record player? Why aren't record players free? For that
matter, why aren't all goods free? To answer these questions, let's consider another
example. If you were to decide to go swimming after school you could not play
baseball at the same time because it is physically impossible for you to do both things
at once. The cost of enjoying the swim is the enjoyment you necessarily give up by not
playing baseball. This same consideration applies to the production of record players.
Given the total resources that are available, it is physically impossible to produce all of
the record players, baseball equipment, swimming pools, new dresses, T-bone steaks,
cars, amusement parks, movies, milk shakes, etc., that people want. As a result, if
people want more of some of these items (for example, record players), they will
necessarily give up some other things they otherwise would have enjoyed. Record
players are not free because the resources needed to produce them, as well as the
other goods people want, are scarce.
When you engage in some activity in order to obtain the record player, you are
engaging in an economic activity. An economic activity is any activity that attempts to
deal with the problem of relative scarcity.
Let's examine this concept more closely. Economic activity clearly involves
making choices. The problem of relative scarcity requires that you decide. Remember,
you cannot have both the record player and the baseball game.
Would the record player have been less scarce (would the requirement to
choose have been avoided) had you convinced your father to buy it for you? No! The
responsibility for making the choice merely shifts to him, and he must now bear the
cost of obtaining the record player by foregoing something he would have enjoyed
otherwise. Remember, producing more record players so that you can have one is
costly, since it means that other things have been forfeited by someone in society.
It is not surprising that people make different choices when costs change.
Suppose the price of the record player that you want increases but your salary
remains the same. You must now work more hours at your job to obtain enough to buy
the record player. In other words, you will have to give up more baseball games and
other things to acquire the record player. The cost of the record player has increased.
In this situation, you may decide to purchase a record player that is cheaper (less
costly in terms of the number of baseball games its purchase requires you to give up).
If the price of the record player increased substantially, you would certainly make this
substitution. Economists have observed that as the cost of a good increases, most
people will buy less of it. They use a special term––the Law of Demand––to describe
the behavior. The Law of Demand states that people will choose less of a good when
its price (cost) rises in terms of other goods that they value.
On the other hand, suppose you are an exceptionally good employee and your
employer increases your salary. The true cost of the record player to you will decline.
The same record player will not cost you as many baseball games. As a result, you
may decide to buy a record player that is more expensive than the one you originally
intended buying but, after your pay increases, is less expensive in terms of baseball
games.
Sometimes it is convenient to depict the Law of Demand in the form of a graph.
Figure 1 presents Bill's demand curve for milk shakes. The horizontal axis shows the
number of milk shakes Bill decides to consume (demand) per month. The vertical axis
shows various unit prices of a milk shake. The Law of Demand states that as the unit
price of milk shakes increases, Bill will decide to consume fewer milk shakes per
month. The line labeled DD depicts this relationship. If the price of a milk shake is 80
cents, Bill demands three milk shakes per month. However, at a lower price (for
example, 40 cents per milk shake) Bill demands seven milk shakes per month. Bill's
demand curve indicates how Bill's consumption of milk shakes will vary in response to
changes in the unit price of milk shakes.
Previously when we discussed the purchase of record players, the price was
stated in terms of the number of baseball games given up. Don't be confused by the
fact that Figure 1 expresses the price of milk shakes in dollars rather than in units of
some other good. If the price of a milk shake is 80 cents and the price of a soda is 20
cents, purchasing one more milk shake requires that Bill give up four sodas. At this
price, Bill decides to buy three milk shakes per month. If the dollar price of milk shakes
falls to 40 cents (while the dollar price of soda remains unchanged), the price of milk
shakes in terms of soda falls to two sodas per shake. Since a milk shake costs fewer
sodas after the price change, Bill increases his purchase of milk shakes to seven per
month.
The price of milk shakes can be stated in terms of any other good as long as we
know the dollar price of milk shakes and the dollar price of the other good. The number
of other goods that Bill is required to give up when he purchases a milk shake is what
is important to him in making a decision concerning how many milk shakes to buy.
There are, of course, many people who like to consume milk shakes, and each
will have a demand relationship similar to Bill's in that each person will demand fewer
milk shakes at higher prices than at lower prices. Of course, they will differ in other
respects. At a price of 80 cents, Bill demands three milk shakes. At the same price, Jim
might demand 10 milk shakes while Sally, who is on a diet, demands only two.
The community demand for milk shakes at a price of 80 cents is the sum of the
number of milk shakes demanded by each individual at that price. If Bill, Jim and Sally
were the only individuals in the community, the community demand would be 15 milk
shakes at a price of 80 cents. At a price lower than 80 cents, each person would
demand a greater quantity and this increase would be reflected in the community
demand.
Let's summarize what we have said. Economic activity involves making choices
in the face of scarcity. Making choices involves a cost. Costs are things we would like
to have, but choose to give up in order to obtain the things we want more. The choices
we make will depend on the costs we experience.
Production and Cooperation
Economic activity involves production. Production occurs when less-valued
goods are transformed into goods that are valued more highly. Let's see how this
concept applies in our example.
With the help of the person who sells record players, you convert baseball
games (the good you value less) into a record player (the good you value more). With
your help, the person who sells record players converts record players (the good he or
she values less) into ball games or whatever else he or she values more highly than
record players.
While this simple explanation extracts the essence of what occurs in the
production process, productive activity is much more complicated. For example, if you
accept a job as a cook's assistant at a local restaurant, you are engaged in productive
activity. You are converting lower-valued goods (baseball games, etc.) into a highervalued good (the record player). However, there are a number of intermediate steps in
this process. You search for the best job and you cooperate with the restaurant owner,
the cook, the waiters, the men who deliver food from suppliers, the people who wash
dishes, etc., in producing meals for customers. Because you are helping to produce
something (meals) that the customers value and because in doing so you are giving
up something (baseball games) that you value, you earn a wage. Finally, you use your
wage to buy the record player. Your ability to buy the record player (the good you
value more highly) with your wage compensates you for giving up baseball games
(the good you value less highly).
All of the individuals you help and who help you to produce meals for the
restaurant's customers are accomplishing the same thing that you are accomplishing.
They are converting goods that they value less highly into goods they value more
highly. The people who help produce record players are engaged in the same
process. People find it advantageous to cooperate with each other in the production
process.
Let's summarize. Economic activity necessarily involves production. Production
means transforming less-valued goods into goods valued more highly. People will
cooperate with each other in producing goods.
Specialization
Why do people find it advantageous to cooperate in producing goods? To put
the question another way, why don't you build your own record player instead of
working at the restaurant? When the question is posed this way, the answer is
obvious. Because you are not an expert in producing record players and because it
would take too long to become an expert, you decide that record players are cheaper
(cost fewer ball games) if you specialize in the productive activity you do best and
trade with other experts for the things you want. People specialize when they produce
some specific good in greater quantity than they want for their personal use. You
specialize in producing meals; the record player producer specializes in producing
record players. In doing so, you both obtain the other things you want at lower cost.
In short, people specialize in production because specialization lowers the cost
of the things they want. When a person specializes, he produces more of a particular
good than he personally uses. The specialist uses his share of the proceeds from the
sale of goods he helps produce to buy other goods.
How is the productive activity of all these specialists coordinated? It is unlikely
that you would be willing to help the restaurant owner produce meals if he were not
willing to pay for your help. You must give up other things that you like to do in order to
help him produce meals and, if he does not pay you, you cannot obtain the record
player and other goods in compensation. Consequently, if employers do not
compensate people for the costs they incur, they will be unable to obtain help. The
same is true for you. If you do not pay the producer of record players, he will not help
you obtain a record player. These payments, or prices, are very important in
coordinating the activity of all specialists in the production process.
If the compensation (price) that a specialist (producer) receives rises relative to
the costs (prices) of the goods he buys, he will be encouraged to produce more. This is
just another way of saying that he will make a different choice when prices change
(you may want to review the previous discussion of choice). If the compensation that
the specialist receives rises, he will work more at his specialty, produce more of the
good in which he specializes and buy more from others in the community.
On the other hand, if the prices of the goods he buys rise relative to the
compensation (price) he receives for his help, he will work less at his specialty,
produce less of the good in which he specializes and buy less as well. Note that we
said he would "work less at the specialty" and not that he would work less. if your wage
as a cook's assistant falls relative to the prices of the goods you buy, you will probably
decide to work fewer hours per week at the restaurant since the things you buy with
your wage cost you more now in terms of the things you give up by working. You will
work fewer hours per week at the restaurant, but more hours per week organizing
baseball games or doing other things that you value.
Does the above discussion seem confusing? What we are saying is really very
simple. If your wage goes up relative to the prices of the things you buy, you will now
be able to "afford" more of the other things that compensate you for the ball games you
give up. From your point of view, working in your specialty is now more productive in
terms of satisfying your wants. As a result, you will spend more time working and less
time playing ball. Of course, the opposite occurs if your wage falls relative to the prices
of the other things you buy.
The above discussion can be summarized as the Law of Supply. The Law of
Supply states that people will supply (offer for sale) more of a good when its price rises
relative to the prices of other goods. Just as with the Law of Demand, it is sometimes
convenient to depict the Law of Supply in the form of a graph. Figure 2 does this for
milk shakes. The horizontal axis shows the number of milk shakes offered for sale per
month, and the vertical axis shows the various unit prices of a milk shake. The line
labeled SS shows the relationship between the price of milk shakes and the quantity
supplied. The SS line is called a supply curve.
The supply curve in Figure 2 indicates that at a low price of 30 cents per milk
shake, the collection of individuals who specialize in the production of milk shakes will
offer for sale only 200 milk shakes per month. However, at a higher price of 70 cents,
they will offer 1,000 milk shakes for sale. At prices higher than 70 cents, more than
1,000 will be offered for sale.
Just as the demand curve shown in Figure 1, the particular supply curve shown
in Figure 2 is imaginary. The purpose of these particular curves is not to reflect the real
world exactly, but to help us think correctly when we are using the Laws of Demand
and Supply.
Markets
What is a Market?
Broadly speaking, a market consists of all of the people who are interested in
buying or selling a particular good or service. You become a part of the restaurant
market when you decide to look for a job as a cook's assistant. You are part of the
market for phonographs when you decide to buy a record player. More particularly, a
market is the collection of specialists who are interested in producing and selling a
particular good, along with the people who are interested in buying that good.
For our purposes, think of markets as being made up of people. It is not useful
for us to think of markets as places. In some cases, buyers and sellers find it
convenient to come together in a common place to conduct their business. That is why
people refer to their grocery store as the market. However, a particular grocery store
does not make up the entire market for groceries. There are, clearly, many grocery
stores and customers located throughout the United States. The market for groceries
includes all of the individuals who sell groceries in these stores, the people who
supply groceries to the stores and the customers.
Markets and Exchange Cost
Individuals who participate in the market process perform some very important
functions, apart from simply exchanging goods. For example, the specialist who sells
phonographs provides potential customers with a considerable amount of information
at low cost. If you were interested in buying a phonograph, you would want to know
who is interested in selling phonographs, what different kinds of phonographs are
available, how each kind operates, how each is maintained and how much each costs.
It would be very difficult (costly) for you to gather all of this information without the help
of the specialist. The attempt to buy a phonograph is costly because it cuts into the
amount of time you have to play ball or work on other things you like to do.
The specialist reduces these information costs. He lets you know that he is
interested in selling record players by opening a store in a convenient location, by
putting up signs and by advertising on radio, television and in the Yellow Pages.
Through his advertisements, he tells you about the available kinds of phonographs
and the prices at which he is willing to sell them. He also provides a ready inventory of
phonographs from which to choose, as well as a pleasant establishment in which to
conduct your business. By engaging in these activities, the specialist reduces your
total cost of obtaining the goods.
Markets and Prices
Previously, we noted that prices are important in coordinating the economic
activity of individuals. If the prices of the things a person buys rise relative to his wage,
he will buy less of those things and he will work less in his specialty. He does this
because working in his specialty is no longer as productive as it once was in satisfying
his wants. The opposite is true if prices fall.
What factor determines the prices to which individuals react? The interaction of
buyers and sellers in the market determines prices. Let's apply our example to this
concept. When you begin to search for work as a cook's assistant, you want to find a
job that pays a very high wage (price) for your services. As far as you are concerned,
the higher the wage, the better. Although nothing prevents you from offering your
services at $100 per hour, you will find that no one is willing to accept your offer
because other potential employees are willing to offer their service at wage rates lower
than what you are asking. The restaurant owner will not accept your offer if he thinks
he can hire someone else at a lower wage who is essentially as good as you at the
job. In this example, you have confronted the basic market rule facing sellers of all
goods and services. Competition among sellers prevents any one of them from
obtaining a higher price for their goods or services than is obtained by other sellers.
On the other hand, what prevents the restaurant owner from offering a very low
wage rate, say, one dollar per hour? In this case, the restaurant owner is the buyer. He
would like to buy your help at a low price. As far as he is concerned, the lower the
wage, the better. However, there are many other buyers (restaurant owners and
others) who would be willing to pay you much more than one dollar per hour to obtain
your services. You will not have to sell your services at this low wage because you
know there are other competing buyers who would be willing to pay you more. If any
buyer wants to obtain your services, he will have to offer you at least as much as
competing buyers are willing to pay. It is this competition ––sellers against other
sellers and buyers against other buyers<longdash>that finally determines the wage
you will receive and the prices you pay.
Of course, if you do not like the results of this competition, i.e., if the highest
wage offer is too low to compensate you for the ball games you must give up by
working, you can always withdraw your offer. Nothing requires you to accept the job.
On the other hand, if the wage compensates you for the things you must forego
because of working, you will accept the job. Competition among buyers and sellers
determines the wage you receive.
The above discussion is summarized in Figure 3, which combines in one
diagram the community demand curve (Line DD) and supply curve (Line SS) of milk
shakes. Various unit prices of a milk shake are measured along the vertical axis, while
the quantity of milk shakes per month is measured along the horizontal axis, as in
Figures 1 and 2. Figure 3 is read in the same way as Figures 1 and 2. For example, if
the price of a milk shake is 80 cents, the number of milk shakes demanded per month
is 600 (read from 80 cents on the vertical axis over to the DD line and then down to the
horizontal axis). At a lower price of 40 cents, the number of milk shakes demanded is
1,000. The amounts supplied at these two prices are 1,200 at a price of 80 cents and
400 at a price of 40 cents (read from the relevant price on the vertical axis over to the
SS line and then down to the horizontal axis).
Suppose that the price of a milk shake is 80 cents. At this price, total community
demand for milk shakes is 600, while the number offered for sale is 1,200. More milk
shakes are offered for sale at a price of 80 cents than buyers want. Sellers, of course,
will only be able to sell 600 at a price of 80 cents even though they would like to sell
1,200. Frustrated sellers will attempt to lure buyers away from other sellers through
competition. An effective way to do this is to offer milk shakes at a lower price.
As a result of this competition among sellers, the price of milk shakes will begin
to fall. As the price falls, the DD curve indicates that customers will begin buying more
milk shakes. The competition among sellers that results in the price decline is effective
in increasing sales. The SS curve indicates that the price decline is also effective in
reducing the number of milk shakes offered for sale by sellers.
Competition among sellers will result in lower prices as long as the number of
milk shakes that customers want to buy at the existing price is less than the number
that sellers want to sell at the existing price.
At the price of 60 cents, the number of milk shakes customers want to buy is
800. The number of milk shakes that sellers offer for sale at this price (60 cents) is 800,
exactly the number that buyers want to buy. At a price of 60 cents, there are no
frustrated sellers. Because the number of milk shakes individuals want to buy is equal
to the number sellers offer, there is no further pressure to lower price. Sellers believe
they are able to sell just the right amount at this price. At any price above 60 cents,
competition among sellers will result in decreasing the price of milk shakes to 60
cents.
What happens if the price falls below 60 cents? For instance, at a price of 40
cents, customers will want to buy 1,000 milk shakes per month while sellers will want
to offer only 400. Customers will be frustrated because they will be unable to obtain as
many milk shakes as they want. Consequently, they will compete for the relatively few
milk shakes that are available. In the process, they will offer higher prices. As the price
increases, more milk shakes will be offered for sale (sellers move up the SS curve),
while the number demanded by customers decreases (customers move up the DD
curve). The pressure to increase price is eliminated at a price of 60 cents, because the
number of milk shakes customers want to buy at a price of 60 cents is exactly the
number that sellers offer. The 60-cent price is called the equilibrium price because at
any other price (given the SS and DD curves) competition among sellers and buyers
will result in pushing the price to 60 cents.
What are Profits?
Profits are the gains that buyers and sellers experience when they engage in
exchange. The prospect of earning a profit is what motivates buyers and sellers to
seek exchange opportunities. In the example we have been using, you want a
phonograph. Essentially you have two ways to obtain it: you can build one yourself or
you can buy one from someone else. Either of these choices will incur costs in terms of
foregone ball games and other goods. The first choice requires that you learn how to
construct and assemble each different piece, that you obtain the materials you need
and that you then construct the phonograph. The other method requires you to
produce something that others value and trade it for the phonograph. Which method
costs less? For most of us, it is certainly cheaper to produce something that others
value and trade for the record player. This is what you do when you decide to work as
an assistant cook. You give up fewer ball games in obtaining the record player by this
method than you would if you tried to build one yourself. The reduction in the number
of ball games you give up by trading for the phonograph is your profit from the
exchange.
Similar reasoning applies to the seller. He specializes in the production or sale
of phonographs and trades for the other things he wants. By doing so, he obtains
these other things at lower cost. As in your case, this reduction in his cost represents
his profit from the exchange.
Profits are nothing more than the benefits individuals derive from the process of
exchanging goods. Both buyers and sellers earn profits in the trading process. If it
were not for these profits, buyers and sellers would not trade because there would be
no reason for them to do so. This means that the owner of the phonograph shop would
be unwilling to sell record players to you or anyone else and the owner of the
restaurant would be unwilling to buy your services as an assistant cook. In fact, there
would be no restaurants, phonograph shops, movie theaters, grocery stores, clothing
stores, schools, gas stations, amusement parks, etc.
There is one further point concerning profit that is very important. When the
profits earned from a particular activity change, people change the amount of time and
energy they devote to that activity. If people should change so that they now want more
record players than phonograph producers want to produce at the current price, the
price of record players will rise (as discussed above) along with the profits earned by
sellers of record players. These sellers will, as a result, devote more time and energy
to supplying more record players. You would do the same thing if the profits you earn
as an assistant cook were to rise because people now prefer to eat out more. Prices
and profits change in response to changes in the desires of buyers. Sellers respond to
these changes in profits by supplying additional amounts of those things that buyers
want more of and fewer amounts of goods buyers want less of.
How Large are Profits?
Table 1 presents some data concerning the profits of sellers for various years.
Examination of these data will help us determine the magnitude of sellers' profits and
how they have been changing.
The before-tax profits of sellers in 1980 amounted to about 14 percent of
National Income. On average, sellers who were sole proprietors earned $4,430 in
profits during this year. Partnerships earned profits that averaged $5,797, while the
average profits of corporations were $88,159. Although the average profits of
corporations appear to be higher than those of proprietorships and partnerships,
corporations include more owners than other business organizations and the higher
profits must be divided among more people. The average dividend paid to individuals
who owned corporate stock traded on the New York Stock Exchange was $1,878 in
1981(7).
Table 1
Before-Tax Profits of Sellers(6)
Type of
Organization
1970
1975
1976
1977
1978
1979
1980
Proprietorships:
Total Profit (bil.
of $)
Average Profit
$33
3,511
$45
4,135
$50
4,402
$51
4,495
$59
4,909
$61
4,947
$55
4,330
Total Profit as
a percent of
National Income
Partnerships:
Total Profit (bil.
of $)
Average Profit
4.1%
3.6%
3.6%
3.3%
3.4%
3.1%
2.6%
$10
$8
7,456
$10
9,124
$13
11,275
$14
11,345
$15
$8
5,797
10,684
Total Profit as
a percent of
National Income
Corporations:
Total Profit (bil.
of $)
Average Profit
Total Profit as
a percent of
National Income
11,538
1.2%
0.6%
0.7%
0.8%
0.8%
0.8%
0.4%
$66
$143
$185
$219
97,681
$247
103,912
$285
$239
39,640
70,652
88,857
11,459
88,159
8.1%
11.5%
13.4%
14.5%
11.3%
14.1%
14.0%
Changes in Willingness to Buy
Prices, of course, change from time to time. Typically, these changes are
caused either by a change in the willingness of sellers to offer goods at the existing
price or a change in the willingness of customers to buy at the existing price. Suppose
that individuals change in that they now demand more restaurant meals than before at
the existing price of these meals.
This change is shown in Figure 4 by a shift in the demand curve from D0D0 to
D1D1. Prior to this change, D0D0 was the relevant demand curve. The equilibrium price
of a meal was $4.50 and the quantity offered for sale (1,800,000) at this price was
equal to the quantity demanded (1,800,000) at this price. After the change in customer
wants, D1D1 becomes the relevant demand curve. At the same price of $4.50 per meal,
customers now want to buy 2,000,000 meals per month in restaurants. However, at
this same price, sellers will continue to offer 1,800,000 meals. At a price of $4.50,
sellers believe that 1,800,000 meals is exactly the right number to offer for sale. They
will not produce more than 1,800,000 meals because they would have to spend more
time at the restaurant serving customers and have to forego other goods (ball games,
etc.) they want to enjoy. Since the compensation the sellers receive for the things they
would have to give up has not changed, they will continue to offer only 1,800,000
meals at a price of $4.50. This falls short of customer demand.
Because the number of meals demanded exceeds the number of meals
supplied, customers will find that the tables in restaurants are filling up more rapidly
than before. Customers will have to wait longer in line during peak hours, and lines
will form at hours that were previously slack periods. Some restaurants will run out of
food and have to close early. All of these developments will frustrate customers. As we
have discussed previously, customers will compete among one another for the
relatively few meals that are available. Some customers will offer higher prices and
these customers will be successful in obtaining the number of meals they want. Note
that the new demand curve indicates that some customers are willing to pay $6 per
meal for the 1,800,000 meals available. Other customers may become indignant and
decide to take their business elsewhere, but this is just what the successful customers
who bid higher prices had in mind. The increase in price increases the profit of the
restaurant owners because they are serving more meals now at higher prices than
before the change in wants. The increase in price also helps the individuals who
choose to remain customers of the restaurant because they no longer have to wait in
line to be served. Their willingness to pay the higher prices means that the other things
they give up by paying higher prices are less valuable than the other things they would
have given up by waiting in line longer.
What about the individuals who decide to take their business elsewhere? They
will find even longer lines at the lower-priced restaurants because other people
switched restaurants when prices were raised. Eventually, these people will grow tired
of the long wait, the overcrowding, the cold food, the poor service and all of the other
problems that arise because of the shortage of meals at the lower price. Prices in
these restaurants will eventually increase as well, with an accompanying increase in
profits to owners sufficient to compensate them for the additional cost they incur in
serving meals.
The result is that the price of meals served in restaurants is somewhat higher
and more meals are served. It is important to note that the increase in price and the
resulting increase in profit to restaurant owners is caused by customers wanting more
meals than restaurant owners were willing to provide at the old price. The action taken
by the restaurant owners in supplying additional meals has the effect of holding the
price increase below what it would have been otherwise.
These points are illustrated in Figure 4. The price rises to a new equilibrium of
$5 per meal. The number of meals supplied by restaurants increases from 1,800,000
to 1,950,000. Note that at the old price of $4.50, customers wanted 2,000,000 meals.
However, as the price rises to $5, the number of meals demanded by customers falls
to 1,950,000, which is equal to the number supplied at this price.
A further point is important. Had the restaurant owners not increased the supply
of meals, the price of a meal would have increased to $6. This is the price that equates
the number of meals demanded (given the new demand curve, D1D1) to the original
supply of meals, 1,800,000. In fact, the price does not rise to $6 because the restaurant
owners increase the number of meals supplied from 1,800,000 to 1,950,000.
The reverse would have happened if the willingness of customers to buy at
existing prices had declined.
Changes in Willingness to Sell
The above developments occurred because of a change in the willingness of
customers to buy at existing prices. On the other hand, there may be a change in the
willingness of sellers to offer goods at existing prices. To illustrate this, let's take the
market for phonographs as an example. Suppose that some enterprising owner of a
phonograph shop discovers that he can purchase high-quality record players in Japan
and have them shipped to the United States at lower prices than he can purchase
record players from domestic producers. There is clearly a profit potential in importing
phonographs. Of course, other phonograph shops will copy him, with the result that
more phonographs become available for sale at the existing price. The sellers now are
willing to offer more record players for sale at the existing price than buyers want at
that price. The sellers will complain that business is slow even though they are selling
as many record players as they had been prior to importing them from abroad.
Eventually, some of the sellers will announce a sale of phonographs at reduced
prices. They are willing to do this because of obtaining imported record players more
cheaply. Although they would like to sell at the old higher prices, they have discovered
that customers do not want to buy the number of phonographs offered for sale at the
old price.
When the price is lowered, some customers who were planning to buy at the old
price will decide to buy a better record player. Others who were not going to buy at the
old price will be attracted by the lower price. Others will decide to replace their old
phonograph sooner than they would have. In short, the price reduction will increase
the number of record players sold.
The situation discussed above is illustrated in Figure 5. The original price
($400) and quantity of record players bought and sold (2,200) are shown by the
demand curve (DD) and initial supply curve (S0S0). When importing begins, the supply
curve shifts to S1S1. At a price of $400, sellers are now willing to offer 3,400
phonographs for sale. At this price, however, buyers continue to demand 2,200.
Competition among sellers drives the price down to $350, and the price reduction
increases sales from 2,200 to 2,600.
The result of this change is that more phonographs are sold at lower prices. The profits
of sellers are somewhat higher than they were before they began importing from
Japan.
The Impact of Price Control
One of the best ways to appreciate the role that prices and profits play in
helping buyers and sellers direct the production and use of goods is to consider what
has happened during periods of price and profit control. On August 15, 1971,
President Nixon froze all prices in the United States. This made it illegal for the price of
any good to rise above its August 15, 1971, level. The results were disastrous.
It was no accident that shortly after the price controls went into effect, shortages
of many different types of goods began to appear. Some of the more notable
shortages involved the markets for oil, gas, wood, beef, paper bags and bailing wire.
The fact that these shortages occurred should not surprise you if you consider what
happened in the restaurant example when buyers decided they would like to eat more
meals in restaurants at the existing price. Customers wanted more meals at the
existing price than sellers were willing to offer. People had to wait in long lines to be
served. When they finally did get a table, the service was poor and the food was cold. It
was not until the price of meals and profits of restaurant owners rose that more meals
were provided to satisfy the increased demand. Along with the increase in supply
induced by the higher prices and profits, some customers were discouraged by the
higher prices and decided to eat out less often. The increase in price matched the
amount sellers wanted to supply to the amount customers wanted to purchase.
With the price freeze of 1971, prices were not allowed to move upward when
the willingness of customers to buy at the existing price increased. As a result, when
customers wanted more gasoline, a shortage developed. We had to wait in long lines
to buy gasoline. When we finally got to the pump, we served ourselves and washed
our own windows and checked our own oil. The same thing happened in many other
markets during the period of price control. It was not until prices were allowed to rise
that the shortages vanished.
Another example of the impact of price control occured in 1979. This example,
also, concerns gasoline. In 1979, because of internal strife, Iran reduced the amount of
oil it was producing. Since the United States was importing oil from Iran and because
oil is used to produce gasoline, the supply of gasoline available in the U.S. decreased.
Had the price of gasoline been free to move upward in 1979, the result would have
been a higher price for gasoline. The higher price would have discouraged some
consumption and encouraged more production from sources other than Iran, thus
matching the amount demanded to the reduced supply. This is shown in Figure 6 by
the shift in the supply curve because oil is used to produce gasoline, the supply of
gasoline available in the U.S. decreased. Had the price of gasoline been free to move
upward in 1979, the result would have been a higher price for gasoline. The higher
price would have discouraged some consumption and encouraged more production
from sources other than Iran, thus matching the amount demanded to the reduced
supply. This is shown in Figure 6 by the shift in the supply curve because oil is used to
produce gasoline, the supply of gasoline available in the U.S. decreased. Had the
price of gasoline been free to move upward in 1979, the result would have been a
higher price for gasoline. The higher price would have discouraged some
consumption and encouraged more production from sources other than Iran, thus
matching the amount demanded to the reduced supply. This is shown in Figure 6 by
the shift in the supply curve from S0S0 to S1S1. The shift would have increased the
price of gasoline from 82 cents per gallon to $1 per gallon, while decreasing
consumption from 6.8 to 6.4 billion gallons per week.
However, the price of gasoline was prevented from rising by a U.S. government
price control which made it illegal for sellers of gas to charge higher prices. As a result,
the quantity of gasoline demanded did not decline when supply fell, nor did production
from other sources rise. A shortage of gasoline developed equal to the difference
between the amount demanded (6.8) at a price of 82 cents and the new amount
supplied at this price (5.9). Just as in 1971, this shortage was reflected by long lines at
gas stations. Again, it was not until the government reversed its position and allowed
gas prices to rise that the lines were eliminated.
Note that when the price is allowed to rise, the amount demanded declines from
6.8 to 6.4 billion, while the amount supplied from sources other than Iran increases
along the new supply curve from 5.9 to 6.4. The important lesson to draw from this
example is that the shortage of gasoline in the U.S. was not caused by internal strife in
Iran, but by the U.S. price control that prevented price from adjusting when supply or
demand conditions changed.
Summary: The purpose of this pamphlet is to help you understand how the
economic activity of individuals is coordinated in producing the goods we all want. The
answer is very simple. Individuals interact in markets by inducing one another, through
the prices they offer, to supply the goods each wants. There is nothing mysterious
about this process. It is not controlled by any particular individual or group of
individuals. Each person who participates in the market process (and we all do) helps
determine the results.
Questions for Discussion
1. Are good grades scarce? Why?
2. How is choice related to cost?
3. What is the cost of going swimming after school?
4. Do people make different choices when costs change? Why?
5. Are you engaged in productive activity when you watch television?
6. What is meant by specialization?
7. Why do people specialize?
8. How are the productive activities of specialists coordinated with the wants of
buyers?
9. What is the Law of Demand?
10. Did Congress pass the Law of Demand? What makes it a Law?
11. What is economic activity?
12. What is a market?
13. How does the specialist who sells shoes reduce the cost of acquiring a pair of
shoes.
14. How are prices determined?
15. What causes prices to change?
16. What are profits?
17. "Buyers as well as sellers earn profits when they trade." Comment on that
statement.
18. What happens when prices are not allowed to rise in response to an increase is
the willingness to buy at the existing price?
19. Who controls economic activity?
FOOTNOTES
(1)Board of Governors, Washington, D.C.
(2)Ibid.
(3)Statistical Abstract of the United States, 1984. Bureau of the Census, Department of
Commerce, December 1983, p. 406 and 409.
(4)Board of Governors, Washington, D.C.
(5)Ibid.
(6)Statistical Abstract of the United States, 1984, p. 532.
(7)Ibid. p. 524.