The Market System in Action

Session 3

Professor Dermot McAleese

OUTLINE

The market system

The role of prices

Demand and supply

Taxes, subsidies and quantitative restrictions

The efficiency of the free market

Free market in the social context

Large number of sellers and buyers (free entry and exit)

Full information

Consumers maximise utility

Firms maximise profit

Flexible prices

COMPETITIVE MARKET

THE MARKET SYSTEM

Product

market

Labour

market

Capital

market

FOREIGN SECTOR

GOVERNMENT

Sell goods

Buy labour

Invest in capital goods

FIR

MS

Buy goods

Sell labour

Borrow money

Save money

HO

USE

HO

LD

S

MARKET ECONOMY

TOTAL ECONOMIC ACTIVITY

SHADOW ECONOMY

FORMAL ECONOMY

Non-marketed economic activity

Marketed economic activity

Non-marketed economic activity

TOTAL MARKET ECONOMY

Marketed economic activity

THE SHADOW ECONOMY

Measurement monetary aggregates method

income expenditure discrepancy

special investigations

Causes high taxes and perceived lack of ‘fairness’

high burden of regulations

high unemployment combined with high unemployment compensation

onerous employment regulations

cultural and personal behavioural characteristics

Cures lower tax rates and ‘broaden’ tax base

improve regulation and legal restrictions

enhance monitoring and international co-operation

Source: F. Schneider, ‘The shadow economies of Western Europe’, Economic Affairs, September 1997.

Table 1. Size of the shadow economy (% GDP)

Country 1990 1997

Austria 5 9Belgium 20 22Canada 14 15Denmark 11 18Germany 12 15Greece 27 30France 9 15Ireland 12 16Italy 23 27Netherlands 14 14Norway 15 19Spain 21 23Sweden 16 19Switzerland 7 8UK 10 13USA 7 9

China

Illicit syphoning of funds from projects and companies has amounted to 13-16% of China’s GDP over the

past decadeSource: Asian Wall Street Journal, March 2001,

citing research of Professor Hu Angang, Qinghua University

Price is determined by DEMAND and SUPPLY

Price as incentive

Price as source of information

Market equilibrium (D=S)

THE ROLE OF PRICES

THE ROLE OF PRICES

Pri

ce

PE

P1

O HQEQ Quantity

E

OPS

S

D

BA

SHIFTS IN DEMAND AND SUPPLY

Causes of shifts in demand

level of income available to consumers

price of substitute / complementary goods

income distribution

demographic structure

tastes and fashion

seasonal factors

Causes of shifts in supply

technological innovation

changes in prices (L, K, inputs)

natural and man-made disasters

strikes / government regulations

organisation and management restructuring

SHIFTS IN DEMAND AND SUPPLY

“…..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 their self-love…”

Adam Smith Wealth of Nations, Book 1, Chapter II, p. 18

INCIDENCE OF TAXS1

S

QQT

V

P

PT

Quantity

Price

F

$2R

E

U

PRICE CEILING

Pri

ce

PE

Ceiling

O QER Quantity

E

S

D

BA

Water is becoming an increasingly scarce resource. About 70% of water supplies in countries such as China and Morocco is consumed by farmers for irrigation at below-cost prices.

• Explain the effect of the subsidy on the equilibrium level of water used.

• Instead of such subsidisation, could any more efficient policy be used to protect the income of farmers?

• Should farmers be charged the full economic cost for the water they use?

Do-it-yourself: Demand and Supply in Action

E7 The minimum price set by the European Commission for many foodstuffs and dairy products is set above the world equilibrium price. The objective of this price ‘floor’ is to support farm incomes. Use a supply and demand diagram to illustrate the effects of setting the minimum price on a) food prices in the EU b) farm incomes

c) government spending and d) other countries.

Exercises

E1. Draw a graph showing the demand curve and the supply curve of personal computers. How would the graph be affected by:

 

   a rise in the price of software

a rise in the price of electric typewriters

    a fall in the price of desktop printers

an expected increase in next year's PC prices

 a 10 per cent sales tax on computers

a fall in income tax

(p. 94)

THE EFFICIENCY OF THE MARKET SYSTEM

Price

per

unit

Output

Cost of

production

Utility

Marginal

utility

Marginal

cost

E

S

D

W

VR

QO

P

QE

S

QT

PE

mu > mc

mu < mc

mu = mc

‘INVISIBLE HAND’ OF THE MARKET SYSTEM

Seeking only to satisfy their individual wants and needs, consumers are led to do so in a way that puts least strain on society’ s resources for the level of satisfaction achieved

Businesses, pursuing private profits, are led to produce goods and services which consumers want, at lowest cost

Owners of capital and land, seeking only to increase their wealth, are led to deploy their assets in the most socially productive ways

Employees, attempting to maximise their welfare, are led to select the training and careers which are most valuable to society

Assumptions: prefect competition, full information and completeness

Stable and reliable medium of exchange

Transparent prices, competition and full information

Private property and legal framework

Minimum standards of truth, trust, acceptance and obligation

Equitable distribution of income

FIVE CONDITIONS FOR AN EFFECTIVE FREE MARKET SYSTEM

QUESTIONS

Demand for cigarettes is insensitive (inelastic) with respect to price, but demand for a particular type or brand of cigarette could be very elastic. Use demand and supply curves to analyse the following:To encourage better quality cigarettes the government will raise the tax rate on low

quality brands while lowering the tax rate on more expensive cigarettes. This is aimed at strengthening the position of bigger producers such as Hongta Group, while pushing many smaller local manufacturers out of business. EIU China Country Report August 2001

Discuss what you would consider to be the main determinants of demand and supply of rented apartments. Suppose the government decides that rents are too high and sets a maximum rent. What would you expect the consequences of this action to be for (a) apartment owners, (b) existing renters and (c) future renters?

The government gains revenue by imposing a sales tax. Who stands to lose the most, the consumer or the producer or both?  

Exercises

E6. (a) Consider the economic consequences of a prohibition on the consumption of alcohol. What happens to the supply curve? What happens to the demand curve? How will the prohibition affect equilibrium consumption and price? What further indirect effects are likely to follow? (According to some writers, prohibition is likely to raise the level of violence by increasing the marginal benefits and lowering the marginal costs of breaking the law.)

 

(b) Suppose the head of an anti-drugs enforcement agency reports, as evidence of the agency's success in deterring drug users, that the street price of drugs has fallen. Is this evidence conclusive? What other factors might have caused the fall in price?

 

Question for Class

Use demand and supply analysis to illustrate the effects of China’s removal on restrictions on imports of automobiles. Import tariffs on automobiles will fall to 25% by mid 2006 from present level of 70-90%.

What will be the effect on:• the price of imports in RMBs?• the dollar price of imports?• employment in import competing industries?• government tax revenues?