This is “Basic Economics”, section 8.2 from the book A Primer on Politics (v. 0.0).
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Now that we’ve established the importance of markets in understanding society, let’s learn something about how markets work. First, some basic econ. Economics is another subject that confuses some people, and it shouldn’t. In fact, most of it turns out to be common sense. People respond fairly predictably when it comes to money, and that’s true for both consumers and businesses. And if you understand the laws of supply and demand, you understand most of what you need to know about economics. And if you understand something about how our economy works, it should be easier to understand how government affects the economy.
First, the law of supplyThe higher the price, the more suppliers want to tell, generally speaking, and vice versa.: The higher the price, the more suppliers want to sell. If the price of iPods goes up, Apple ships more units. Why? Because higher prices mean a supplier can cover the cost of added production and still make a profit. If the price falls, they ship fewer units.
Second, the law of demandThe higher the price, the less consumers want to buy, generally speaking, and vice versa.: At higher prices, consumers want to buy less of an item, and at lower prices, they tend to want to buy more. If the price of downloads for an iPod go up, you buy less; if they fall, you may buy more.
Obviously, you can’t think about one law without thinking about the other. If demand rises for a product—consumers want more of it—that tends to bid up the price. More suppliers will enter that market, increasing supply, which eventually will drive down the price. If demand falls, suppliers will leave the market, supplying less of the good in question. (Suppliers will not raise the price in the face of falling demand, hoping to make up the difference. Remember the law of demand: Higher prices would simply drive demand down even further.)
A lot of other factors can influence supply and demand (such as people’s level of income, the price of inputs for suppliers, and the availability of substitutes for consumers. Taxes and subsidies also can influence supply and demand). But most of what happens in the economic world comes back to simple supply and demand.
Why this matters is because we live—and much of the world lives—in a market-driven economy. To varying degrees, most nations on earth rely on markets to make decisions about prices and production.
So how are markets supposed to work? First, let’s remember what a marketAll the people and businesses involved in the production, distribution and consumption of any good or service. is: A market is the collection of buyers and sellers for a given product. So when we talk about markets, we’re talking about all the people involved in the production, buying and selling of any particular product, from artichokes to Zambonis. When we talk about markets, then, we’re not necessarily talking about a particular place. We’re talking about a lot of places and a lot of people, usually scattered all over the world.
A market has a demand side—the buyers—and a supply side—the sellers. Buyers and sellers seek each other out to improve their welfare. Markets don’t need to be organized; they just happen. At the right price, almost anything is available.A friend of mine from the gym once decided he wanted to get bigger and so set off in search of anabolic steroids (which will make you bigger sometime before they kill you). He found, for a price, all manner of drugs, people willing to do things not normally regarded as legal, and even weapons such as Uzi submachine guns, but, fortunately, didn’t find anyone willing to sell him ‘roids. If there’s a demand for a product, sellers will try to meet that demand. As the demand for fuel-efficient vehicles grows with rising gasoline prices, automakers are more willing to supply them, such as hybrid vehicles. In the last decade, for example, sales of Toyota’s Prius soared while sales of gas-guzzling Hummers plummeted. (Eventually, General Motors stopped producing Hummers altogether and started producing the all-electric Volt.)
By definition, buyers and sellers will reach an agreement on price. The price will be one that lets suppliers make a profit but isn’t more than buyers are willing to pay. For this reason, we say that markets tend to self-regulate. If demand is less than output, or exceeds output, the market will respond by changes in price and/or quantity supplied. Markets for this reason typically don’t require outside organization. As we’ll see, they do, however, sometimes require oversight to ensure that everyone is playing fair. (Not everyone agrees with that idea, and you will have to decide whether you think that’s true.)
Some people have a rather high degree of faith in markets; other people think they’re good at some things but not without their challenges. (And some people argue that markets simply have too many problems; at the moment, those folks aren’t winning the argument.) For example, markets work when there’s real competition. If there isn’t real competition, it’s not much of a market. Despite what everyone says about free enterprise, firms tend to want to limit competition, because that means higher prices. For example, in the 1930s, U.S. airlines (and also the trucking industry) went to the government and sought regulation as way of limiting “ruinous” competition—having to compete on price over what is basically a commodity—airline seats—meant that profit margins were lower. As we will discuss below, that led to 40 years of no price competition in the airline industry.
In a true market, no one sets the price alone. Prices are determined by 1) the costs of production and 2) the demand for the product [remember the laws of supply and demand]. In some countries and in some periods of our history, we have attempted to interfere with markets through price controls: arbitrarily setting the price of goods to ensure that no one has to pay too much. This usually doesn’t work very well. Price controls distort the functioning of a market, typically limiting supply. Remember, according to the law of supply, at a given price, sellers will only supply so much of a good. But the higher price, the more suppliers want to sell, so a lid on prices necessarily means suppliers will only want to sell so much. Selling more means selling at a loss, and nobody does that for very long. Price controls, such as those imposed in this country during World War II, mean that supply will be limited. That meant that people also had to be issued ration cards so that they could get their share of scarce foodstuffs such as meat. Ending rationing would have meant higher prices, but it also would have meant more meat for sale.
Figure 8.2 Chart TK: Different kinds of markets, with examples
There are different kinds of markets—different kinds of competition—throughout the economy. Not every market for every product operates the same way.
Before we talk about different kinds of competition, here are a couple of concepts that are useful to understanding the nature of competition:
With that in mind, consider the different kinds of competition that we might find in the economy:
Usually, when there’s only one firm, government steps in with some level of regulation, attempting to keep the one firm from charging monopoly prices (prices higher than the market would otherwise allow). In the U.S., the government uses anti-trust regulation to keep any single firm from dominating its market, so as to preserve some minimum of competition.
In the case of a natural monopolyA market where it appears that consumers will be most efficiently served by one firm., for some services it may be better to have only firm providing that service. This tends to be true for services such as water, sewer, electricity and garbage collection (though not everyone agrees on this). It would not be profitable for a competing firm to build a second set of water, sewer and electric lines through your neighborhood. Consequently, these natural monopolies usually are regulated by the government—in the case of the United States, usually at the state level. This prevents the firms from charging whatever prices they want, but tends to also mean the state regulators give the service provider some minimum level of profit. It’s an admittedly imperfect system. These utility firms aren’t always as efficient as they might be, nor are regulators perfect at determining when a rate hike is or isn’t justified.