CHAPTER 2
HOW A MARKET ECONOMY WORKS: THE PRICE SYSTEM
After reading Chapter 2, HOW A MARKET ECONOMY WORKS: THE PRICE SYSTEM, you should be able to:


Explain what is meant by a MARKET
Explain the differences between SOLE PROPRIETORSHIPS, PARTNERSHIPS, and
CORPORATIONS.
Explain the interactions between households and business firms illustrated by the circular flow diagram.
 Define the terms RELATIVE PRICE, PRICE SYSTEM, PROPERTY RIGHTS, and the
PRINCIPLE OF SUBSTITUTION.
 Discuss the themes behind Adam Smith's INVISIBLE HAND and relate the invisible hand to the price
system and equilibrium.
 Explain how the price system solves the economic problem of "what," "how," and "for whom".
 Discuss imperfections of the invisible hand mechanism.
 Give the definition of PUBLIC GOODS and explain why both parts of the definition are important.
 Define EXTERNALITY.
CHAPTER OUTLINE
I. A MARKET brings buyers and sellers of a good together to determine conditions of trade, such as the
price and quantity sold.
II. A.
PROPERTY RIGHTS are the legal rights of owners to use or trade their property as they desire.
Private owners are guided by relative prices to use their property in order to make the maximum
possible profit.
B. The three forms of business organization are:
1. SOLE PROPRIETORSHIP: a business owned and run by an individual who makes all the
decisions and receives all the profits or losses.
2. PARTNERSHIP: a business owned and run by two or more people who share in all the profits
or losses.
3. CORPORATION: a business with the legal status of an individual, owned by many
shareholders, who share in the profits but have limited liability for any losses. This type of
business is frequently run by professional managers.
III. THE CIRCULAR FLOW
A.
B.
Business firms use inputs, provided by households, to produce products to supply to households.
Firms pay money for the use of the inputs and receive money from the sale of their output.
Households use the income earned from providing productive factors to business firms in order to
purchase products from firms. Households receive money for the use of their productive factors,
and they pay money to purchase products.
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IV. THE PRICE SYSTEM
A.
B.
The PRICE SYSTEM is the collection of the millions of relative prices.
1. RELATIVE PRICES are the prices of products expressed in terms of other goods.
2. MONEY PRICES are the prices of products given in terms of dollars or other monetary units.
Market allocation uses the relative prices of the price system together with the principle of
substitution and property rights to solve the economic problem of resource allocation.
1. The PRINCIPLE OF SUBSTITUTION states that users are able to replace one good with
another as relative prices change.
2. Changes in relative prices motivate users to switch from one product to another.
V. THE INVISIBLE HAND
A.
B.
C.
The INVISIBLE HAND is Adam Smith's idea that a capitalist economy can use the price system to
function efficiently, so that government intervention is not necessary.
Buyers and sellers base their decisions on the relative prices contained in the price system.
1. If more of a product is produced than the amount consumers will buy, then its relative price
falls. As the relative price falls, the amount produced decreases, while the amount demanded
increases. This eliminates the excess.
2. The invisible hand drives prices to their equilibrium levels. The EQUILIBRIUM PRICE is
the relative price at which the number of goods suppliers wish to sell just equals the amount
buyers wish to purchase.
The price system solves the "what," "how," and "for whom" questions:
1. What: the goods and services produced are those that people are most willing to spend dollars
on, thereby raising the products' relative prices.
2. How: firms produce products using the lowest cost combination of inputs.
3. For Whom: People with high priced resources consume many goods and services; people with
low priced resources consume fewer goods and services.
VI. IMPERFECTIONS: PUBLIC GOODS AND EXTERNALITIES
A.
The invisible hand will not work well when firms gain a monopoly; it may lead to an unfair
distribution of income; it cannot supply public goods; it may not work well when there are
externalities, such as pollution; and it may lead to business cycles.
B. A PUBLIC GOOD has two characteristics:
1. One person's consumption does not reduce the consumption of others (that is, the good is
nonrival in consumption).
2. It is not feasible to exclude nonpayers from consuming the good.
C. An EXTERNALITY is present when an action causes someone who is not party to the action to
suffer an uncompensated cost or enjoy an unpaid for benefit.
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REVIEW QUESTIONS
True or False
If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question
give a short statement that supports your answer.
____ 1.
Households supply labor to businesses and demand goods and services from businesses.
____ 2.
Firms buy land, labor, and capital from households and provide goods and services for
households to purchase.
____ 3.
Households receive money in the form of wages from business firms and spend this money by
purchasing things from the firms.
____ 4.
Computer chips purchased by IBM from Intel are an example of an intermediate good.
____ 5.
Shareholders of corporations have limited liability for the debts of the company.
____ 6.
Money prices play a key role in determining resource allocation.
____ 7.
Adam Smith's idea of an invisible hand guarantees that an economy settles upon the most
equitable division of income.
____ 8.
It is possible for a good's relative price to fall while its money price rises.
____ 9.
The principle of substitution suggests consumers buy more goods whose relative prices rise,
since these goods must be high quality items.
____ 10. Property rights involve the rights of owners of real estate but have nothing to do with the rights
of factory owners.
____ 11. Shareholders in large corporations often play major parts in running the business.
____ 12. Each partner in a partnership is liable for any losses or debts of the company.
____ 13. One characteristic of a public good is that free riders cannot easily be excluded.
____ 14. The only cure for the problem of externalities is a government action such as a subsidy and/or
tax.
____ 15. In all markets, the actual buyer and seller must meet face-to-face.
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Multiple Choice
Circle the letter corresponding to the correct answer.
1.
An equilibrium price is established when
a. the number of sellers equals the number of buyers.
b. everyone who wants the good gets it.
c. sellers are unable to sell any more of the good.
d. buyers cannot find sellers willing to sell to them.
e. none of the above.
2.
Which of the following is not a possible imperfection in the operation of the invisible hand and the
price system?
a. The fact that most people work for business firms rather than being self-employed
b. The possibility of a highly unfair distribution of income
c. The presence of economy-wide business cycles
d. The chance that one firm could gain control over an entire market
e. The possibility that the price system cannot supply public goods
3.
Not shown in the circular-flow diagram is the flow of
a. factors of production from households to businesses.
b. goods from businesses to households.
c. wage payments from businesses to households.
d. payments for goods and services from households to businesses.
e. none of the because all these flows are shown in the circular flow diagram.
4.
The principle of substitution suggests that
a. every individual endeavors to employ his or her capital so that what it produces has the greatest
value.
b. prices will always be equilibrium prices.
c. no single person need know all prices to function in daily economic life.
d. users are usually able to switch from one good to another as relative prices change.
e. changes in relative prices signal what goods are cheap and what goods are expensive.
5.
How does the price system solve the "how" problem of resource allocation?
a. Business firms use the principle of substitution and seek the least-cost combination of productive
factors.
b. Consumers tell business firms how to produce the goods.
c. Business firms always use the highest quality productive factors to manufacture their products.
d. Government actions tell firms how to produce their products.
e. None of the above.
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6.
Which of the following is a relative price?
a. a price of 15,000 dollars for a Honda Civic
b. a price of 4 food processors for a microwave oven
c. a wage of 15 dollars per hour
d. a price of 2000 yen for a steak dinner
e. none of the above
7.
Redefining property rights emerges as a solution to the problem of
a. externalities.
b. public goods.
c. public choice.
d. rational ignorance.
8.
Which of the following is an example of a pure public good?
a. A municipal sewer system
b. Government provided flood insurance for people living in a flood prone area
c. The public school system
d. National defense
e. All of the above
9.
An example of a nonrival good is
a. a crowded movie theater.
b. a bushel of wheat.
c. an uncrowded movie theater.
d. free medical care provided by medicaid.
e. gasoline.
Essay Questions
Write a short essay answering each question.
1. Suppose the price of gold is 400 dollars per ounce and the price of silver is 10 dollars per ounce. What
is the relative price of gold? If the dollar price of gold and silver both rise 10 percent, what would be the
relative price of gold? Suppose from the initial prices, the money price of gold rises 10 percent while
the money price of silver did not change. What would be the relative price of gold?
2. Is it possible for the relative price of a good to fall while its money price rises? If so, give a numerical
example.
3. Describe how a market based economy solves the "what" problem of resource allocation. Be sure to
discuss the role played by property rights and relative prices.
4. Discuss how the price system solves the "what" problem when consumers change their desires and want
more of a particular good. Mention the roles played by the invisible hand and equilibrium prices.
5. Describe how the price system solves the "for whom" problem. What issues can arise with regard to this
solution?
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6. "Market allocation cannot be desirable, for it forces firms to produce things as cheaply as possible.
Obviously no one wants only cheap and poorly produced goods." Comment on this.
7. Is turkey at 40 cents per pound a good buy?
8. What is "limited liability?" What business organization enjoys limited liability?
9. Why is it that we pay realtors 6 percent commissions or buy our used textbooks from the college
bookstore at a high markup when we could buy at lower prices from the immediate sellers?
10. Is mail delivery a public good?
ANSWERS TO REVIEW QUESTIONS
True or False
True
1.
This is an example of the circular flow: households participate in both the factors market and
the goods market.
True
2.
This is another example of the circular flow of services and goods.
True
3.
This is an example of the circular flow of money. Business firms and households are linked
firmly together through the circular flow.
True
4.
Intermediate goods are items purchased by a business firm for use in another product. In other
words, intermediate goods are components of the "final" goods ultimately produced and sold.
True
5.
This is the major advantage of the corporate form of business organization.
False
6.
Relative prices, not money prices, play the important role.
False
7.
One of the problems of allowing the price system to work without any checks from the
government is that the resulting distribution of income may be deemed "unfair."
True
8.
If a good's money price rises less rapidly than the money prices of other goods, its relative
price falls.
False
9.
The principle of substitution says consumers buy fewer goods whose relative prices rise.
False
10. Property rights are the rights owners have with respect to all kinds of property.
False
11. Professional managers typically control the day-to-day activities of the business.
True
12. This is a drawback to the partnership as a method of business organization.
True
13. Public goods have high exclusion costs; it is hard to exclude people who want a free ride.
False
14. Voluntary agreements and/or a redefinition of property rights are other potential solutions.
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False
15. The stock exchange, where stock brokers act as agents, is an example of a market where the
actual buyers and sellers rarely meet.
Multiple Choice
1.
e. The equilibrium price is that price at which the number of goods producers wish to sell just equals
the number demanders want to purchase.
2.
a. People working for business firms is a reflection of specialization and not an imperfection of the
invisible hand.
3.
e. The circular-flow diagram illustrates the linkages between firms and households.
4.
d. This is the definition of the principle of substitution.
5.
a. If a firm does not use the least-cost method of production, ultimately it will be driven from
business by firms that do and are therefore able to under-cut the original firm's price.
6.
b. This gives the price of one good (a microwave oven) in terms of another type of good (food
processors). All the other prices are in terms of a monetary unit.
7.
a. If no one has a clear property right to a resource in a free market, the resource will tend to be used
too intensively.
8.
d. It would be easy (though perhaps undesirable) to exclude nonpayers from a sewer system, flood
insurance, or school system. Thus, although the government frequently provides all the goods
listed in the question, only national defense meets the nonexclusion characteristic of a pure public
good.
9.
c. Only in this case does one person's consumption of the given good not deprive someone else from
consuming the same good.
Essay Questions
1. The relative price of gold is 40 ounces of silver per ounce of gold. If both dollar prices rise 10 percent,
the dollar price of gold is $440 per ounce, the dollar price of silver is $11 per ounce, so the relative price
remains 40 ounces of silver per ounce of gold. If only the dollar price of gold rises, the relative price of
gold would be 44 ounces of silver per ounce of gold.
2. It is possible for the relative price of a good to fall while its monetary price rises. This happens when
the good's money price rises less rapidly than the money prices of other goods. For example, assume the
initial price of gold is $400 per ounce and silver is $10 per ounce. Then the relative price of gold is 40
ounces of silver per ounce of gold. If the money price of gold rises 10 percent to $440 per ounce while
the money price of silver rises 100 percent to $20 per ounce, the relative price of gold declines to 22
ounces of silver per ounce of gold.
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3. What is produced depends on consumers' desires for the various goods as reflected in the number of
dollar "votes" they are willing to cast for different products. The more dollar votes cast for a particular
good, the higher is its relative price. Businesses, motivated by the fact that their property rights allow
them to keep any profit they can earn from the use of their property, produce goods with high relative
prices.
4. When consumers want more of a good, they cast more dollar votes for it. This raises its relative price.
The invisible hand points out that producers, searching for profit, produce more of the good to gain
advantage of its higher relative price. Additionally, consumers, following the principle of substitution,
are led by the higher relative price to cut back from their initial increase in demand for the good. These
actions of producers and consumers tend to restore the market to a (new) equilibrium price where the
amount firms supply equals the amount consumers demand. The actions are an example of how the
invisible hand causes markets to reach equilibrium.
5. People's income depends on the quantities and relative prices of the resources they own. The major
issue that arises from this method of solving the "for whom" problem is that the resulting distribution of
income may be "unfair."
6. The statement displays a basic error about the market mechanism. The claim that firms use the least-cost
combination of productive resources says nothing about the quality of the goods produced. If people
desire high quality goods, they will cast a large number of dollar votes for them. Thus, quality goods
will have a high relative price and firms will be motivated to produce high quality goods as cheaply and
efficiently as possible.
7. It is impossible to tell if turkey is a good buy, for this is a money price rather than a relative price. In
today's supermarket, with steak at $5.00 per pound, turkey at 40 cents per pound is relatively cheap. In
the markets of 1800 (when turkey actually cost 40 cents per pound) steak was 3 cents per pound, so
turkey was quite expensive. This example illustrates the importance of relative prices and the
irrelevance of money prices.
8. Limited liability means that an owner of a company is not liable for the company's debts. Corporations
enjoy limited liability. If a corporation goes bankrupt, the corporation's owners (that is, its
shareholders) do not have to pay the company's debts. This can be contrasted with the situation for a
partnership and sole proprietorship. If either of these go bankrupt, the partners or sole proprietor is
personally responsible for paying the company's debts. Limited liability is an immense advantage
possessed by the corporate form of business organization.
9. If we tried to buy homes directly from sellers or used textbooks directly from other students, we would
have to use our time and resources to acquire information on where the products were located, their
characteristics, and their prices. It is actually cheaper to acquire this information through realtors or
through college bookstores in return for paying a commission or higher used-book price.
10. No, the delivery of mail is not a public good; it fails to meet the two characteristics. Mail delivery is
rival in consumption: if the postal carrier delivers a letter to my house, the carrier has less time available
to deliver letters to others. And, it is easy to exclude someone from postal service: if the customer does
not buy a stamp, the letter is not delivered.
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