The Price System and

the Case for Free

Markets

Module 6
IEA 1201
Principles of Economics
University of San Carlos – School of Engineering
 • Efficient Resource Allocation and Pricing
• Scarcity and the need to coordinate Economic
Decisions
• How Perfectly Competition achieves Efficiency
Topics
Efficient allocation
of Resources

• An efficient resource allocation of

resources is one that takes
advantage of every opportunity to
make some individuals better off in
their own estimation while not
worsening the lot of anyone else.
Puzzle
How high should the price to cross the
San Francisco-Oakland Bay bridge be?
 Case
In California, the San Francisco-Oakland Bay Bridge is very heavily
traveled. The large volume of toll-paying traffic has probably long
since paid for the cost of building this bridge, although that is
probably less likely for the nearby San Mateo-Hayward and
Dumbarton bridges, which are less crowded. Yet economists argue
that the price charges to use the San Francisco-Oakland Bay bridge
should be higher than the prices charged for use of the other two
bridges.
Why may that make sense?
What are you comments on this?
 Route 1 :

Pricing to Over the Richmond-San Rafael Bridge,

across the Golden Gate Bridge, through
San Francisco, and on southward via
Promote Highway 101

Efficiency 125,000 vehicles per day

Route 2 :
Across the bay on the San Francisco-
Oakland Bay Bridge and on southward via
Highway 101 as before.

270,000 vehicles per day

Route 3 :
Down the eastern shore of the bay, across
the San Mateo-Hayward Bridge or the
Dumbarton Bridge, and then on to Palo
Alto
81,000 vehicles per day (San Mateo)
61,000 vehicles per day (Dumbarton)
 • Low prices may not always be serve the public interest!
• If a price, such as the toll charged for crossing a crowded
Can Price bridge or the prices of gasoline, is set “too low,” then
Increase Ever consumers will receive the “wrong” market signals. Low
Serve the prices will encourage them to crowd the bridge even
Public more or to consume more oil, thereby squandering
society’s precious resources.
Interest?
• “Attempts to repeal the laws of supply and demand: The
Market Strikes Back”
 Three
Coordination
How much of each commodity should
Tasks in the be produced?

Economy OUTPUT
SELECTION

Scarcity and
the need to
Coordinate
Economic
Decisions
PRODUCTION DISTRIBUTION
PLANNING
How should the resulting products be
divided among consumers?

What quantity of each of the available

inputs should be used to produce
each good?
 Output Selection

When there is When there is

Free Market Laisse-faire
shortage? surplus?

A free market system The market mechanism The same mechanism Refers to a situation in
decides what should pushes the price works is reverse which there is minimal
be produced via what upward, thereby government
encouraging more interference with the
we have called the
production and less workings of the market
“law of supply and consumption of the system. The term
demand” commodity that is in implies that people
supply shortage. should be left alone in
carrying out their
economic affairs
 Production Planning
In a free market, inputs are assigned to the firms that can make the most
productive (most profitable) use of them. Firms that cannot make a sufficiently
productive use of some input will be priced out of the market for that item.
 Distribution of Products Among Consumers

To decide which consumers gets each of the goods that has been produced.
• Coffee lovers must not be flooded with Tea.
• Because the output required from any one industry depends on outputs from
many other industries, planners can be sure that the production of the various
outputs will be sufficient to meet both consumer and industrial demands only
by taking explicit account of this interdependence among industries.
• If they change the output target for one industry, they must also adjust every
other industry’s output target

The Trade-Off between efficiency and Equality

• The price system carries out the distribution process by rationing goods on
the basis of preferences and relative incomes.
• The price system does not favor the rich, and this is a problem to which
market economies must face up.
 Input-Output Analysis
IOC
• Is a mathematical procedure that
takes account of the interdependence
among the economy’s industries and
determines the amount of output
each industry must provide as inputs
to the other industries in the
economy.
Central Planning
• A full rigorous central planning
solution to the production problem is
a tremendous task, requiring an
overwhelming quantity of information
and some incredibly difficult
calculations. Yet this very complex job
is carried out automatically and
unobtrusively by the price mechanism
in a free-market economy.
 Which Buyers and Which Sellers Get Priority?

Other things being equal, the price mechanism

ensures that consumers who want a scarce
commodity most will receive it, and that those
sellers who can supply it most efficiently will get to
supply the commodity

Buyers Sellers

The price mechanism always 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.
 How perfect competition achieves efficiency

THE IMPORTANCE OF THINKING AT THE MARGIN

Marginal Analysis – efficiency in the choice of
output quantities that, for each of the economy’s
outputs, the marginal cost (MC) of the last unit
produced be equal to the marginal utility (MU) of
the last unit consumed.
Step 1 MU = MC
Step 2
Rule for
The price
Efficient
system’s
Output
Critical Role
Selection

We must show that under perfect competition,

the price systems automatically leads buyers and
sellers to behave in a way that equalizes MU and
MC
MC = P

Under perfect competition, producers and consumers will make uncoordinated decisions that we can expect
automatically (and amazingly) to produce exactly the quantity of each good that satisfies the MC = MU rule for
efficiency. That is, under the idealized conditions of perfect competition, the market mechanism, without any government
intervention and without anyone else directing it or planning for it, is capable of allocating society’s scarce resources
efficiently.
 The Invisible Hand at work

• When all prices are set • A perfect analogous
equal to marginal costs,
the price system gives
correct cost signals to
consumers.
• It has set prices at levels
explanation applies to that induce consumers to
the decisions of use society’s resources
producers. with the same care they
devote to watching their
own money, because the
money cost of a good to
consumers has been set
to equal to the
opportunity cost of the
good to society.
Thank you