Chap- The (Free) Market System

Different Economic Systems

 In order to solve the basic economic problem of scarcity, economic systems emerge or
are created by different economic agents within the economy

o These agents include consumers, producers, the government, & special

interest groups (e.g. environmental pressure groups or trade unions)
o Any economic system aims to allocate the scarce factors of production
 
 The three main economic systems are a (free) market system, mixed economy,
& planned economy

What Determines The Economic System Of A Country  

How the three questions are answered determines the economic system of a
country

 Economic decisions need to be made to answer three important questions

1. What to produce? As resources are limited in supply, decisions carry an opportunity

cost. Which goods/services should be produced e.g. better rail services or more public
hospitals?
 2. How to produce it? Would it be better for the economy to have labour-intensive
production so that more people are employed, or should goods/services be produced
using machinery?

3. For whom are the goods and services to be produced? Should goods/services only be

made available to those who can afford them, or should they be freely available to all?

  
How These Questions Are Answered Determines the Economic System

Type of What to  How to

For Whom?
System Produce? Produce?

Market Demand & Most efficient, Those who

System supply (the profitable way can afford it
price possible.
mechanism)

Mixed Demand, supply Some efficiency Those who

System & the but also a focus can afford
Government on welfare/well- it, plus
being some
provision to
those who
cannot
afford it

Planned The Ensure everyone Everyone

System Government has a job

How a Market System Works

 A market system works to allocate scarce resources efficiently, purely through the forces
of demand & supply (the price mechanism)
o There is no government intervention in a pure market system (no taxes or
government spending)
o In reality, there is no economy which is a pure market system
 
  In a market system, prices for goods/services are determined by the interaction of
demand & supply 
o A market is any place that brings buyers & sellers together
o Markets can be physical (e.g. McDonald's) or virtual (e.g. eBay)
 
 The price mechanism is the interaction of demand and supply in a free market
o This interaction determines prices which are the means by which scarce
resources are allocated between competing wants/needs

 The price mechanism fulfils several functions in an economy

o Prices allocate (ration) scarce resources. When resources become scarcer the
price will rise further. Only those who can afford to pay for them will receive
them. If there is a surplus then prices fall & more consumers can afford them
o Prices provide information to producers & consumers where resources are
required (in markets where prices increase) & where they are not (in markets
where prices fall)
o When prices for a good/service rise, it incentivises producers to reallocate
resources from a less profitable market to this market in order to maximise their
profits. Falling prices incentivise reallocation of resources to new markets 

Market Equilibrium & Disequilibrium

 Equilibrium in a market occurs when demand = supply

 At this point the price is called the market clearing price

o This is the price at which sellers are clearing their stock at an acceptable rate
A graph showing a market in equilibrium with a market clearing price at P and
quantity at Q

 Any price above or below P creates disequilibrium in this market

o Disequilibrium occurs whenever there is excess demand or supply in a market

The price mechanism is a mechanism through which prices of goods and services are
determined in a market economy. It is a system that facilitates the interaction between buyers
and sellers and enables them to exchange goods and services through voluntary transactions.

 The price mechanism provides answers to the three key allocation questions in the
following ways:

1. What to produce: In a market economy, the price mechanism provides information to

producers about the goods and services that are in demand. When the demand for a
particular good or service increases, the price of that good or service will also increase,
indicating to producers that there is a shortage of that good or service in the market.
Producers will respond to this price signal by increasing the production of that good or
service, thus ensuring that the needs and wants of consumers are being met.

2. How to produce: The price mechanism also provides information to producers about the
most efficient ways to produce goods and services. When the price of a particular factor of
production, such as labor or raw materials, increases, producers will respond by seeking out
more cost-effective methods of production, such as investing in new technologies or
changing production processes. This ensures that resources are being used efficiently and
that production costs are minimized.

3. For whom to produce: The price mechanism also determines the distribution of goods and
services among consumers. When prices are high, consumers who are willing and able to pay
the higher price will purchase the goods or services. Conversely, when prices are low,
consumers who are less willing or able to pay the higher price will purchase the goods or
services. This ensures that goods and services are distributed among consumers according to
their willingness and ability to pay, rather than according to some arbitrary criteria.
In summary, the price mechanism plays a crucial role in answering the three key
allocation questions in a market economy by providing information to producers about
what to produce, how to produce, and for whom to produce.