Chapter 14/The Case for Free Markets: The Price System
CHAPTER 14
THE CASE FOR FREE MARKETS: THE PRICE
SYSTEM
Chapter 14 shows how the market system can solve the enormously complex coordination
problems of an economy, and do so efficiently. The uncontrolled market system need not lead to
CHAPTER OUTLINE
EFFICIENT RESOURCE ALLOCATION AND PRICING
Efficiency exists when it is not possible to make some people better off without making
others worse off.
Pricing to Promote Efficiency: An Example
The example of San Francisco Bay bridges shows that it is possible to reduce congestion and
Can Price Increases Ever Serve the Public Interest?
Price increases can be useful when they lead people to economize on the use of scarce goods
and resources.
SCARCITY AND THE NEED TO COORDINATE ECONOMIC DECISIONS
The invisible hand of the price system automatically coordinates millions of interconnected
economic activities.
Three Coordination Tasks in the Economy
The market system solves the three principal tasks, first introduced in Chapter 2, which every
economy faces:
1. what to produce? (output selection)
Input-Output Analysis: The Near Impossibility of Perfect Central Planning
If the coordination tasks of an economy have to be made by a planner rather than the market,
the data and computational complications will be overwhelming.
Chapter 14/The Case for Free Markets: The Price System
Which Buyers and Which Sellers get Priority?
The price mechanism ensures that those consumers who want a scarce commodity most will
HOW PERFECT COMPETITION ACHIEVES EFFICIENCY: A
GRAPHICAL ANALYSIS
A simple supply and demand graph along with the concepts of consumer’s surplus and
producer’s surplus will address the issue of efficiency in the marketplace.
Under perfect competition, the equilibrium price and quantity will be optimal in terms of
Taxes would also distort the marketplace and create inefficiency.
HOW PERFECT COMPETITION ACHIEVES OPTIMAL OUTPUT:
MARGINAL ANALYSIS
Perfect competition leads automatically to the efficiency criterion: marginal utility equals
marginal cost.
Firms produce according to the rule: MC = P
The Invisible Hand at Work
When all prices are set equal to marginal costs, the price system gives correct cost signals to
consumers and producers.
Other Roles of Prices: Income Distribution and Fairness
Prices have an impact on equity as well as efficiency.
Yet Another Free-Market Achievement: Growth versus Efficiency
In addition to producing efficient solutions, free markets are a tremendous engine of
economic growth.
Chapter 14/The Case for Free Markets: The Price System
PUZZLE RESOLVED: SAN FRANCISCO BRIDGE PRICING REVISITED
Efficient bridge use requires higher tolls on more crowded bridges.
TOWARD ASSESSMENT OF THE PRICE MECHANISM
The free enterprise system is not flawless, but it accomplishes tasks that no other system can.
MARGIN DEFINITIONS
Efficient Allocation of Resources: when it is not possible to make some people better off
without making others worse off.
Laissez Faire: the practice of minimal government interference with the workings of the market
system.
Input-Output Analysis: a mathematical procedure that takes account of the interdependence
Consumer’s Surplus: the difference between the maximum amount the consumer would be
willing, if necessary, to pay for the item bought, and the price that the market actually charges.
MAJOR IDEAS
1. An efficient situation is one in which it is not possible to make someone better off
without making at least one other person worse off.
2. Resource allocation involves three basic coordination tasks: a) how much of each good to
produce, b) what quantities of available inputs to use in producing the different goods,
and c) how to distribute the goods among different consumers.
ON TEACHING THE CHAPTER
The material in this chapter can be very interesting to students. The efficiency conditions, such as
MC = MU, might seem by themselves to be a bit abstract, but when situated in the right context,
they can be extraordinarily revealing.
Chapter 14/The Case for Free Markets: The Price System
The class might begin, for example, by discussing how economic coordination could be
accomplished without prices and markets. Students could think of particular coordination
problems like, for example, how to get their dinner on the table tonight. The box on input-output
analysis shows how difficult the coordination problem is. The calculations are almost impossible,
and in any case the results give only feasible solutions, and say nothing at all about efficiency,
about whether some other solutions might be preferable to everyone. Once the students have
really confronted the difficulties inherent in economic coordination, they may be properly
PROBLEMS
1. A community’s marginal utility and total cost schedules for wooden chairs are as follows
(all units in thousands):
Marginal Total
Chairs Utility Cost
1 $10 $2
2 9 5
3 8 9
4 7 14
5 6 20
6 5 27
7 4 35
8 3 44
9 2 54
a) What is the efficient level of output?
b) What are the supply and demand schedules for chairs, and the equilibrium output and
price?
c) Explain why the free market does or does not achieve the efficient level of output.
Chapter 14/The Case for Free Markets: The Price System
Solution:
a) Five units, at which MC = MU, condition for efficiency.
b)
2. Suppose that in Problem 1 the government imposed
a) a price ceiling of $4.
b) a price floor of $7.
What quantity of chairs would be sold at these prices?
Explain why these quantities either would or would not be efficient.
Solution:
a) At a price of $4, the quantity of chairs sold will be three units. It is not efficient
3. There is equilibrium in the purely competitive market for oranges, and the optimal
amount of oranges is being produced. Explain if and how the optimal amount of oranges
will change if the following events occur:
a) New fertilizers increase the yields of orange trees.
b) Frost destroys part of the orange crop.
c) Frost destroys part of the grapefruit crop. The resulting increase in the price of
grapefruits raises the demand for oranges.
d) People get tired of oranges.
Solution:
a) Supply curve of oranges will shift outward so the equilibrium quantity of output will
4. When the events in Problem 3 occur, how does the market system signal that something
has changed, and how does it provide incentives for people to behave in constructive
ways?
Solution: The market system signals players in the market by making changes in the
4 3
3 2
2 1
Chapter 14/The Case for Free Markets: The Price System
5. Draw a supply and demand diagram where the supply curve is perfectly inelastic.
Describe the consumers’ surplus and the producers’ surplus. Do the same thing for the
situation where the demand curve is perfectly inelastic.
Solution:
DISCUSSION QUESTIONS
1. Some people argue that the poor should be given money; others say that the poor should
be given vouchers to provide for necessities, such as food, shelter, and clothing.
Presuming that both methods cost the taxpayers the same, which do you think would be
better, from the point of view of poor people and from the point of view of society as a
whole?
Suggested Answer: Student answers may vary. In-kind transfers may assure that the poor
get what they need most. Alcohol and drug addiction is more prevalent among the poor.
2. Why do you think the leaders of communist countries have historically distrusted the free
market as a means for solving the problems of economic coordination?
Suggested Answer: Communists believed that free markets allowed wealth to be
distributed unequally. Those who are lucky, talented, or shrewd often end up with more of
3. Why do you think many formerly communist and Soviet bloc countries moved toward
the market?
Suggested Answer: Central planning is just too difficult in a complex, modern economy.
Chapter 14/The Case for Free Markets: The Price System
4. What sorts of economic problems do you think the market is not good at solving?
Suggested Answer: The market system is weak at solving many problems of the economy