The Market System in Action

1. The Market System in Action Session 3 Professor Dermot McAleese

2. OUTLINE  The market system  The role of prices  Demand and supply  Taxes, subsidies and quantitative restrictions  The efficiency of the free market  Free market in the social context

3. COMPETITIVE MARKET Large number of sellers and buyers (free entry and exit) Full information Consumers maximise utility Firms maximise profit Flexible prices

4. THE MARKET SYSTEM FOREIGN SECTOR Product market Sell goods Buy goods HOUSEHOLDS Buy labour Sell labour Labour market FIRMS Invest in capital goods Borrow money Save money Capital market GOVERNMENT

5. MARKET ECONOMY TOTAL ECONOMIC ACTIVITY FORMAL ECONOMY SHADOW ECONOMY Non-marketed economic activity Non-marketed economic activity Marketed economic activity Marketed economic activity TOTAL MARKET ECONOMY

6. THE SHADOW ECONOMY  Measurement monetary aggregates method  income expenditure discrepancy  special investigations  Causes  high taxes and perceived lack of ‘fairness’  high burden of regulations  high unemployment combined with high unemployment compensation  onerous employment regulations  cultural and personal behavioural characteristics  Cureslower tax rates and ‘broaden’ tax base  improve regulation and legal restrictions  enhance monitoring and international co-operation

7. Table 1. Size of the shadow economy (% GDP) Source: F. Schneider, ‘The shadow economies of Western Europe’, Economic Affairs, September 1997.

8. China Illicit syphoning of funds from projects and companies has amounted to 13-16% of China’s GDP over the past decade Source: Asian Wall Street Journal, March 2001, citing research of Professor Hu Angang, Qinghua University

9. THE ROLE OF PRICES  Price is determined by DEMAND and SUPPLY  Price as incentive  Price as source of information  Market equilibrium (D=S)

10. THE ROLE OF PRICES Price S A B P1 PE E OPS D O Q QE H Quantity

11. SHIFTS IN DEMAND AND SUPPLY • Causes of shifts in demand •  level of income available to consumers •  price of substitute / complementary goods •  income distribution •  demographic structure •  tastes and fashion •  seasonal factors

12. SHIFTS IN DEMAND AND SUPPLY • Causes of shifts in supply •  technological innovation •  changes in prices (L, K, inputs) •  natural and man-made disasters •  strikes / government regulations •  organisation and management restructuring

13. “…..It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but their self-love…”Adam Smith Wealth of Nations, Book 1, Chapter II, p. 18

14. INCIDENCE OF TAX S1 Price F S R $2 PT E P V U Quantity QT Q

15. PRICE CEILING Price S E PE B A Ceiling D O R QE Quantity

16. Water is becoming an increasingly scarce resource. About 70% of water supplies in countries such as China and Morocco is consumed by farmers for irrigation at below-cost prices. • Explain the effect of the subsidy on the equilibrium level of water used. • Instead of such subsidisation, could any more efficient policy be used to protect the income of farmers? • Should farmers be charged the full economic cost for the water they use?

17. Do-it-yourself: Demand and Supply in Action E7The minimum price set by the European Commission for many foodstuffs and dairy products is set above the world equilibrium price. The objective of this price ‘floor’ is to support farm incomes. Use a supply and demand diagram to illustrate the effects of setting the minimum price on a) food prices in the EUb) farm incomes c) government spending and d) other countries.

18. Exercises E1. Draw a graph showing the demand curve and the supply curve of personal computers. How would the graph be affected by: a rise in the price of software a rise in the price of electric typewriters a fall in the price of desktop printers an expected increase in next year's PC prices a 10 per cent sales tax on computers a fall in income tax (p. 94)

19. THE EFFICIENCY OF THE MARKET SYSTEM Price per unit mu > mc Cost of production S R Marginal utility V P mu = mc PE E mu < mc W S Utility Marginal cost D O QE Q QT Output

20. ‘INVISIBLE HAND’ OF THE MARKET SYSTEM Seeking only to satisfy their individual wants and needs, consumersare led to do so in a way that puts least strain on society’ s resources for the level of satisfaction achieved Businesses, pursuing private profits, are led to produce goods and services which consumers want, at lowest cost Owners of capital and land, seeking only to increase their wealth, are led to deploy their assets in the most socially productive ways Employees, attempting to maximise their welfare, are led to select the training and careers which are most valuable to society Assumptions: prefect competition, full information and completeness

21. FIVE CONDITIONS FOR AN EFFECTIVE FREE MARKET SYSTEM Stable and reliable medium of exchange Transparent prices, competition and full information Private property and legal framework Minimum standards of truth, trust, acceptance and obligation Equitable distribution of income

22. QUESTIONS Demand for cigarettes is insensitive (inelastic) with respect to price, but demand for a particular type or brand of cigarette could be very elastic. Use demand and supply curves to analyse the following: To encourage better quality cigarettes the government will raise the tax rate on low quality brands while lowering the tax rate on more expensive cigarettes. This is aimed at strengthening the position of bigger producers such as Hongta Group, while pushing many smaller local manufacturers out of business. EIU China Country Report August 2001 Discuss what you would consider to be the main determinants of demand and supply of rented apartments. Suppose the government decides that rents are too high and sets a maximum rent. What would you expect the consequences of this action to be for (a) apartment owners, (b) existing renters and (c) future renters? The government gains revenue by imposing a sales tax. Who stands to lose the most, the consumer or the producer or both? 

23. Exercises E6. (a) Consider the economic consequences of a prohibition on the consumption of alcohol. What happens to the supply curve? What happens to the demand curve? How will the prohibition affect equilibrium consumption and price? What further indirect effects are likely to follow? (According to some writers, prohibition is likely to raise the level of violence by increasing the marginal benefits and lowering the marginal costs of breaking the law.) (b) Suppose the head of an anti-drugs enforcement agency reports, as evidence of the agency's success in deterring drug users, that the street price of drugs has fallen. Is this evidence conclusive? What other factors might have caused the fall in price?

24. Question for Class Use demand and supply analysis to illustrate the effects of China’s removal on restrictions on imports of automobiles. Import tariffs on automobiles will fall to 25% by mid 2006 from present level of 70-90%. What will be the effect on: • the price of imports in RMBs? • the dollar price of imports? • employment in import competing industries? • government tax revenues?