Boundless EconomicsThe Market System
Introducing the Market System
Defining a Market SystemA market system is a way to match buyers and sellers.
Learning ObjectivesIdentify the characteristics of a market system
Key TakeawaysKey PointsPublishing current prices is a key component with a market system.Competition is the primary regulatory mechanism in a market system.Economists recognize a number of different structures of market systems basedon characteristics such as the level of competition.
Key Termsprice: The quantity of payment or compensation given by one party to anotherin return for goods or services.
In an economy, a market system is any systematic process that enables manymarket players to bid and ask. In other words, a market system is a place (virtualor physical) that facilitates the matching of buyers and sellers. Many marketsexist, and each can be defined based on a number of characteristics, such aswhat is being exchanged in the market, the regulations, who is allowed toparticipate, and how transactions occur.
One defining component of markets is the medium of exchange, or the price. Inmost American markets, the medium of exchange is dollars. Both buyers andsellers look at the price to determine whether or not they want to trade. A sellerhas a certain minimum price at which s/he is willing to sell, though s/he wouldhappily accept more. Likewise, a buyer has a certain maximum price at whichs/he is willing to buy, though s/he would happily pay less. If the minimum theseller would accept is less than the maximum a buyer would pay, a transactioncan occur. Markets help such buyers and sellers meet to trade.
In market systems, prices are discoverable; both buyers and sellers are capableof finding out the current price at which a transaction could occur. Publishingcurrent prices is a key component with a market system. The chosen pricesimpact the immediate group of buyers and sellers, but also may impact longterm supply and demand decisions within the market.
There are many examples of market systems. Perhaps the most famous is thestock market in which buyers and sellers trade stocks. The prices at which thosesales occur is recorded, and is the basis for the stock price you may have seen inthe newspaper or on TV. There are markets for many types of products otherthan stocks: the global oil market, your local farmers' market, and eBay are allforms of markets with their own defining characteristics.
NASDAQ Stock Market Display: The NASDAQ is a stock market wherebuyers and sellers of stocks can meet and trade.
Another important component of market systems is that there is competition,which serves as the main regulatory mechanism. Based on the level ofcompetition in a market system, economists have identified a number ofdifferent types of structures, such as monopoly, oligopoly, and perfectcompetition. We will go into more detail on different market structures later inthe book.
Gains from MarketsGains in a market are referred to as total welfare or economic surplus.
Learning ObjectivesExplain how to calculate total welfare
Key Takeaways
Key PointsWithin total welfare, economists look at consumer surplus and producer surplus.Consumer surplus is the monetary gain that consumers receive when theypurchase a good for less than the highest price they are willing to pay.Producer surplus is the amount that producers benefit by selling a good at amarket price that is higher than the least that they would be willing to sell it for.In order to calculate the total welfare, the supply and demand of the good mustbe used to determine the economic gain.When the supply of a good increases, the price falls which increases consumersurplus. When the demand for a good increases, the price increases and thesupply decreases resulting in producer surplus.
Key Termswelfare: Health, safety, happiness and prosperity; well-being in any respect.
Gains within a market are referred to as total welfare or economic surplus.Within total welfare, economists look at consumer surplus and producer surplus.A surplus is defined as the excess of a good or service when the quantitysupplied exceeds the quantity demanded; this occurs when the price is abovethe equilibrium price.
Consumersurplus
Producersurplus
Supply curve
Demandcurve
Equilibrium
Equilibrium quantity
Mar
ket p
rice
Price
Quantity
Economic Surpluses: The total welfare (or economic surplus)is the sum of the consumer surplus and the producer surplus.
Consumer surplus is the monetary gain that consumers receive when theypurchase a good for less than the highest price they are willing to pay. Forexample, a customer is willing to pay $50 for a new pair of running shoes. Theyare able to purchase the pair for $35 and consumer surplus is $15.
Producer surplus is the amount that producers benefit by selling a good at amarket price that is higher than the least that they would be willing to sell it for.An example would be a manufacturer that makes jeans. The lowest price theproducer is willing to sell a pair of jeans for is $40, but the jeans actually sell for$50. The producer surplus is $10.
In order to calculate the total welfare, the supply and demand of the good mustbe used to determine the economic gain. On a demand and supply curve graph,the consumer surplus is located under the demand curve and above ahorizontal line that shows the actual price of a good (equilibrium price).
When the supply of a good increases, the price falls which increases consumersurplus. When the demand for a good increases, the price increases and thesupply decreases resulting in producer surplus. When a good is in high demand,consumers are willing to pay more in order to obtain the good.
Production Possibility FrontierA production-possibility frontier (PPF) graphs the combinations for theproduction of two commodities with which the same amounts are used.
Learning ObjectivesExplain the benefits of trade and exchange using the production possibilitiesfrontier (PPF)
Key TakeawaysKey PointsA PPF graph shows the maximum production level for one commodity for anyproduction level of the other commodity.If a point on the graph is above the curve it indicates efficiency, while a pointbelow the curve signifies inefficiency.The PPF graph shows how resources must be shared among goods during theproduction process.Within an economy, if the capacity to produce both goods increases whichresults in economic growth.
Key Terms
commodity: Raw materials, agricultural and other primary products as objectsof large-scale trading in specialized exchanges.marginal: Of, relating to, or located at or near a margin or edge; also figurativeusages of location and margin (edge).
Within a market system, economists use the production possibility frontier (PPF)to graph the combinations of the amounts of two commodities that can beproduced using the same amount of each factor of production. A PPF graphchooses specific input quantities. As a result, it shows the maximum productionlevel for one commodity for any production level of the other commodity. PPF isused to define production efficiency.
Qua
ntity
of G
uns P
rodu
ced
Quantity of Butter Produced
D
A
C
B
- 50
- 5
+10 +10
A common PPF: A common PPF where there is anincrease in opportunity cost.Within a PPF graph, the use of a curve or line acts as a benchmark formeasuring efficiency. If a point on the graph is above the curve it indicatesefficiency, while a point below the curve signifies inefficiency. For furtheranalysis, additional information is always supplied with a PPF including theperiod of time taken for the observation, production technologies, and theamounts of inputs that were available.
Economists can use a PPF to illustrate a number of economic concepts includingscarcity, opportunity cost, productive efficiency, allocative efficiency, andeconomies of scale.
When an economy is operating on the PPF curve it is efficient. It is not possibleto produce more of one good without decreasing the amount produced for theother good. Likewise, if the economy is operating below the PPF curve, it isinefficient. In this case, the economy can reallocate resources and produce moreof both the goods.
The PPF graph shows how resources must be shared among goods during theproduction process. The points of the graph show the trade -off that takes placebetween two goods. For example, if more of Good A needs to be produced, theamount of resources in use by Good B must be reduced and transferred toGood A. The sacrifice in production of Good B is called opportunity cost. Whengraphing PPF there are three types: the common, the straight line, and theinverted PPF. All three of the PPF graphs are directly influenced by theopportunity cost.
Qua
ntity
of G
uns P
rodu
ced
Quantity of Butter Produced
D
A
C
B- 50
- 5
+10 +10
An inverted PPF: An inverted PPF where theopportunity cost is decreasing.
Qua
ntity
of G
uns P
rodu
ced
Quantity of Butter Produced
- 25
- 25
+10 +10
B
A
D
C
A straight line PPF: A straight line PPF where theopportunity cost is constant.
The slope of the PPF shows the rate at which the production of one good canbe transferred to another. The slope is called the marginal rate oftransformation (MRT).
Within an economy, if the capacity to produce both goods increases, the resultis economic growth. Factors that influence economic capacity includetechnology, an increase in the supply of factors of production, and productioninteractions such as trade and exchange. When any of these factors are used itallows for an increase in capacity so that the production of neither good has tobe sacrificed.
PPF graphs help economists study the current state of production as well aspossible production scenarios. The output of the economy is impacted by many
factors. When production can be graphed and monitored it allows adjustmentsto be made to work towards attaining economic growth and stability.
The Circular Flow ModelIn economics, a circular flow model is a diagram that is used to represent themonetary transactions in an economy.
Learning ObjectivesState the function of the circular flow diagram and the production possibilitiesfrontier
Key TakeawaysKey PointsThere are two flows present within the model including flows of physical things(goods or labor) and flows of money (what pays for physical things).The circular flow of income follows a specific pattern: Production → Income →Expenditure → Production.The production possibility frontier can be used to illustrate the circular flowmodel.Economists use data, statistics, and natural experiments in order to makeeconomic "laws" that explain general patterns.
Key Termsexpenditure: Act of expending or paying out.Factors of production: In economics, factors of production are inputs. Theymay also refer specifically to the primary factors, which are stocks includingland, labor, and capital goods applied to production.
In economics, a circular flow model is a diagram that is used to represent themonetary transactions in an economy. There are two flows present within the
model including flows of physical things (goods or labor) and flows of money(what pays for physical things). A circular flow model depicts the inner workingsof a market system and specific portions of the economy.
The basic circular flow model consists of two sectors that determine income,expenditure, and output. A state of equilibrium is reached when there is notendency for the levels of income (
), expenditure (
), and output (
) to change (
). This equation means that the expenditure of buyers (households) becomesincome for sellers ( firms ). The firms spend the income on factors of production,which "transfers" the income to the factor owners. The factor owners spend theincome on goods which leads to the circular flow of payments.
Y
E
O
Y = E = O
Circular flow of goods income: The circular flow model shows the flow ofpayments between households and firms.
The circular flow of payments is important within an economy because it 1)measures the national income, 2) provides knowledge of interdependence, 3)illustrates the unending nature of economic activities, and 4) shows injectionsand leakages.
The circular flow of income follows a specific pattern: Production → Income →Expenditure → Production. This circular flow is ongoing between householdsand firms.
The circular flow of income can also be analyzed using the productionpossibility frontier (PPF). The PPF is a graph that shows the various
combinations of amounts of two commodities that could be produced using thesame fixed total amount of each of the factors of production. The graph showsthe maximum possible production level of one commodity for any productionlevel of the other, based on the state of technology. The PPF defines productionefficiency. A point of the frontier line indicates the efficient use of availableinputs, while a point beneath the curve shows inefficiency. A PPF graphs showsopportunity cost, actual output, potential output, and economic growth.
Qua
ntity
of G
uns P
rodu
ced
Quantity of Butter Produced
D
A
B
X
C
Production Possibilities Frontier Curve: The graphillustrates a typical production possibilities frontiercurve. When a market is operating on the PPF it is saidto be efficient.
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