Chapter 1 Outline
A. The Price System
1. In a command economy, government plans what and how to produce.
2. In a market economy, individuals plan.
3. In a market economy, consumórs attempt to maximize satisfaction and producers attempt to maximize profits.
a. Both consumers and producers are price takers.
b. Both consumers and producers base their plans on the prices of goods and services.
B. Information, Motivation, and Rationing in a Market Economy
1. The price system informs economic actors about underlying changes in theeconomy, motivates these actors to adjust to those changes, and provides incentives for economic actors to conserve and adjust production levels.
2. An increase in demand will have several effects upon the economy.
a. As demand increases, there will be an increase in price.
1. The increase in price tells consumers that the good is more costly,and consumers will ration consumption or reduce the quantity of the good they demand.
2. The increase in price will cause the profits of producers to go up, motivating them to produce a greater quantity of the good.
3. As producers increase production, price will begin to fall, motivating consumers to purchase greater quantities of the good.
3. The distinction between scarcity and excess demand is important.
a. Scarcity is an economic condition in which our wants exceed our ability to satisfy them.
b. Excess demand means that at the market price the amount consumers want to buy exceeds the amount that producers want to supply.
1. Excess demand will be eliminated as price adjusts to a new higherlevel and rations the good to those willing to pay the new, higher price
C. Information, Motivation, and Rationing in a Command Economy
1. In a command economy, the price system does not provide producers andconsumers with accurate and timely information about underlying changes in the market.
a. Because of both the political and monetary cost, price changes are infrequent in a command economy.
b. Since price changes are infrequent, there is no signal for producers and consumers to change their behavior, and excess supply and demand do not disappear.
c. Even if prices were allowed to change, this would probably not motivate producers to increase (decrease) the quantity supplied because they would not reap the profits (losses) associated with higher (lower) prices.
D. Information, Motivation and Rationing - Price Ceilings
1. A price ceiling is a law or regulation imposed by government that sets a maximum legal price for a good.
2. In the housing market, price ceilings are found in the form of rent controls.
3. Because these controls set price below the equilibrium market price, an excess demand for rental housing develops.
4. Rent controls can restrict mobility.
a. Because of the excess demand for rental units, individuals may fear that they will be unable to find other housing at the low rent and remain in their present unit, even if they would prefer a larger or smaller unit.
5. Rent controls can result in illegal activity.
a. Individuals may pay the tenant a price greater than the controlled price to sublet a unit.
b. The landlord may use under-the-counter payments in the form of key money, furniture rental, and security deposits to extract a higher price for the unit.
c. Because of the excess demand, landlords can reject potential renters on the basis of personal characteristics such as race, national origin, sex, religion, or family type without financial sacrifice.
6. The quality of rental units may fall.
a. Because the landlord is not earning a normal rate of return on the investment, there may be less maintenance and upkeep performed on the rental unit.
7. The excess demand caused by the imposition of rent control may become worse over time.
a. If the population grows over time, there will be an increase in demand, but (because the rent control allows no increase in profit) there will be no response in the form of an increase the quantity of housing supplied.
b. Landlords may convert rental units into condominiums and sell them to individuals who prefer to own rather than rent, thereby decreasing the supply of rental units.
E. Systems and Coordination
1. A market system provides goods to people based on their willingness to pay.
2. Command and market economies with price controls are less successful in coordinating demand and supply.
a. These two systems do not have the ability to automatically and inexpensively collect information about consumer preferences and production capabilities.
b. These two systems do not have the capability to automatically and inexpensively provide incentives and motivation for people to make wealth-promoting decisions.
3. A market system fosters the division of labor that is responsible for increasing the 'wealth of nations.'
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