How Markets Solve the Three Economic Problems

We have just described how prices help balance consumption and production (or demand and supply) in an individual market. What happens when we put all the different markets together-beef, cars, land, labor, capital, and everything else? These markets work’simultaneously to.determine a general equilibrium of prices and production.

By matching sellers and buyers (supply and demand)in each market, a market economy simultaneously solves the three problems of what, how, and for whom. Here is an outline of a market equilibrium: 1. What goods and services will be produced is determined by the dollar votes of consumers-not every 2 or 4 year at the polls, but in their daily purchase decisions. The money that they pay into businesses’ cash registers ultimately provides the payrolls, rents, and dividends that consumers, as employees, receive as income.

Firms, in turn, are motivated by the desire to maximize profits. Profits are net revenues, or the difference between total sales and total costs. Firms abandon areas where they are losing prof.its; by the same token, firms are lured by high profits into production of goods in high demand.Some of the most profitable activities today are producing and marketing legal drugs drugs for depression, anxiety, impotence, and all other manner of human frailty. Lured by the high profits, companies are investing billions in research to come up with yet more new and improved chemicals.

2. How things are produced is determined by the competition among different producers. The best way for producers to meet price competition and maximize profits is to keep costs at a minimum by adopting the most efficient methods of production. Sometimes change is incremental and consists of.little more than tinkering with the machinery or adjusting the input mix to gain a cost advantage., which can he very important in a competitive market. At other times there are drastic shifts in technology, as with steam engines displacing horses because steam was cheaper per unit of useful work, or airplanes replacing railroads as the most efficient mode for long distance travel. Right now we are in the midst of . just such a transition to a radically different technology, with computers revolutionizing many tasks in the workplace, from the checkout counter to the drafting table.

3. For whom things are produced-a-who is consuming and how much-depends, in large part, on the supply and demand in he markets-for factors of production. Factor markets (i.e., markets for factors of production) determine wage rates, land rents, interest rates, and profits. Such prices are called factor prices. The same person may receive wages from ajob, dividends from stocks, interest on a bond, and rent from a piece of property. By-adding up all the revenues from factors, we can calculate the person’s market income. .The distribution of income among the population is thus determined by the quantity of factor services (person-hours, acres, etc.) and the prices of the factors (wage rates, land rents, etc.)

Be warned, however, that incomes reflect more than the rewards for sweaty labor or frugal living. High incomes can come from large inheritances, good luck, and skills highly prized in the marketplace. Those with low incomes are often pictured as lazy, but the truth is that low incomes are generally the result of poor education, discrimination, or living where jobs are few and wages are low. When we see someone on the unemployment line, we should rem-em-· her, “There, but for the grace of supply and demand,go I.

Monarchs of the Marketplace

Who rules a market economy? Do giant companies like Microsoft and AT&T call the tune? Or perhaps Congress and the president? Or the advertising moguls from Madison Avenue? All these entities can affect us, but the core determinants of the shape of our economy are the dual monarchs of tastes and technology. Innate and acquired tastes-as expressed in the dollar votes of consumer demands-direct the uses of society’s resources. They pick the point on the production-possibility frontier (PPF).

But consumers alone cannot dictate what goods will he produced. The available resources and technology place a fundamental constraint on their choices. The economy cannot go outside its PPF. You can fly to Hong Kong, but there are no flights to Mars. An economy’s resources, along with the available science and technology, limit the candidates for the dollar votes of consumers. Consumer demand has to dovetail with business supply of goods. So business cost and supply decisions, along with consumer demand, help determine what is produced.

You·will find it helpful to recall the dual monarchy when you wonder why some technologies fail in the marketplace. From the Stanley Steamer-a car that ran on steam-to the Premiere smokeless .cigarette, which was smokeless but also tasteless,
history is full of products that found no markets. How do useless products die off? Is there a government agency that pronounces upon the value of new products? No such agency is necessary. Rather, they become extinct because there is no consumer demand for the products at the going market price. These products earn losses rather than profits. This reminds us that profits serve as the rewards and penalties for businesses and guide the market mechanism.

Like a farmer using a carrot and a stick to coax a donkey forward, the market system devoutness profits and losses to induce firms to produce desired goods efficiently.

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