Every society has a system of institutions that determines what is produced, how it is produced, and who gets what produced. In some societies, these decisions are made centrally, through planning agencies or by government directive. In every society, however, many decisions are made in a decentralized way, through the operation of markets.
The Price System, Supply, Demand
The market system or price system performs two important and closely related functions:
- it distributes goods and services when the quantity demanded exceeds the quantity supplied (known as price rationing), and
- it determines the allocation of resources among producers, and hence the final mix of outputs.
There are several types of elastic demand:
- Perfectly inelastic, whose quantity demanded does not respond at all to changes in price
- Inelastic demand, whose quantity demanded responds somewhat to changes in price
- Elastic demand, for which the percentage change in quantity demanded is larger in absolute value than the percentage change in price
- Unitary elasticity of demand, for which the percentage change in the quantity of a product demanded is the same as the percentage change in price
- Perfectly elastic demand, for which a small increase in the price of a product causes the quantity demanded for that product to drop to zero
Household Behavior and Consumer Choice
Every household must make three basic decisions:
(1) how much of each product to demand;
(2) how much labor to supply; and
(3) how much to spend today and how much to save for the future.
Within the constraints of prices, income, and wealth, household decisions ultimately depend on preferences: likes, dislikes, and tastes.
Whether one item is preferable to another depends on how much utility, or satisfaction, it yields relative to its alternative. The law of diminishing utility states that the more of any good we consume in a given period of time, the less satisfaction, or utility we get out of each additional unit of that good.
In addition to deciding how to allocate its present income among goods and services, a household may also decide to save or borrow. A household is using current income to finance future spending when it decides to save part of its current income. A household finances current purchases with future income when it borrows.
General Equilibrium and Efficiency
A general equilibrium exists when all markets in an economy are in simultaneous equilibrium. An event that disturbs the equilibrium in one market may disturb the equilibrium in many other markets as well. Partial equilibrium analysis can be misleading, because it looks only at adjustments in one isolated market.
An efficient economy is one that produces the goods and services that people want at least possible cost. A change is said to be efficient if it improves some members of society without worsening others. An efficient (or Pareto optimal) system is one in which no such changes are possible.
Perfectly competitive firms will produce as long as the price of their product is greater than the marginal cost of production; therefore, they will continue to produce as long as a gain for society is possible. The market thus guarantees that the right things are produced. In other words, the perfectly competitive system produces what people want.
Market efficiency depends on the assumption that buyers have perfect information about product quality and price, and that firms have perfect information regarding input quality and price. Imperfect information can lead to wrong choices and inefficiency.
