60 THE ECONOMIC SYSTEM

deploy effectively. But once you find it and exploit it, you win. (Stewart, 1997.
Reproduced by permission of Currency Publishers.)

From the perspective of encouraging an economy to be efficient it is a challenge to

ensure that all resources, including knowledge, are used in the best way possible.
As outlined in Chapter 1, economists generally believe that the free-market system
provides the most appropriate form of economic organization to encourage efficient
resource use. Each person or organization has the incentive to use their knowledge
to maximize their utility.
Adam Smith discussed the concept of the ‘invisible hand’ when he referred to
how the economic system performed as though it were guided towards getting
the most out of its resources in spite of the fact that individuals in the economic
system do not make their economic decisions with such a goal in mind. Within
the free-market system any ‘guiding’ activity is the result of how people and firms
react to the prices and the market opportunities they observe. Prices are the signals
that feed into economic decisions about what to buy and what to sell, how to use
resources, or whether to supply labour or not.
Hayek (1945) described how the price system operates in by allowing all rel-
evant information and knowledge to be incorporated into the functioning of
markets without the participants necessarily being fully aware of why changes occur,
but by reacting to them and taking any new information into account in their
decision making.

It is worth contemplating for a moment a very simple and commonplace

instance of the action of the price system to see what precisely it accomplishes
. . . [S]omewhere in the world a new opportunity for the use of some raw
material, say, tin has arisen . . . All that the users of tin need to know is
that some of the tin they used to consume is now more profitably employed
elsewhere and that, in consequence, they must economize tin . . . If only
some of them know directly of the new demand and switch resources over
to it, and if the people who are aware of the new gap thus created in
turn fill it from still other sources, the effect will rapidly spread throughout
the entire economic system. This influences not only all of the uses of tin
but also those of its substitutes and the substitutes of these substitutes, the
supply of all things made of tin, and their substitutes and so on. All this
takes place without the great majority of those instrumental in bringing
about these substitutions knowing anything at all about the original cause
of these changes. The whole acts as one market, not because any of its
members surveys the whole field, but because their limited individual fields
 M A R K E T A N A LY S I S : D E M A N D A N D S U P P LY 61

of vision sufficiently overlap so that through many intermediaries the relevant

information is communicated to all. The mere fact that there is one price
for any commodity – or rather that local prices are connected in a manner
determined by the cost of transport, etc. – brings about the solution which
(if conceptually possible) might have been arrived at by one single mind
possessing all the information which is in fact dispersed among all the people
involved in the process. (Hayek, 1945. Reproduced by permission of the
American Economic Association.)

Economic decision-making in free markets is decentralized across all the indi-

viduals dispersed in each market and is synchronized or coordinated by the
price system.
Decisions in command economies are not made on the basis of price signals
because the central planners decide what should be produced and in what quantities,
without reference to supply and demand. Central planners attempt to assemble as
much information as possible in making their decisions but given the dispersion of
knowledge throughout an economy; it would be impossible for central planners to
gather all relevant information for each economic decision that must be made. In
the case of specific knowledge, even when it is possible to transfer knowledge it is
often costly. Centralized decision-making creates problems for the effective use of
information and knowledge within an economy and so leads to a less efficient use
of resources than a free-market system.
Another principle that differentiates free markets from centrally planned eco-
nomic systems is the right to own private property. Private property rights are
often taken for granted by those of us in free markets. Since we have the rights
to personally own and use property – as opposed to a system of centrally owned
and operated property within a centrally planned economy – both individuals and
firms have the incentive to use their specific knowledge to maximize their utility.
Economists argue that, in general, when decision-makers do not own resources that
they may have control over, their incentive to make optimal use of the resources is
reduced. Bring this close to home by focusing on the incentive to take care of a TV
(or room) you rent rather than one you own!

2.7.1 DECENTRALIZED DECISION-MAKING – THE OPTIMAL FORM

OF ORGANIZATION?
Allowing economic decisions to be the outcome of market decisions rather than cen-
tral planning appears to be Hayek’s conclusion. Even the expressions ‘free-market
62 THE ECONOMIC SYSTEM

system’ or ‘market economy’ indicate the central role of markets in how many
economies are organized. However, it would be incorrect to argue that decentral-
ized decision-making is always the most efficient form of economic organization.
Look at how firms function by making many of their decisions centrally – by the
chief executive officer (CEO) or board of directors – with staff ‘lower down’ in the
hierarchy making few, if any, decisions.
Economic activity within the market system relies largely on firms for the markets
to function. In principle, it would be possible for economic decisions to be made
without the existence of firms – if I want a new wooden table I could contact a timber
supplier and organize a carpenter to assemble it. In practice, however, most tables
are manufactured by firms and sold on to consumers because some transactions
are more efficiently conducted by firms rather than in markets. Consumers save
time, effort and, therefore, money in buying from a firm rather than having
to deal with what may be a multitude of different suppliers of individual parts
and assemblers.
Searching out suppliers is more time-consuming the more complex the product
and such search costs represent just one element of what are called transac-
tions costs.

Transactions costs are the complete price plus non-price costs of a transaction,
including search, information, bargaining and policing costs.

Consumers incur information costs when they must find out about suppliers or
about the quality of different parts; they incur bargaining and decision costs when
they must haggle to negotiate the final price with the supplier and decide between
alternatives; policing and enforcement costs when the consumer must ensure that
the other party to the transaction is honouring the agreed terms of the transaction.
The most efficient way of organizing a transaction minimizes transactions costs.
Firms will make and supply goods and services and consumers will buy from them
when the transactions cost to the consumer is lower than using markets. Firms too
incur transactions costs in organizing their economic activities but exist when these
costs are lower than the costs of organizing in markets. Usually transactions costs in
firms increase as the firms grow and it becomes more difficult for the management
to keep track of all relevant knowledge for their decision-making. Hence, there is a
limit to the size of firms that is related to the cost of their transactions and this is
one explanation as to why firms do not grow indefinitely.
 M A R K E T A N A LY S I S : D E M A N D A N D S U P P LY 63

2.8 MORE ON EQUILIBRIUM IN THE

D E M A N D A N D S U P P LY M O D E L
The demand and supply model and the role of equilibrium within it outlined in this
chapter is the foundation of the economics discipline, allowing analyses of different
markets and assessment of the implications of changes across a range of factors on
market outcomes. The demand and supply model, however, does not provide any
answers. Rather, it provides a framework for economists who use the model as best
they can for making sense of what they observe. Despite its place at the centre of the
economist’s toolbox there is disagreement among economists as to the purpose of
equilibrium analysis, which is viewed alternatively by some as a description of reality
or by others as a theoretical construct.

• Equilibrium as a description of reality: According to this view, real markets

come sufficiently close to being approximated by the supply and demand
model – tending towards equilibrium – and in cases where an individual market
does not, the supply and demand model allows us to make better explanations
and predictions of that market than any alternative model available.
• Equilibrium as a theoretical construct: Holders of this view consider that the supply
and demand model can help us to understand things that might occur in
reality but it is through our observations of the economy that we figure out
what is going on in any particular market and why. Allowance is made for a
market that is in disequilibrium and this helps us to understand how markets
change over time as individuals (on demand or supply sides of the econ-
omy) learn from available information and incorporate it into their economic
decisions.

The definition of equilibrium as a state from which there is no tendency to

change does not describe markets all of the time as the quantities of goods
bought and sold change over time as does their price. Hence we need to
understand what equilibrium means, how it comes about, its implications for
sellers and buyers and causes and consequences of changes in factors that
feed into economic decision-making. Irrespective of your preference for one
description or other, the supply and demand model allows us to address these issues.
64 THE ECONOMIC SYSTEM

2.9 A M A R K E T AT W O R K : T H E L A B O U R
MARKET
The labour market can be analysed using the supply and demand framework
but in many respects it is a unique market and a number of different elements
require analysis in considering how it functions. As labour is one of the factors of
production, the labour market is also described as a factor market. Since labour is
an input into production, labour demand is a derived demand since it depends on
the demand for goods and services.
Firms demand labour taking into account, among other factors, the cost of the
labour, which in turn depends on the wage rate that must be paid. At higher wage
rates we expect firms to hire fewer workers than at lower rates. Labour supply
refers to people’s willingness to make some of their time available for paid work
and also depends on the wage rate. We expect more people to wish to supply
their labour if wage rates are high rather than relatively low. When we discuss
price in relation to the labour market we refer to the price of labour, which is
the wage rate. The wage rate in a labour market is determined similarly to any
equilibrium price, i.e. via supply and demand for labour, which are discussed in
more detail below.

2.9.1 LABOUR DEMAND

Labour demand is graphed like other demand curves with quantity (of labour) on
the horizontal axis and the price (wages) on the vertical axis, as in the example
in Figure 2.9. Firms in the industry shown wish to employ 60 000 workers if wages
are £10 per hour; at higher wage rates, firms would demand fewer workers because
costs rise as wages rise.

Price
£/hour
20 Labour
Demand
15

10
5
0 Quantity (000, workers)
0 30 60

FIGURE 2.9 INDUSTRY LABOUR DEMAND CURVE

 M A R K E T A N A LY S I S : D E M A N D A N D S U P P LY 65

The wage rate enters into the labour demand decision of firms but the firm must
also take into account the output that the workers they employ can produce for the
firm, and the revenue the firm can earn from that output. The firm must try to work
out how many workers it can profitably employ. This process involves consideration
of the output of each worker.

The following example is considered to figure out the number of workers

demanded by Safelock, a hypothetical company manufacturing steering locks
(anti-theft devices for steering wheels).

Given the available machinery and equipment in the steering lock factory, the firm
considers that output could be produced as shown in Table 2.3. In the second
column Table 2.3 shows the output that could be produced if the firm employed
between one and 10 workers. One worker could produce 25 locks per day, rising
to 55 if two workers were employed and so on. In the third column the marginal
physical product of Labour is computed.

The marginal physical product of labour is the change in the quantity of output
(
Q) produced by each additional worker (
L).

TA B L E 2 . 3 LABOUR OUTPUT
No. of workers Output (per day)∗ MPPL

1 25 25
2 55 30
3 82 27
4 102 20
5 116 14
6 124 8
7 130 6
8 132 2
9 130 −2
10 125 −5
∗
A working day is assumed to consist of 8 hours.
66 THE ECONOMIC SYSTEM

A B
Daily output MPPL
30
140 25
120 20
100 15
80 10
60 5
40 0
20 –5
0 –10
1 2 3 4 5 6 7 8 9 10 11 1 2 3 4 5 6 7 8 9 10 11
Workers Workers

F I G U R E 2 . 1 0 T O TA L O U T P U T A N D M A R G I N A L P H Y S I C A L
PRODUCT OF LABOUR

For example, the change in output generated by hiring the first worker is 25
(
Q/
L = 25/1) since when no workers are hired output is zero. In hiring the
second worker output increases from 25 to 55, a change of 30. The second worker
adds 30 steering locks extra to total output, the third adds 27 locks and so on.
When a second worker is hired the two can cooperate to divide up the work
between them and there are advantages of this division of labour that allows them
to produce more than double the output of the first worker (55 compared to 25).
Hiring the third worker changes the division of labour too but in this case the
additional output is 27 locks extra. This happens because of how the materials and
equipment are shared and used among the workers. The total output increases with
each worker up until worker 8 but when the next worker is hired, they do not add
any additional output. In fact output falls by half a unit – this is because given the
available equipment, there is nothing for this worker to do. Hiring the ninth worker
leads to a fall in output (from 132 to 130 locks) because the worker actually gets
in the way of others trying to do their job. The total output of the factory and the
marginal physical product of labour are shown in Figure 2.10.
Once any more than two workers are employed, the additions to total output
decline (from 30 to 27 to 20 to 14, etc.) by diminishing amounts. This is reflected
in the flattening slope of the total output curve in panel A of Figure 2.10 and in
the downward (negative) slope of the MPPL in panel B. This reveals the law of
diminishing marginal returns.

The law of diminishing marginal returns states that when a firm adds workers to
a given amount of capital – machinery, equipment, etc. – it eventually leads to a