The (Free) Market System

Different Economic Systems

• In order to solve the basic economic problem of scarcity, economic systems emerge or
are created by different economic agents within the economy

o These agents include consumers, producers, the government, & special

interest groups (e.g., environmental pressure groups or trade unions)
o Any economic system aims to allocate the scarce factors of production

• The three main economic systems are a (free) market system, mixed economy,
& planned economy

What Determines the Economic System Of A Country

How the three questions are answered determines the economic system of a country

Economic decisions need to be made to answer three important questions

1. What to produce? As resources are limited in supply, decisions carry an opportunity

cost. Which goods/services should be produced e.g. better rail services or more public
hospitals?
2. How to produce it? Would it be better for the economy to have labour-intensive
production so that more people are employed, or should goods/services be produced
using machinery?

3. For whom are the goods and services to be produced? Should goods/services only be
made available to those who can afford them, or should they be freely available to all?

How These Questions Are Answered Determines the Economic System

What to Produce? How to Produce? For Whom?

Type of System

Market System Demand & supply (the Most efficient, profitable Those who can afford
price mechanism) way possible. it

Mixed System Demand, supply & the Some efficiency but also Those who can afford
Government a focus on welfare/well- it, plus some provision
being to those who cannot
afford it

Planned System The Government Ensure everyone has a Everyone

job

How a Market System Works

• A market system works to allocate scarce resources efficiently, purely through the forces
of demand & supply (the price mechanism)
o There is no government intervention in a pure market system (no taxes or
government spending)
o In reality, there is no economy which is a pure market system

• In a market system, prices for goods/services are determined by the interaction of

demand & supply
o A market is any place that brings buyers & sellers together
o Markets can be physical (e.g., McDonald's) or virtual (e.g., eBay)

• The price mechanism is the interaction of demand and supply in a free market
 o This interaction determines prices which are the means by which scarce
resources are allocated between competing wants/needs

• The price mechanism fulfils several functions in an economy

o Prices allocate (ration) scarce resources. When resources become scarcer the
price will rise further. Only those who can afford to pay for them will receive
them. If there is a surplus then prices fall & more consumers can afford them
o Prices provide information to producers & consumers where resources are
required (in markets where prices increase) & where they are not (in markets
where prices fall)
o When prices for a good/service rise, it incentivises producers to reallocate
resources from a less profitable market to this market in order to maximise their
profits. Falling prices incentivise reallocation of resources to new markets

Market Equilibrium & Disequilibrium

• Equilibrium in a market occurs when demand = supply

• At this point the price is called the market clearing price

o This is the price at which sellers are clearing their stock at an acceptable rate

A graph showing a market in equilibrium with a market clearing price at P and

quantity at Q

• Any price above or below P creates disequilibrium in this market

o Disequilibrium occurs whenever there is excess demand or supply in a market
Demand, Price & Quantity

Introduction to Demand

• Demand is the amount of a good/service that a consumer is willing & able to

purchase at a given price in a given time period
o If a consumer is willing to purchase a good, but cannot afford to, it is not effective
demand

• A demand curve is a graphical representation of the price & quantity demanded

(QD) by consumers
o If data were plotted, it would be an actual curve. Economists, however, use
straight lines so as to make analysis easier

Individual & Market Demand

• Market demand is the combination of all the individual demand for a good/service
o It is calculated by adding up the individual demand at each price level

The Monthly Market Demand for Newspapers in A Small Village

Market
Customer 3 Customer 4
Customer 1 Customer 2 Demand
15 4 4 53
30

Individual & market demand can also be represented graphically

 Market demand for children's swimwear in July is the combination of boys & girls demand

Diagram Analysis

• A shop sells both boys & girls swimwear.

• In July, at a price of $10, the demand for boys’ swimwear is 500 units & girls is 400 units
• At a price of $10, the shops market demand during July is 900 units.

Movements Along a Demand Curve

• If price is the only factor that changes (ceteris paribus), there will be a change in the
quantity demanded (QD)
o This change is shown by a movement along the demand curve

A demand curve showing a contraction in quantity demanded (QD) as prices increase & an
extension in quantity demanded (QD) as prices decrease

Diagram Analysis

• An increase in price from £10 to £15 leads to a movement up the demand curve from
point A to B
o Due to the increase in price, the QD has fallen from 10 to 7 units
o This movement is called a contraction in QD
• A decrease in price from £10 to £5 leads to a movement down the demand curve from
point A to point C
o Due to the decrease in price, the QD has increased from 10 to 15 units
o This movement is called an extension in QD

• The law of demand captures this fundamental relationship between price and QD
o It states that there is an inverse relationship between price and QD
▪ When the price rises the QD falls
▪ When prices fall the QD rises
 2.4.1 Supply, Price & Quantity
Introduction to Supply

• Supply is the amount of a good/service that a producer is willing & able to supply
at a given price in a given time period

• A supply curve is a graphical representation of the price and quantity supplied by

producers
o If data were plotted, it would be an actual curve. Economists, however, use
straight lines so as to make analysis easier

• The supply curve is sloping upward as there is a positive relationship between the
price and quantity supplied
o Rational profit maximising producers would want to supply more as prices
increase in order to maximise their profits

Individual & Market Supply

• Market supply is the combination of all the individual supply for a good/service
o It is calculated by adding up the individual supply at each price level

The Monthly Market Supply of Bread From 4 Bakeries In A Small Town

Bakery 3 Bakery 4 Market Supply

Bakery 1 Bakery 2
600 180 320 1400 loaves
300

Individual & market supply can also be represented graphically

Market supply for smart phones in December is predominantly the combination of

iPhone & Samsung supply.
Diagram Analysis

• In New York City, the market supply for smart phones in December is predominantly the
combination of iPhone & Samsung supply
• At a price of $1000, the supply of iPhones is 300 units & the supply of Samsung
phones is 320 units
• At a price of $1,000, the market supply of smart phones in New York City during
December is 620 units

Movements Along a Supply Curve

• If price is the only factor that changes (ceteris paribus), there will be a change in
the quantity supplied (QS)
o This change is shown by a movement along the supply curve

A supply curve showing an extension in quantity supplied (QS) as prices increase & a
contraction in quantity supplied (QS) as prices decrease

Diagram Analysis

• An increase in price from £7 to £9 leads to a movement up the supply curve from point A to
B. Due to the increase in price, the quantity supplied has increased from 10 to 14 units.
This movement is called an extension in QS. A decrease in price from £7 to £4 leads to
a movement down the supply curve from point A to C. Due to the decrease in price, the
quantity supplied has decreased from 10 to 7 units. This movement is called
a contraction in QS