Not Chaos but Economic Order

The market looks like a jumble of different sellers and buyers. It seems almost a miracle that food is produced in suitable amounts, gets transported to the right place, and arrives in a palatable form at the dinner table. But a close look at New York or other economies is convincing proof that a market system is neither chaos nor miracle. It is a system with its own internal logic. And it works.

A market economy is an elaborate mechanism for coordinating people, activities, and businesses through a system of prices and markets. It is a communication device for pooling the knowledge and actions of billions of diverse individuals. Without central intelligence or computation, it solves problems of production and distribution involving billions of unknown variables and relations, problems that are far beyond the reach of even today's fastest supercomputer. Nobody designed the market, yet it functions remarkable well. In a market economy, no single individual or organization is responsible for production, consumption, distribution, and pricing.

How do markets determine prices, wages, and outputs? Originally, a market was an actual place where buyers and sellers could engage in face-to-face bargaining. The marketplace—filled with slabs of butter, pyramids of cheese, layers of wet fish, and heaps of vegetables—used to be a familiar sight in many villages and towns, where farmers brought their goods to sell. In the United States today there are still important markets where many traders gather together to do business. For example, wheat and corn are traded at the Chicago Board of Trade, oil and platinum are traded at the New York Mercantile Exchange, and gems are traded at the Diamond District in New York City.

In a general sense, markets are places where buyers and sellers interact to set prices and exchange goods and services. There are markets for almost everything. You can buy artwork by old masters at auction houses in New York, or pollution permits at the Chicago Board of Trade, or legal drugs from delivery serivces in many large cities. A market may be centralized, like the stock market. It may be decentralized, as in the case of labor. Or it may exist only electronically, as is increasingly the case with "e-commerce" on the Internet.

A market is a mechanism through which buyers and sellers interact to set prices and exchange goods and services.

In a market system, everything has a price, which is the value of the good in terms of money (the role of money will be discussed in Section B of this chapter). Prices represent the terms on which people and firms voluntarily exchange different commodities. When I agree to buy a used Ford from a dealer for $4050, this agreement indicates that the Ford is worth at least $4050 to me and that the $4050 is worth at least as much as the Ford to the dealer. The used-car market has determined the price of a used Ford and, through voluntary trading, has allocated this good to the person for whom it has the highest value.

In addition, prices serve as signals to producers and consumers. If consumers want more of any good, the price will rise, sending a signal to producers that more supply is needed. When a terrible disease reduces beef production, the supply of beef decreases and raises the price of hamburgers. The higher price encourages farmers to increase their production of beef and, at the same time, encourages consumers to substitute other foods for hamburgers and beef products.

What is true of the markets for consumer goods is also true of markets for factors of production, such as land or labor. If more computer programmers are needed to run Internet businesses, the price of computer programmers (their hourly wage) will tend to rise. The rise in relative wages will attract workers into the growing occupation.

Prices coordinate the decisions of producers and consumers in a market. Higher prices tend to reduce consumer purchases and encourage production. Lower prices encourage consumption and discourage production. Prices are the balance wheel of the market mechanism.

Market Equilibrium. At every moment, some people are buying while others are selling; firms are inventing new products while governments are passing laws to regulate old ones; foreign companies are opening plants in America while American firms are selling their products abroad. Yet in the midst of all this turmoil, markets are constantly solving the what, how, and for whom. As they balance all the forces operat ing on the economy, markets are finding a market equilibrium of supply and demand.

A market equilibrium represents a balance among all the different buyers and sellers. Depending upon the price, households and firms all want to buy or sell different quantities. The market finds the equilibrium price that simultaneously meets the desires of buyers and sellers. Too high a price would mean a glut of goods with too much output; too low a price would produce long lines in stores and a deficiency of goods. Those prices for which buyers desire to buy exactly the quantity that sellers desire to sell yield an equilibrium of supply and demand.

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