How a Market System Functions - Vocabulary Flashcards

Money and the Functions of Money

  • money: an asset that is socially and legally accepted as a medium of exchange
  • three functions of money:
    • medium of exchange
    • store of value
    • unit of measure

Demand and Supply: Core Concepts

  • Demand
    • definition: the relationship between the price of a good and the quantity that consumers are willing and able to purchase, all other factors fixed
  • Supply
    • definition: the relationship between the price of a good and the quantity that firms are willing and able to sell, all other factors fixed
  • Law of Demand
    • holding all else fixed, a greater quantity of a good will be demanded at lower prices
    • implication: demand curves are downward sloping
  • Law of Supply
    • holding all else fixed, a greater quantity of a good will be supplied at higher prices
    • implication: supply curves are upward sloping
  • Horizontal vs Vertical interpretations of the curves
    • Demand:
    • Horizontal interpretation: start with a given price, move horizontally to read the quantity demanded
    • Vertical interpretation: start with a given quantity demanded, move vertically to read the price
    • Supply:
    • Horizontal interpretation: start with a given price, move horizontally to read the quantity supplied
    • Vertical interpretation: start with a given quantity supplied, move vertically to read the price
  • Buyer’s reservation price
    • definition: the maximum amount of money a buyer is willing to pay for an item
  • Seller’s reservation price
    • definition: the minimum amount of money a seller is willing to accept for an item
  • Equilibrium (market equilibrium)
    • a stable state that persists unless outside factors change
    • at market equilibrium, no individual buyer or seller can alter behavior to increase their own surplus
  • Excess supply vs excess demand
    • excess supply: quantity supplied > quantity demanded; downward pressure on price
    • excess demand: quantity demanded > quantity supplied; upward pressure on price

Market Equilibrium: Stability, Uniqueness, and Self-Strengthening Forces

  • The Market Equilibrium in the model of Supply and Demand is:
    • stable: if at equilibrium, tends to stay there unless disrupted by outside forces
    • unique: there is one and only one equilibrium price-quantity pair (a consequence of Law of Demand and Law of Supply)
    • self-enforcing: if price is above equilibrium, downward pressure; if price is below equilibrium, upward pressure; movements push toward p* and q*
  • Shifts of Demand and Supply
    • Increase in Demand: rightward shift of the demand curve; at every price, quantity demanded increases
    • Decrease in Demand: leftward shift of the demand curve; at every price, quantity demanded decreases
    • Increase in Supply: rightward shift of the supply curve; at every price, quantity supplied increases
    • Decrease in Supply: leftward shift of the supply curve; at every price, quantity supplied decreases
  • Determinants of Demand (factors that change demand)
    • decreases in price of a complement good → increases demand
    • increases in the price of a substitute good → increases demand
    • increase in income (for a normal good) → increases demand
    • decrease in income (for an inferior good) → increases demand
    • increased consumer preference for the good
    • increase in market size
    • expectation of higher future prices
  • Determinants of Supply (factors that change supply)
    • decrease in the cost of factors of production → increases supply
    • improvement in technology that reduces production costs → increases supply
    • favorable realization of natural events → increases supply
    • increase in market size → increases supply
    • expectation of lower future prices → increases current supply (in some contexts)
  • Role of Profits in a Free Market Economy
    • profits: vital signaling device that directs resources to their most valuable use
    • entrepreneur: someone who organizes and manages a business, typically with initiative and exposure to risk
    • profits serve as signals insofar as entrepreneurs can recognize, appreciate, and respond to different profit levels

Spontaneous Order and I, Pencil

  • Spontaneous Order: the natural and undirected emergence of order from seeming chaos
  • Three surprising insights from “I, Pencil”
    • no single person possesses all the know-how to make a pencil
    • most who helped make the pencil did not intend to or necessarily care to specifically make a pencil
    • yet the entire process takes place and goods (like pencils) are produced without any single planner overseeing the process
  • Circular Flow of Economic Activity
    • Markets for factors of production (labor, land, capital, etc.) ↔ households (labor, capital, etc.)
    • Firms hire factors of production and pay wages and rents
    • Households provide factors of production and receive income (wages, rents)
    • Firms produce finished goods and services; households purchase them as consumer expenditures
    • The flow: Factors of Production -> Firms -> Finished Goods and Services -> Households -> Consumption

Market Equilibrium: Numerical Illustration from the Diagram

  • At price $50:
    • quantity supplied S(50) = 75
    • quantity demanded D(50) = 15
    • Result: excess supply (60 sellers unable to find buyers) → downward pressure on price; price above equilibrium is unstable
  • At price $20:
    • quantity demanded D(20) = 105
    • quantity supplied S(20) = 40
    • Result: excess demand (65 buyers unable to find sellers) → upward pressure on price; price below equilibrium is unstable
  • At price p* = 30:
    • D(30) = S(30) = 55
    • No excess demand or excess supply; stable outcome
    • Equilibrium price: $p^* = 30$, Equilibrium quantity: $q^* = 55$

Practice Problem: Peanut Market (2023 vs 2024)

  • Problem setup (based on the graph):
    • Determine whether the change is an increase or decrease in supply
    • Determine the most plausible explanation for the change in supply (among provided options)
    • Compare 2024 equilibrium price and quantity to 2023, assuming no change in demand
  • Answer summary (from the solution):
    • Change in supply illustrated: a leftward shift of the supply curve; this is a decrease in supply
    • Plausible explanation for the decrease in supply: an increase in the wage rate for unskilled labor in agriculture (factors of production cost rose)
    • With a decrease in supply and no change in demand, the 2024 equilibrium price rises and equilibrium quantity falls relative to 2023
  • Additional context from the solution:
    • A decrease in supply means the new supply curve lies to the left of the original
    • A decrease in supply typically causes higher equilibrium price and lower equilibrium quantity

Additional Multiple Choice Questions — Key Answers

  • 1. The principal functions of money include recognizing that money is a basic unit of measuring economic activity: answer is C
  • 2. Health-driven decrease in beef production: answer is D (decreased demand from private consumers for health concerns) [note: other explanations involve policies or activism but the provided key selects the demand-side explanation]
  • 3. Law of Demand implications: answer is D (the most accurate among provided options is that more than one statement is correct; however, conventional teaching notes identify A and B as true; C is not necessarily true in all cases)
  • 4. Excess supply in the oranges market implies equilibrium price must be: answer C (below the given price of $2.35)
  • 5. Brenda’s casino winnings used to purchase a TV illustrates money serving as a: medium of exchange; answer B
  • 6. I, Pencil author: Leonard Read; answer C
  • 7. In a free market, profits serve as signaling devices directing resources to valued uses: answer B
  • 8. Income increase leads to higher demand for a normal good: answer A
  • 9. Privately owned enterprises’ primary goal: earning as large a profit as possible; answer B
    1. The concept referring to the natural and undirected emergence of order from chaos: Spontaneous Order; answer C
    1. The height of the demand curve at a given quantity illustrates buyers’ reservation price for that unit: answer B

Equations and Notation to Remember

  • Equilibrium condition:
    • qD(p^) = qS(p^)
  • Equilibrium values (example):
    • p^* = 30,\ q^* = 55
  • Demand and supply shifts (conceptual notation)
    • Increase in Demand: shift of the demand curve to the right: D
      ightarrow D' ext{ (rightward shift)}
    • Decrease in Demand: shift to the left: D
      ightarrow D'' ext{ (leftward shift)}
    • Increase in Supply: shift to the right: S
      ightarrow S' ext{ (rightward shift)}
    • Decrease in Supply: shift to the left: S
      ightarrow S'' ext{ (leftward shift)}

Connections and Relevance

  • Foundational principles: demand, supply, and equilibrium underlie how markets allocate resources efficiently in the absence of externalities, information asymmetries, or policy interventions
  • Real-world relevance: shifts in supply/demand explain price changes due to weather, technology, income, market size, or wage changes; the I, Pencil example illustrates the complexity of coordinating production without central planning
  • Ethical and practical implications: market signals (profits) guide resource allocation, but disparities in information or market power can distort outcomes; spontaneous order demonstrates potential for cooperation without planning, while requiring absence of coercion and well-defined property rights

Quick Reference: Key Terms to Memorize

  • Money: a socially and legally accepted medium of exchange
  • Functions of money: ext{medium of exchange}, ext{store of value}, ext{unit of measure}
  • Demand, Supply: relationships between price and quantity demanded/supplied, holding other factors fixed
  • Equilibrium: stable, unique, and self-enforcing condition where qD(p^) = qS(p^)
  • Excess supply: qS > qD; excess demand: qD > qS
  • Reservation prices: buyers' maximum willingness to pay; sellers' minimum willingness to accept
  • Spontaneous Order: order arising without central planning