Lesson 4: Markets in Action

Introduction

This lesson has two goals:

• The first is to expand students’ understanding of markets by discussing government-imposed frictions that affect the market-clearing price and quantity.
• The second is to involve students in analyzing examples of economic reasoning using problems and activities.

Through two optional mini activities and a 1 vs 100 Game Show, students practice applying the tools of supply and demand analysis real-world scenarios.

Objectives

At the end of this lesson students will be able to

• Explain how various policies and regulations impact market price and quantity.
• Use a supply and demand graph to illustrate the impact of various policies and regulations.

Economic Concepts

Demand	Supply	Market clearing price
Competition	Exchange	Price ceilings & floors
Property rights	Marginal analysis

Key Ideas

1. Review:

• In open markets, prices moving freely in response to changes in supply and demand allocate resources to their most highly valued uses.
• Market equilibrium, the condition where quantity supplied equals quantity demanded, emerges from the predictable responses of buyers and sellers to price incentives.

2. Institutions establish the rules of the game under which markets operate. Government(s) may create or affect institutional arrangements.

• Government actions that support the effective operation of open markets include such important activities as enforcing the rule of law and defining and protecting property rights.
• Government actions that reduce the openness of markets inhibit the ability of price incentives to allocate resources to their most highly-valued uses.
  • Examples of changes in the rules of the game that inhibit markets include restrictions on price levels or on the conditions of production, sale, and consumption.
  • Controls that prevent prices from rising to an equilibrium result in shortages
  • Controls that prevent prices from falling to an equilibrium result in surpluses.
  • Regulations, such as licensing, production regulations, and quality specifications reduce supply and increase prices.
• Government actions that are well-intentioned often produce unintended consequences such as “black markets” to allocate goods, or impacts on other markets that were not the target of the actions.

3. Understanding how prices act as incentives that influence people’s choices allows us to predict and explain the results of government actions that restrict the operation of markets.

• Price controls lead to shortages (price ceilings) and surpluses (price floors).
• Restrictions on competition, regulations, and subsidies reduce quantities sellers offer in the market and raise prices to buyers.

4. Economists conceptually organize the apparent chaos of markets by using the supply and demand model.

• Review:  Law of demand and law of supply introduced in Lesson 2.
• Demand – people’s willingness and ability to buy – is affected by such factors as tastes, incomes, and the price and availability of substitutes and complements.
• Supply – producers’ and sellers’ willingness and ability to offer products for sale – is affected by such factors as availability of resources and production cost; the number of sellers; and the prices of other products.
• Prices coordinate market activity by providing incentives to buyers and sellers to act so that both gain from trade.

5. Equilibrium (market clearing) prices emerge from the interactions of demanders and suppliers in markets and provide incentives that shape buyers’ and sellers’ future choices.

• If sellers offer more than buyers are willing to purchase at the current price, inventories accumulate and the market receives a signal that price is too high.
• If buyers cannot purchase all that they demand or cannot find certain goods at the current price, the market receives a signal that price is too low.
• The inventory and purchase signals move price in the direction of an equilibrium price, or market clearing price, where quantity demanded equals quantity supplied.

6. Markets function most effectively when prices move freely in response to changes in supply and demand.  Institutional support for markets, in the form of clearly defined property rights and the rule of law, facilitate the free movement of prices.

7. Market power results from successful efforts to reduce competition.

• (Option:  Re-run the “In the Chips” activity with limited seller competition.)
• Economic growth is restricted when competition is reduced in a market.

Ideas To Take Away From This Lesson

• Open markets benefit both buyers and sellers by providing a low cost mechanism in which they can trade with each other.
• Open markets encourage economic growth.
• Open entry and exit and competition between participants are necessary for markets to function effectively.
• Clearly defined property rights and a stable rule of law are necessary for markets to function at low cost to participants.