Lesson 3: Open Markets

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Key Terms

Demand Supply Market Clearing Price
Competition Substitutes Price Ceilings
Property Rights Equilibrium Price Market Power

National Content Standards Addressed

Standard 7: Markets

Markets exist when buyers and sellers interact. This interaction determines market prices and thereby allocates scare goods and services.

  • Market prices are determined through the buying and selling decisions made by buyers and sellers.
  • Relative price refers to the price of one good or service compared to the prices of other goods and services. Relative prices are the basic measures of the relative scarcity of products when prices are set by market forces (supply and demand).
  • The market clearing or equilibrium price for a good or service is the one price at which quantity supplied equals quantity demanded.
  • If a price is above the market clearing price, it will fall, causing sellers to produce less and buyers to purchase more; if it is below the market clearing price, it will rise, causing sellers to produce more and buyers to buy less.

Standard 8: The Price System

Prices send signals and provide incentives to buyers and sellers. When supply or demand changes, market prices adjust, affecting incentives.

  • Higher prices for a good or service provide incentives for buyers to purchase less of that good or service and for producers to make or sell more of it. Lower prices for goods or services provide incentives for buyers to purchase more of that good or service and for producers to make or sell less of it.
  • An increase in the price of a good or service encourages people to look for substitutes, causing the quantity demanded to decrease, and vice versa. This relationship between price and quantity demanded, known as the law of demand, exists as long as other factors influencing demand do not change.
  • An increase in the price of a good or service enables producers to cover higher per-unit costs and earn profits, causing the quantity supplied to increase, and vice versa. This relationship between price and quantity supplied is normally true as long as other factors influencing costs of production and supply do not change.
  • Demand for a product changes when there is a change in consumers’ incomes or preferences, or in the prices of related goods or services, or in the number of consumers in a market.
  • Supply of a product changes when there are changes in the prices of the productive resources used to make the good or service, the technology used to make the good or service, the profit opportunities available to producers by selling other goods or services, or the number of sellers in the market.
  • Changes in supply or demand cause relative prices to change; in turn, buyers and sellers adjust their purchase and sales decisions.

Standard 9: Role of Competition

Competition among sellers lowers costs and prices, and encourages producers to produce more of what consumers are willing and able to buy. Competition among buyers increases prices and allocates goods and services to those people who are willing and able to pay the most for them.

  • Competition among sellers results in lower costs and prices, higher product quality, and better customer service.
  • The level of competition in a market is influenced by the number of buyers and sellers.
  • The level of competition in an industry is affected by the ease with which new producers can enter the industry and by consumers’ information about the availability, price, and quantity of substitute goods and services.
  • Collusion among buyers or sellers reduces the level of competition in a market. Collusion is more difficult in markets with large numbers of buyers and sellers.
  • The introduction of new products and production methods by entrepreneurs is an important form of competition, and is a source of technological progress and economic growth.

Key Ideas

1.Review:

  • Institutions are the formal and informal rules of the game that shape incentives and outline expected and acceptable forms of behavior in social interaction.
  • Incentives are the rewards and punishments that shape people’s choices.

ERP-3: People respond to incentives in predictable ways.
Choices are influenced by incentives, the rewards that encourage and the punishments that discourage actions. When incentives change, behavior changes in predictable ways.

ERP-4: Institutions are the “rules of the game” that influence choices.
Laws, customs, moral principles, superstitions, and cultural values influence people’s choices. These basic institutions controlling behavior set out and establish the incentive structure and the basic design of the economic system.

2. Open markets are a key institution for fostering economic growth and improving standards of living.

  • Price allocation (rationing) in markets creates incentives that address the problem of scarcity better than other forms of rationing.
    • Prices communicate, at extremely low cost, the information about the opportunity costs of exchange which buyers and sellers need to make decisions in the market.
    • In open markets, prices allocate goods and services without buyers and sellers needing additional knowledge about one another.
  • The entry and exit of competitors in open markets helps to direct resources to their most highly-valued uses.
    • Prices provide the information and incentives that move competitors into and out of markets.

3. Competition regulates market activity with profits acting as a motivator for sellers.

  • Sellers compete with other sellers for profits and buyers compete with other buyers for goods in markets.
  • Buyers and sellers do not compete with each other. Their interactions are largely cooperative.

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.