Romanian Economics - What Makes Markets Tick

Economics is a subject notoriously difficult to define clearly for outsiders: a formal definition might be that it is a social science that deals with the production, consumption and distribution of goods and services; in simpler terms it deals with how people produce and work, in order to survive in this world. Mainstream economics covers things such as how prices are determined in the market; how best to organise the economy for efficiency and growth, and what sort of things can prevent a perfect solution; how wages are determined; what causes undesirable events like inflation and unemployment and what can be done about it; and how and why countries interact through foreign trade and foreign investment.

Sciences attempt to be value-free and objective; economics is no exception, and for this reason words like “ought” or “should” tend to be avoided, as they are normative and the discipline sticks to facts which are positive. It has to be confessed that it is harder to be completely objective in the social sciences, dealing as they do with human beings and their behaviour, than in the natural sciences, which are concerned with the inanimate world and non-human life forms. In life we constantly make choices and each time we decide to do something, let us call it “X”, then we choose not to do something else, we can call “Y”. Economists refer to this as the opportunity cost, i.e., what is given up to get what is actually chosen. It is most clearly seen when constructing a budget and deciding how to allocate money between competing uses, but it applies everywhere. It lies behind all cost calculations and cost curve diagrams: the cost is the price that has to be paid for person A to get to use the stuff (iron ore, the service of a worker, a delivery truck ) rather than let someone else (B) use it. The study of the economy is traditionally divided into two sections, microeconomics, which looks at bit of the economy (think of looking down a microscope at something small), especially prices, what firms decide to do about price and output decisions, and wage determination. Then there is macroeconomics, which looks at the entire economy and as such is concerned with the size of total output, the level of inflation, the amount of unemployment, and also foreign trade. We will look at these in turn.

The determination of prices in the market and the system known as the price mechanism Students used to be taught to chant in unison “prices are determined by demand and supply” and no doubt some still are. If we take an object (again we shall call it X) if no one wants it at all, then it has no price – there simply is no demand. Probably a wrecked and burnt out car would fit this description. If some people want X then it will have a price, as whoever owns X can sell it and use the proceeds for some purpose or other. Will the price be high or low? It all depends on supply and demand. Think of an auction: if there are four old pianos for sale and 12 people really want to buy one, the price will be bid up and up, and therefore be high. Supplyand demand! But if there are 20 pianos for sale and again 12 people want a piano, the price of each will be low.

That is the way that prices are roughly determined in the world. We use diagrams to show and analyse this. An increase in demand occurs if at the auction next week, say, 18 people turn up wanting a piano and there are still only 4 instruments to bid on. This increase in demand leads to an increase in the price of the pianos. Again comparing with the first week, a decrease in demand would occur if only 2 people turn up wanting a piano rather than 12, which would lead to a lower price than in the week before. A decrease in supply? Instead of four pianos, the number falls, say to one, and with an unchanged number trying to buy one, the price will increase. Correspondingly, an increase in supply (with unchanged demand) causes a fall in price.

These simple examples illustrate the working of supply and demand, which operates outside auction rooms as well as inside them. Notice that the process of the analysis is to start in equilibrium then alter just one element, holding all the other features unchanged. In economics we mostly do this and then look at the result. This is called comparative statics: “comparative” because we compare two equilibrium states; and “static” because everything works through to equilibrium where things cease to change. Dynamic analysis is different as things keep altering over time. A course in elementary economics does not get this far. There is one objection to the theory of price setting which on the surface seems valid, but is in fact false. Some object that firms set prices and that is all there is to it – the theory of price is just wrong. However, if we think about it, if a firm sets it too high it will wind up with unsold stock, which is costly to store, but if it sets it too low the firm will run out quickly. Either way the firm could do better: it is not profit maximising. If firms want to do as well as they can, they have to set a price that just clears the market, i.e. they sell it all but only just.

So it’s back to supply and demand! What if they do not profit maximise? Competition will eventually force them out of business. It is no accident that most economists have an inbuilt urge to promote competition wherever possible. Only those economists paid by organisations trying to cling on to a monopoly position tend to be against it. Are they bad economists? No, just like lawyers, they are paid to promote the interests of their client but they do not have to believe it implicitly. We will not even think about political spin-doctors.

What about the operation of the price mechanism (market mechanism)? When a firm believes that it can make a profit by producing something, X, which perhaps has a relatively high price the firm moves in and does so. This increases the supply of X and drives the price down. As different firms in different industries constantly chase profits in this way, resources (land, labor and capital) keep being reallocated from what they are producing to doing something else, as someone hopes that will make more profit. In this way, the price mechanism allocates resources to where they are most needed and high prices (indicating that people want to buy X), along with potentially high profits, act as signals to producers.