Economics Online Tutor

Free Market Pricing

(Basic Economics Explained on One Page
in Everyday Language)
Everything has a cost.  There simply is not enough of everything to satisfy all of the wants and needs
that exist in the world.  In other words, the world does not contain an endless supply of everything.  
Consumers must choose among all of their available options in order to decide what to spend their
limited budgets on.  Producers (businesses) must consider what consumers want and the costs of their
resources to determine what, and how much, to produce.

The next three (short) paragraphs include the basic theory of free markets.  If you only read that far, you
will come away with a basic understanding of the theory of the free market system (capitalism).  If you
read through to the end, you will come away with a basic understanding of some of the differences
between capitalism and socialism, and between the theory and real-world applications of capitalism.
Consumers will tend to purchase more of something if the cost of that something decreases relative to
their other options.  Producers will tend to produce more of something if they can receive a higher price
for selling, within the framework of their cost structure.  Consumers will use their budgets in such a way
as to get as much satisfaction as possible; producers will determine what to sell in such a way as to
maximize their profits.

Since consumers want to pay the smallest price possible, and producers want to sell for the highest price
possible, the amount that actually gets traded would be the quantity where the price that consumers are
willing and able to pay matches the price that produces are willing and able to sell for.  This is the basic
concept of the free market system: demand equals supply.

The beauty of this system is in its efficiency.  Everything is done voluntarily.  Each party to each
transaction is entering into it voluntarily.  Whoever decides to opt out does so voluntarily.  If the price is
too high for a particular consumer, that consumer will simply choose not to participate in that particular
market, and use the budget for something else.  If the price is too low, then it won't get produced.  Only
when the demand and supply are equal will the resources used in that market be used efficiently.
The major drawback for a socialist system is that resources will not be used efficiently, resulting in an
inefficient amount of goods and services being produced.  Efficient markets require that all costs be
factored into the voluntary decisions to buy and sell.  But by definition, a socialist system includes costs
that cannot be accurately calculated.  By definition, a socialist system is one in which the government
owns some or all of the factors of production.  For example, the land where the production takes place,
including the natural resources on the land; the equipment, machinery, and raw materials that have been
previously produced but are used in the production process; the labor of the employees.  All of these
have costs because there are many options for their use - determining whether they are getting put to
use most efficiently requires knowing what their costs are.  In a market (capitalist) economy, each of these
resources has its own market to determine their efficient price.  In a socialist economy, some or all of
these resources will not have a market to determine their efficient price.  Instead, the government sets
the price of provides the resources for "free".  For the overall economy to optimize its growth potential,
for maximizing the standard of living for the population, efficient production and pricing is necessary.  
That is why you will tend to see that economic systems that are mostly capitalistic tend to have higher
long-term economic growth, with more consumer choices and higher standards of living, than mostly
socialistic economic systems.
Perhaps you already understand all of this.  Perhaps that means that you know more about economics
than you thought you did.  This truth is somewhat paradoxical, however.  The above explanation makes
sense, but what it doesn't say is that it is all based on certain assumptions.  Often, people who take
economics classes forget about the underlying assumptions and end up drawing the wrong conclusions.  
An explanation of the details of why this is true is beyond the purpose of this writing, but purely free
markets do not exist in the real world.  Economists use assumptions in order to isolate specific
relationships to study, but when those relationships are applied to the real world, the isolating
assumptions have to be lifted.  That is where the complexity of the study of economics comes into play:
knowing what the assumptions are, what makes them unrealistic, and understanding the different
relationships that are changed because the assumptions are not realistic.  The study of economics
involves many different concepts.  Understanding the basics of each of these would be required in order
to have a full understanding of how different economic activities are inter-related.
Here is a tip that might help you to decide if your conclusions regarding economic
issues and economic policy are based on the real-world application of economic
principles or are instead based on unrealistic assumptions: Can you explain both why
and how a particular policy or economic relationship fits into your personal
conclusions?  Have you thought through the process of how things work, everybody
who would be affected, what the likely outcomes would be?  If so, you are on the right
track.  But if the reasoning behind your position is along the lines of "that's how the
system works" or "this is the best solution because economic theory says so, and
therefore I won't consider any alternatives", without having anything more
substantive to back up your position, then you are likely basing your arguments on
unrealistic assumptions.
Free markets may not exist in their purest form, but there are varying degrees of them.  Generalizations,
then, can be made based on concepts like "mostly free" or "mostly not free" markets.  That means that
the concept of free markets can be discussed in real-world terms.  "Market failure" is a broad term used
to describe situations where the free market system creates drawbacks, in fact it creates inefficiencies
instead of efficient markets.  Often, market failure results from free markets not being "purely" free
markets after the assumptions are lifted.  Purely free markets require every party to every transaction to
have the exact same information at their disposal for making decisions, as long as the information is
relevant to that decision.  Purely free markets require all of the factor markets (labor, land, capital) also to
be purely free.  These requirements, and more, do not hold true in the real world; the real world contains
no purely free markets.  It is also beyond the scope of this writing to go into details about this topic; if you
want to learn more, you can get a primer from this page:

Market Failure - Economics Online Tutor

I would like to briefly mention a couple of specific areas where free markets often are not allowed to exist
in today's world.  Both of these topics are controversial.  I won't go into all of the controversy, but I do
want to mention that both valid and invalid arguments have been publicly presented to argue for or
against specific aspects of these areas.  The more you understand about economics, the more you will be
able to use valid arguments to support your personal positions on controversial issues.  At the same
time, the more you understand about economics, the more you will realize that the "other side" of the
issues may also have valid points to make.
The first area is the minimum wage.  A minimum wage is a kind of price control, taking the price away from
being totally set by a free market.  There are two kinds of controversies involved with a minimum wage:
whether to have one at all; and if so, at what level to set it.  I won't go into those controversies (doing so
would involve a very lengthy discussion), but they involve real or perceived market failures.  I just want
to mention how minimum wages affect supply and demand in the market.  In this case, the market for
labor.  In the labor market, a free market will set the price (wage rate) at the level where the demand (the
number of workers that employers want to hire) is equal to the supply (the number of potential
employees, or people offering their labor services).  A minimum wage will set a floor price that the wage
rate can go to.  If the minimum wage is below the market wage, then the market will not be affected.  The
market wage will prevail.  But if the minimum wage is set above the market wage, then the market wage
will NOT prevail.  The price will be set above the market price.  Since a higher wage means a higher
amount of labor supplied and a lower amount of labor demanded, more potential workers will want jobs at
that wage rate.  But employers will want to hire fewer workers at that wage rate.  The result: more people
will want jobs than the amount of jobs available, resulting in unemployment.  You probably have heard
people say that the minimum wage hurts unskilled workers because it creates unemployment.  This is
what they are talking about.  However - be careful about making the wrong assumptions about this.  Part
of the unemployment is because employers will hire fewer workers than what a free market price would
produce.  The people who lose their jobs for this reason will be "hurt" by the minimum wage.  But the
other part of the unemployment doesn't hurt any workers: the part where more people want to work only
because the wages are higher.  They wouldn't have jobs even at the free market wage - they just get
reclassified to unemployed, where before they were classified as not in the labor force at all.  How much
any increase in the unemployment rate consists of people in the first group, and how much consists of
people in the second group depends on the various elasticities involved.  
Elasticity is an important
concept to understand if you want to learn about economics.

If you want to learn more about the relationship between the minimum wage and the unemployment rate,
you can find a "textbook" version on this page:

Effects of Minimum Wage Laws on Unemployment - Economics Online Tutor
The other area where free markets do not exist that I want to mention is the area of health care.  
Obviously, with high costs and politically-charged opinions dominating the news, this is a very
controversial issue, and I don't want to get into the controversy here.  I just want to relate it to free
market supply and demand, and why the free market does not always prevail (regardless of any personal
beliefs).  Remember that in a free market, the price is set at the amount produced where demand equals
supply.  This only works in a free market when people voluntarily take themselves out of the market
because of the price.  For health care, this would mean that people who cannot afford health care do not
get health care.  It means that the resulting supply of health care workers, and the amount and quality of
health care research will be based on price, not on any other consideration.  The other considerations to
take into account would be such things as life expectancy, healthy workers to keep the economy going,
reducing the number of disabled people in society, the idea of letting people die or suffer simply because
of their personal financial situation even if the technology and national wealth exist to prevent these
problems.  All of these concepts, and more, would not be taken into consideration if health care was left
entirely up to the free market system.  Just as importantly, all of these involve
externalities, where costs
and benefits to society can be easily identified, but not factored into any market price or quantity.
The study of economics is divided into two broad categories: microeconomics and macroeconomics.  
Microeconomics is the study of economics on an individual basis: the individual business, the individual
worker, the individual consumer - that sort of thing.  Macroeconomics is the study of the overall
economy: a nation's total output, unemployment, inflation, globalization, taxation, government spending,
monetary policy.  Both microeconomics and macroeconomics require an understanding of
economic principles and supply & demand concepts.