How the Market System Works

The market system works by producing what consumers want for the least cost. These wants are communicated by the prices that consumers are willing to pay for products and services. The essential feature of the market system is that people must have freedom: freedom for consumers to buy what they want, and freedom for producers to produce what consumers desire.

What Will Be Produced?

Products and services are provided by businesses to earn a profit, so a business must sell its product for more than its production cost, including compensation to the entrepreneur who started the business, which, in economic terms, is called a normal profit.

Normal Profit = Compensation to Entrepreneur

Pure profit, or economic profit, = the total revenue of the business minus the total economic costs, including normal profit.

Economic Profit = Total Revenue − Total Economic Costs

Economic costs include the wages paid to employees, rent or payments for the land or facilities and other factors of production, interest on loans, and other expenses of doing business. Normal profit is simply the compensation to the entrepreneur for the opportunity cost of his labor, much as wages are compensation to employees. Economic profit is the profit earned over and above normal profit. Of course, entrepreneurs simply look at all profit as the same thing, as business profit.

The distinction between normal and economic profit seems arbitrary, but it is important. If a business yields only normal profits, then there is little temptation for other businesses to enter the market; likewise, there is little temptation for the businesses already in the market to leave, since they are at least earning a normal profit. However, if economic profits are high, then more businesses will enter the market to earn these high profits, thus expanding the industry. But the increasing competition will decrease economic profits until the businesses are earning only a normal profit — at this point, the industry stops expanding. On the other hand, if there are no economic profits and even normal profits are lower or nonexistent, then businesses will leave the industry to find more profitable markets, leaving only the most efficient producers to serve the smaller market.

Entrepreneurs seek to earn the highest profits by producing those goods or services yielding the highest revenue over the cost of their production, by producing what society wants most and for which there is little competition. Consumer sovereignty drives demand and the allocation of resources, since it is the consumer who ultimately determines what products or services are provided, which, in turn, determines how scarce economic resources are allocated.

Market demand can be classified as being either a consumer or a derived demand. A consumer demand is the demand for a product or service by the consumer. A derived demand is the demand by the businesses for the inputs to produce that product or service. So, for instance, people demand cars which causes automobile manufacturers to demand steel, glass, and the other necessary components to manufacture an automobile. This, in turn, causes the steel and glass manufacturers to demand the land, machinery, and other necessary inputs to produce their product, and so on. Thus, demand for scarce resources, such as land, capital, and labor is a derived demand and depends on overall consumer demand. This partially explains economic cycles: as the economy expands, derived demand increases, which increases income for all involved, who then go out and spend it, stimulating the economy even further. Eventually the economy reaches a peak, and starts contracting. Incomes decline, then demand declines, further contracting the economy, until it reaches a minimum.

Competition Minimizes Economic Costs

Businesses must not only compete for customers, but they must also compete for economic resources. To win both competitions, businesses must produce their product for minimal cost. This maximizes their profit and allows them to compete for economic resources to produce their product.

Technology is a major factor in reducing costs. For most businesses, land and labor do not vary nearly as much as technology, so the most cost-efficient producers are the ones that can use technology best. Technology not only allows the cheapest production, but it even determines what can be produced, or what can be produced profitably.

Prices Determine the Distribution of Goods and Services

Goods and services are distributed according to how much consumers are willing to pay. Those willing to pay the market rate can get the product, but not those who cannot or will not. Hence, what consumers will buy depends on what they desire, how much they desire it, and on their income. Obviously, the higher their income, the more they can buy.

Changing Demand is Communicated Through Changing Prices

When consumer demand changes, the prices consumers are willing to pay changes. In other words, the demand curve shifts. When demand declines for a product, suppliers must lower their prices to sell the same output. This will decrease profits, maybe even eliminate them, causing businesses to leave the industry to seek better opportunities, causing a shift in the supply curve, which will increase profits, since the remaining suppliers can charge a higher price by selling to the fewer people willing to pay the price.

An increase in demand has the opposite effect: higher prices will increase economic profits, drawing more businesses into the industry, shifting the supply curve enough to reduce the market equilibrium price, where suppliers will earn a normal profit.

Changing consumer demand also changes derived demand. Decreasing consumer demand will decrease derived demand for inputs necessary to produce the product. These changes in derived demand will percolate through the economy to ultimately reduce the prices that these producers are willing to pay for the factors of production, such as land or labor, which will decrease the quantity of these factors of production used to produce the less demanded product. This will cause these resources to be allocated to other more profitable uses. Increases in product demand has the opposite effect.