U.S. Economy

product at lower prices than they do at higher prices. Sellers are just

the opposite. They hope to sell at high prices, and typically they will

be willing to produce and sell more units of a product at higher prices

than at lower prices.

The price for a product is determined in the market if prices are allowed

to rise and fall, and are not legally required to be above some minimum

price floor or below some maximum price ceiling. When a product, for

example, a personal computer, reaches the market, consumers learn what

producers want to charge for it and producers learn what consumers are

willing to pay. The interaction of producers and consumers quickly

establishes what the market price for the computer will actually be. Some

people who were considering buying a computer decide that the price is

higher than they are willing to pay. And some producers may determine

that consumers are not willing to pay a price high enough for them

profitably to produce and sell this computer.

But all of the buyers who are willing and able to pay the market price

get the computer, and all of the sellers willing and able to produce it

for this price find buyers. If more consumers want to buy a computer at a

specific market price than there are suppliers are willing to sell at

that price—or in other words, if the quantity demanded is greater than

the quantity supplied—the price for the computer increases. When

producers try to sell more of their computers at a price higher than

consumers are willing to buy, the quantity supplied exceeds the quantity

demanded and the price falls.

The price stops rising or falling at the price where the amount consumers

are willing and able to buy is just equal to the amount sellers are

willing and able to produce and sell. This is called the market clearing

price. Market clearing prices for many goods and services change

frequently, for reasons that will be discussed below. But some market

prices are stable for long periods of time, such as the prices of candy

bars and sodas sold in vending machines, and the prices of pizzas and

hamburgers. Most buyers of these products have come to know the general

price they will have to pay for these items. Sellers know what prices

they can charge, given what consumers will pay and considering the

competition they face from other sellers of identical, or very similar,

products.

A System of Markets for All Goods and Services

How markets determine price is simple enough to understand for a single

good or service in a single location. But consider what happens when

there are markets for nearly all of the goods and services produced and

consumed in an economy, across the entire country. In that context, this

reasonably simple process of setting market prices allows an economic

system as large and complex as the U.S. economy to operate with great

efficiency and a high degree of freedom for consumers and producers.

Efficiency here means producing what consumers want to buy, at prices

that are as low as they can be for producers to stay in business. And it

turns out this efficiency is directly linked to the freedom that buyers

and sellers have in a market economy. No central authority has to decide

how many shirts or cars or sandwiches to produce each day, or where to

produce them, or what price to charge for them. Instead, consumers spend

their money for the products that give them the most satisfaction, and

they try to find the best deal they can in terms of price, quality,

convenience, assurances that defective products will be replaced or

repaired, or other considerations.

What consumers are willing and able to buy tells producers what they

should produce, if they hope to make a profit. Usually consumers have

many options to choose from, because more than one producer offers the

same or reasonably similar products (such as two or more kinds of cars,

colas, and carpets). Producers then compete energetically for the dollars

that consumers spend.

Competition among producers determines the best ways to produce a good or

service. For example, in the early 1900s automobiles were made largely by

hand, one at a time. But once Henry Ford discovered how to lower the cost

of producing cars by using assembly lines, other car makers had to adopt

the same production methods or be driven out of business (as many were).

Competition also determines what features and quality standards go into

products. And competition holds down the costs of production because

producers know that consumers compare their prices to the prices charged

by other firms and for other products they might buy. In markets where a

large number of producers compete, inefficient producers will be driven

out of the market.

For example, at one time most towns and cities had independently owned

cafes and drive-in restaurants that sold hamburgers, french fries, and

soft drinks. Some of these businesses are still operating, but many

closed down after larger fast-food chains began opening local franchises

all around the nation, with well-known product standards and relatively

low prices. The increased competition led to prices that were too low for

many of the old cafes and drive-ins to make a profit. The private cafes

that did survive were able to meet that level of efficiency, or they

managed to make their products different enough from the national chains

to keep their customers.

Prices for goods and services can only fall so far, however. Even the

most efficient producers have to pay for the natural resources, labor,

capital, and entrepreneurship they use to make and sell products. The

market price cannot stay below the level of those costs for long without

driving all of the producers out of this market. Therefore, if consumers

want to buy some good or service not just today but also in the future,

they have to pay a price at least high enough to cover the costs of

producing it, including enough profit to make it worthwhile for sellers

to stay in that market.

Once market prices for various goods and services are set, consumers are

free to choose what to buy, and producers are free to choose what to

produce and sell. They both follow their self-interest and do what makes

them as well off as they can be. When all buyers and sellers do that in

an economic system of competitive markets, the overall economy will also

be very efficient and responsive to individual preferences.

This economic process is extremely decentralized. For example, it is

likely that no one person or government agency knows how many corned beef

sandwiches are sold in any large U.S. city on any given day. Individual

sellers decide how many sandwiches they are likely to sell and arrange to

have enough meat and bread available to meet the demand from their

customers.

Consumers usually do not make up their mind about what to eat for lunch

or dinner until they walk into the restaurant, grocery store, or sandwich

shop. But they know they can go to several different places and choose

many different things to eat and drink, while individual sellers know

about how much they are likely to sell on an average business day.

Other businesses sell bread and meat and drinks to the restaurants and

grocers, but they do not really know how many different sandwiches the

different food stores are selling either. They only know how much bread

and meat they need to have on hand to satisfy the orders they get from

their customers.

Each buyer and seller knows his or her small part of the market very well

and makes choices carefully to avoid wasting money and other resources.

When everyone acts this carefully while facing competition from other

consumers or producers, the overall system uses its scarce resources very

efficiently. Efficiency implies two things here: taking into account the

preferences and alternative choices that individual buyers and sellers

face, and producing goods and services at the lowest possible cost.

How and Why Market Prices Change

Another advantage of any competitive market system is a high level of

flexibility and speed in responding to changing economic conditions. In

economies where government agencies and central planners set prices, it

often takes much longer to adjust prices to new conditions. In the last

decades of the 20th century, the U.S. market economy has made these

adjustments very quickly, even compared with other market economies in

Western Europe, Canada, and Japan.

Market prices change whenever something causes a change in demand (the

amount people are willing to buy at different prices) or a change in

supply (the amount producers are willing and able to make and sell at

different prices). see Supply and Demand. Because these changes can occur

rapidly, with little or no advance warning, it is important for both

consumers and producers to understand what can cause prices to rise and

fall. Those who anticipate price changes correctly can often gain

financially from their foresight. Those who do not understand why prices

have changed are likely to feel bewildered and frustrated, and find it

more difficult to know how to respond to changing prices. Market

economies are, in fact, sometimes called price systems. It is important

to understand why prices rise and fall to understand how a market system

works.

Changes in Demand

Demand for most products changes whenever there is a significant change

in the level of consumers’ income. In the United States, incomes have

risen substantially over the past 200 years. As that happened, the demand

for most goods and services also increased. There are, however, a few

products that people buy less of as income falls. Examples of these

inferior goods include low quality foods and fabrics.

Demand for a product also changes when the price of a substitute product

changes. For example, if the price for one brand of blue jeans sharply

increases while other brands do not, many consumers will switch to the

other brands, so the demand for those brands will increase. Conversely,

if the price for beef drops, then many people will buy less pork and

chicken.

Some products are complements rather than substitutes. Complements are

products that are consumed together, for example cameras and film, or

tennis balls and tennis rackets. When the price of a complementary good

rises, the demand for a product falls. For example, if the price of

cameras rises, the demand for film will fall. On the other hand, if the

price of a complementary good falls, the demand for a product will rise.

If the price of tennis rackets falls, for example, more people will buy

rackets and the demand for tennis balls will increase.

Demand can also increase or decrease as a product goes in or out of

style. When famous athletes or movie stars create a popular new look in

clothing or tennis shoes, demand soars. When something goes out of style,

it soon disappears from stores, and eventually from people’s closets,

too.

If people expect the price of something to go up in the future, they

start to buy more of the product now, which increases demand. If they

believe the price is going to fall in the future, they wait to buy and

hope they were right. Sometimes these choices involve very serious

decisions and large amounts of money. For example, people who buy stocks

on the stock market are hoping that prices will rise, while at least some

of the people selling those stocks expect the prices to fall. But not all

economic decisions are this serious. For example, in the 1970s there was

a brief episode when toilet paper disappeared from the shelves of grocery

stores, because people were afraid that there were going to be shortages

and rising prices. It turns out that some of these unfounded fears were

based on remarks made by a comedian on a late-night talk show.

The final factor that affects the demand for most goods and services is

the number of consumers in the market for a product. In cities where

population is rising rapidly, the demand for houses, food, clothing, and

entertainment increases dramatically. In areas where population is

falling—as it has in many small towns where farm populations are

shrinking—demand for these goods and services falls.

Changes in Supply

The supply of most products is also affected by a number of factors. Most

important is the cost of producing products. If the price of natural

resources, labor, capital, or entrepreneurship rises, sellers will make

less profit and will not be as motivated to produce as many units as they

were before the cost of production increased. On the other hand, when

production costs fall, the amount producers are willing and able to sell

increases.

Technological change also affects supply. A new invention or discovery

can allow producers to make something that could not be made before. It

could also mean that producers can make more of a product using the same

or fewer inputs. The most dramatic example of technological change in the

U.S. economy over the past few decades has been in the computer industry.

In the 1990s, small computers that people carry to and from work each day

were more powerful and many times less expensive than computers that

filled entire rooms just 20 to 30 years earlier.

Opportunities to make profits by producing different goods and services

also affect the supply of any individual product. Because many producers

are willing to move their resources to completely different markets,

profits in one part of the economy can affect the supply of almost any

other product. For example, if someone running a barbershop decided to

sign a contract to provide and operate the machines that clean runways at

a large airport, this would decrease the supply of haircutting services

and increase the supply of runway sweeping services.

When suppliers believe the price of the good or service they provide is

going to rise in the future, they often wait to sell their product,

reducing the current supply of the product. On the other hand, if they

believe that the price is going to fall in the future, they try to sell

more today, increasing the current supply. We see this behavior by large

and small sellers. Examples include individuals who are thinking about

selling a house or car, corn and wheat farmers deciding whether to sell

or store their crops, and corporations selling manufactured products or

reserves of natural resources.

Finally, the number of sellers in a market can also affect the level of

supply. Generally, markets with a larger number of sellers are more

competitive and have a greater supply of the product to be sold than

markets with fewer sellers. But in some cases, the technology of

producing a product makes it more efficient to produce large quantities

at just a few production sites, or perhaps even at just one. For example,

it would not make sense to have two or more water and sewage companies

running pipes to every house and business in a city. And automobiles can

be produced at a much lower cost in large plants than in small ones,

because large plants can take greater advantage of assembly-line

production methods.

All these different factors can lead to changes in what consumers demand

and what producers supply. As a result, on any given day prices for some

things will be rising and those for others will be falling. This creates

opportunities for some individuals and firms, and problems for others.

For example, firms producing goods for which the demand and the price are

falling may have to lay off workers or even go out of business. But for

the economy as a whole, allowing prices to rise and fall quickly in

response to changes in any of the market forces that affect supply and

demand offers important advantages. It provides an extremely flexible and

decentralized system for getting goods and services produced and

delivered to households while responding to a vast number of

unpredictable changes.

Creative Destruction

Taking advantage of new opportunities while curtailing production of

things that are no longer in demand or no longer competitive was

described as the process of creative destruction by 20th century Austrian-

American economist Joseph Schumpeter. For example, Schumpeter discussed

how the United States, Britain, and other market economies helped many

new businesses to grow by building systems of canals (such as the Erie

Canal) during the mid-19th century. But then the canal systems were

replaced or “destroyed” by the railroads, which in turn saw their role

diminished with the rise of national systems of highways and airports.

The same thing happened in the communications industry in the United

States. The Pony Express, which carried mail between Missouri and

California in the early 1860s, went out of business with the completion

of telegraph lines to California. In the 20th century, the telegraph was

replaced by the telephone. Time and time again, one decade’s innovation

is partially replaced or even destroyed by the next round of

technological change.

In the modern world, prices change not only as a result of things that

happen in one country, but increasingly because of changes that happen in

other countries, too. International change affects production patterns,

wages, and jobs in the U.S. economy. Sometimes these changes are

triggered by something as simple as weather conditions someplace else in

the world that affect the production of grain, coffee, sugar, or other

crops. Sometimes it reflects political or financial upheavals in Europe,

Asia, or other parts of the world. There have been several examples of

such events in the U.S. economy in the 1990s. Higher coffee prices

occurred after poor harvests of coffee beans in South America, and U.S.

banks lost large sums of money following financial and political crises

in places such as Indonesia and Russia.

The ability to respond quickly to an increasingly volatile economic and

political environment is, in many ways, one of the greatest strengths of

the U.S. economic system. But these changes can result in hardships for

some people or even some large segments of the economy. For example,

importing clothing produced in other nations has benefited U.S. consumers

by keeping clothing prices lower. In addition, it has been profitable for

the firms that import and sell this clothing. However, it has also

reduced the number of jobs available in clothing manufacturing for U.S.

workers.

Many people think the most important general issue facing the U.S.

economy today is how to balance the benefits of quickly adapting to

changing economic conditions against the costs of abandoning the old

ways. It is vital for the economy to adapt quickly to changing conditions

and to focus on producing goods and services that will meet the most

recent demands of the market place. However, when businesses close

because their products no longer meet the demands of the market, it is

important to make retraining or new jobs available to workers who lost

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