What’s in This Chapter?
Why do prices of houses, cars, gasoline, and food fluctuate? What explains increases and decreases in interest rates? Why do prices of stocks and bonds change almost every second? Why does one gas station charge more than an other? Why are salaries of restaurant servers, nurses, and kindergarten teachers so much lower than those of television celebrities, famous athletes and corporate CEOs? Why is it less expensive to visit some foreign countries after their foreign exchange rates decrease in value?
In a free market economy, the answer to all of these questions is: “It is because of changes in supply and demand.” When the demand for a product increases, then its equilibrium price increases, and vice versa. When the supply increases, then the price decreases, and vice versa.
The mechanism of changing prices in a free market economy is powerful. When buyers want more of a product, and can afford it, they communicate this by buying more of the product. This increases the product’s price. The higher price gives producers an incentive (and the financial ability) to make more of the product. The subsequent greater supply satisfies the greater need. The greater supply eventually also brings the price back down for most products (assuming the cost of production doesn’t change). Overall satisfaction and the nation’s standard of living increase because buyers and sellers communicate to each other and satisfy each others’ needs.
The free market system described above has many advantages and has contributed to high standards of living in many industrialized nations. It has some disadvantages, as well, as we will discuss in this unit.