price system

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The subject matter of economics is the social organization of economic activity. There are numerous ways in which economic activity may be organized. When we refer to organization, we mean nothing more than the coordination of individuals, each doing different things, in the furtherance of one or more common ends. It does not take much reflection to realize that economic activities in our world are organized. The number of individuals who have contributed in many different ways to supplying the wants of even the poorest citizen in our country is immense. The type of social organization that we employ for this coordination of activities among individuals is predominantly a market or price system. In such a system, resources tend to flow where they yield the highest rate of return, or highest profit. Prices generate the signals that determine where the resources will flow; prices provide information cheaply and quickly; and prices affect incentives. These prices are determined in myriad markets for myriad goods and services that are bought and sold every day.

In brief, a market is a system of allocating resources and signaling information about their relative values. It is also a system that distributes income in proportion to the amount and market value of owned resources. The market system is one in which there is decentralized decision making. It involves, in essence, spontaneous coordination by millions of participants.

A market system is only one type of social organization for production and distribution. We could depict another social organization in which there was a dictatorship. This is sometimes called an extreme form of a command economy. In such a system, flows of goods and resources are not directed by prices; the flows are directed by whoever is in charge. In this text, we will concern ourselves with the determinants of flows within the market system of social organization.

Actually, within most countries a combination of market and command systems is used. This can be seen in the well-known circular flow of income diagram shown in Figure 1-1. In this simplified economic system, there are individuals, firms, and "government." The activities—i.e., the flows of goods and resources in the private (nongovernment) market sector of the economy— depend on voluntary exchanges. The flows of goods and resources to the government depend on the net result of political activity within the existing institutional framework of law, precedent, tradition, and custom.