Markets, prices, and money

We know now that the basic coordinating mechanism of a capitalist economy is the market system. Without a market economy, there is no capitalism. Deci­sions made by buyers and sellers of products and resources become effective through a system of markets. We already know that a market is a mechanism or arrangement which brings buyers (demanders) and sellers (suppliers) into contact with one another. The preferences of sellers and buyers are reflected in their choices, and the outcome of these choices is a set of prices. These prices are guideposts on which resource owners, entrepreneurs, and consumers make and revise their free choices as they pursue their self-interests.

Just as competition is the controlling mechanism, so a system of markets and prices is the basic organizing force. The market system is an elaborate communication system through which innumerable individual free choices are recorded, summarized, and balanced against one another. Those who obey the dictates of the market system are rewarded; those who ignore them are penalized by the system. Through this com­munication system, society decides what the economy should produce, how produc­tion can be efficiently organized, and how the fruits of productive effort are distributed among the individual economic units which make up capitalism.

The «interaction» between demand and supply in markets influences prices. Market-determined prices — that is, prices determined by producers and con­sumers acting in their own best interest — are the signals that help define the trade-offs we face and that ultimately lead society as a whole to allocate resources efficiently. Understanding how changes in supply and demand affect prices is an important component of economic literacy. When a prospective college student, for example, contemplates majors, she might speculate about where demand for workers is increasing fastest, because wages and job opportunities will probably be greatest in those occupations.

When prices change then trade-offs change, and people's decisions change. Our college student might discover, for example, that the demand for software engineers has increased and, subsequently, that wages for those jobs have also risen. Also, many public policy decisions, such as changes in the tax code, in­volve changing incentives with the hope of changing behaviour.

Many times people are unhappy with the prices that markets produce, but an economically literate person realizes that prices are important signals that reflect underlying changes in supply and demand. Consumers and producers respond to these signals in ways that make society better off. When governments interfere with these market adjustments, society is usually worse off.

When people hear the word «price» they usually associate it with the word «money». Virtually all economies, advanced or primitive, use money. Money per­forms several functions, but first and foremost it is a medium of exchange: it makes trade easier. The use of money facilitates the exchange of goods and ser­vices which specialization requires.

Exchange can, and sometimes does, occur on the basis of barter, that is, swapping goods for goods. But barter can pose serious problems for the economy because it requires a coincidence of wants between the two transactors. If this co­incidence of wants does not exist, trade is blocked.

To overcome such a stalemate, economies use money, which is simply a con­venient social invention to facilitate exchanges of goods and services. Historically, cattle, cigarettes, shells, stones, pieces of metal, and many other commodities have been used, with varying degrees of success, as a medium for facilitating ex­change. But to be money, an item needs to pass only one test: it must be gener­ally acceptable to sellers in exchange for goods and services. Money is socially de­fined: whatever society accepts as a medium of exchange is money. Most econo­mies use pieces of paper as money.

On a global basis the fact that different nations have different currencies complicates international specialization and exchange. However, foreign ex­change markets permit US residents, Japanese, Germans, Britons, and Mexicans to exchange dollars, yen, euros, pounds, and pesos for one another to complete international exchanges of goods and services.