There are two important components of market system: households (consumers) and firms (producers). The main roles of households are to sell resources and to purchase goods and services. In free market system households are able to buy the goods they want, so that they are dictating the demand. This kind of system don’t collapse, because firms produce the kind of goods and services that demanders need and the latter ones provide resources and labour force that firms need.
You may ask “from where firms know what to produce?”. The answer is quite easy. Suppliers seek profit and try to avoid losses, so they will produce the goods and services that continue to offer them profit.
Consumer register their needs on the demand side of the market, so firms and products suppliers respond to this demand by completing this demand.
Consumer sovereignty is represented by consumer demand, which is crucial for determining the type and quantity of goods to be produced. They spend their wages on the goods they are willing and able to buy. By these dollar votes consumers registers their needs on the demand side of the market. If a dollar vote for a certain good is high enough to produce a profit, the industry will expand so will production quantity of it. Otherwise, if there exist a decrease in demand, or fewer dollar votes cast for that good, industry will contract. We may say that the consumers are sovereign, because they collectively direct the market, in sense to produce more goods of some type or not.
Freedom of Market
Actually, firms don’t produce the goods and services they want, they rely on consumer’s buying decision and demand. Ones which don’t obey the rule of the market may face great losses or even bankruptcy.
This fact remains true also for resource suppliers. The demand for resources is called derived demand, derived from demand for goods and services. Consumers register their wants on the demand side of the market, producers and resource suppliers respond to these wants by creating supply for these goods.
In each industry the firms which are able to survive are the most profitable. Competition eliminates producers which are not profitable and efficient, and ones that require less production costs survive.
Least-cost production means that these producers must have the most economically efficient production technique. Efficient production depends on:
- Available technology
- Prices of resources
Economic efficiency means obtaining a particular output by using least input of scarce resource, while both input and output are calculated in the same currency.
Let’s suppose that buyers change their taste and don’t want to buy apple but they are willing to buy cherries. These changes are communicated to producers by an increase in demand of cherries, so the price of apples will decrease and that of cherries will increase. Some of these firms that activated in apple production may leave this industry, because they don’t seek losses. In contrast, in cherries industry some new firms will enters, because they seek self-interest. Higher profit will make cheery industry to expand. Firms will pay even more money to resources producers, who will find some alternatives to get more cherries. So demand can contract or expand an industry.
New capital permits firms to spend less money on production of a good. So the costs are decreasing which offers suppliers higher revenue. Market system is conducted by a very fast spread of technological advances through industries. Rival firms must follow these technological advances elsewhere they may suffer losses or even a total failure. Creative destruction is destruction of market positions of firms that are using older ways of production, by creating new products and new production methods.
Entrepreneurs sometimes spend their revenue on purchasing capital goods. This yields higher revenue in future if new technology is more effective. By selling ownership shares the firm casts dollar votes for buying new capital goods.
Consumer Sovereignty-Determination by consumers of the types and quantities of goods and services that will be produced with the scarce resources of the economy.
Dollar votes- The “votes” that consumers and entrepreneurs cast for the production of consumer and capital goods, respectively, when they purchase them in product and resource markets.
Derived Demand-The demand for a resource that depends on the demand for the products it can be used to produce.