CHAPTER
6
Prices and Decision Making
Section 1: Prices as Signals
• Main Idea: Competitive markets and prices
are important to capitalism.
• Objectives:
• Explain how prices act as signals.
• Describe the advantages of using prices as a way to
allocate economic products.
• Understand the difficulty of allocating scarce goods and
services without using prices.
Section 1 Introduction
• Life is full of signals that help us make
decisions.
• For example, when we pull up to an
intersection, we look to see if the traffic light
is green, yellow, or red.
• We look at the other cars to see if any have
their blinkers on, and in this way we receive
signals from other drivers regarding their
intentions to turn.
Section 1 Introduction (cont.)
• Doctors even tell us that pain is a signal that
something is wrong with our body and may need
attention.
• But have you ever thought about the signals that
help us make our everyday economic decisions?
• It turns out something as simple as a price–the
monetary value of a product as established by
supply and demand–is a signal that helps us make
our economic decisions.
Section 1 Introduction (cont.)
• Prices communicate information and provide
incentives to buyers and sellers.
• High prices are signals for producers to
produce more and for buyers to buy less. Low
prices are signals for producers to produce
less and for buyers to buy more.
Advantages of Prices
• Prices are neutral because they do not favor
the buyer or the consumer. They are the
result of competition.
• Prices are flexible, allowing for the “shocks” of
unforeseen events and changes in the market.
• Prices have no administration costs.
• Prices are familiar and easily understood.
Allocations Without Prices
• Rationing, or the system where the
government decides everyone’s “fair” share,
leads to the question of fairness.
• Rationing leads to high administrative costs.
• Rationing leads to fewer incentives to work
and produce.
Prices as a System
• Together, prices comprise a system that helps
buyers and sellers allocate resources between
markets, linking all markets in the economy.
Section 2: The Price System at Work
• Main Idea: Changes in demand and supply
cause prices to change.
• Objectives:
• Understand how prices are determined in competitive
markets.
• Explain how economic models can be used to predict
and explain price changes.
• Apply the concepts of elasticity to changes in prices.
Section 2 Introduction
• One of the most appealing features of a
competitive market economy is that everyone
who participates has a hand in determining
prices.
• This is why economists consider prices to be
neutral and impartial.
• The process of establishing prices is
remarkable because buyers and sellers have
exactly the opposite hopes and desires.
Introduction (cont.)
• Buyers want to find good buys at low prices.
Sellers hope for high prices and large profits.
• Neither can get exactly what they want, so
some adjustment is necessary to reach a
compromise.
The Price Adjustment Process
• Together, demand and supply make a
complete picture of the market.
• Price adjustments help a competitive market
reach market equilibrium, with fairly equal
supply and demand.
Figure 6.1a
The Price Adjustment Process (cont.)
Figure 6.1b
The Price Adjustment Process (cont.)
• Surpluses occur
when supply
exceeds
demand.
Figure 6.2a
The Price Adjustment Process (cont.)
• Shortages occur
when demand
exceeds supply.
Figure 6.2b
The Price Adjustment Process (cont.)
• The equilibrium
price is the price
at which supply
meets demand.
Figure 6.2c
The Price Adjustment Process (cont.)
Figure 6.2d
Explaining and Predicting Prices
• A change in price is
normally the result
of a change in
supply, a change in
demand, or both.
Figure 6.3a
Explaining and Predicting Prices (cont.)
• Even small
changes in an
inelastic supply
can create big
changes in price.
Figure 6.3b
Explaining and Predicting Prices (cont.)
• Elastic supply and
demand help keep
prices from
changing
dramatically.
Figure 6.4
The Competitive Price Theory
• The theory of competitive pricing represents a set
of ideal conditions and outcomes; it serves as a
model to measure market performance.
• In theory, a competitive market allocates
resources efficiently.
• To be competitive, sellers are forced to lower
prices, which makes them find ways to keep their
costs down.
• Competition among buyers keeps prices from
falling too far.
Section 3: Social Goals vs. Market
Efficiency
• Main Idea: To achieve one or more of its social
goals, government sometimes sets prices.
• Objectives:
• Describe the consequence of having a fixed price in a
market.
• Explain how loan supports and deficiency payments
work.
• Understand what is meant when “markets talk.”
Section 3 Introduction
• Chapter 2 examined seven broad economic and social
goals that most people seem to share.
• We also observed that these goals, while
commendable, were sometimes in conflict with one
another.
• These goals were also partially responsible for the
increased role that government plays in our economy.
• The goals most compatible with a market economy are
freedom, efficiency, full employment, price stability,
and economic growth.
Section 3 Introduction (cont.)
• Attempts to achieve the other two goals—
equity and security—usually require policies
that distort market outcomes.
• In other words, we may have to give up a little
efficiency and freedom in order to achieve
equity and security.
• Whether this is good or bad often depends on
a person’s perspective.
Introduction (cont.)
• After all, the person who receives a subsidy is
more likely to support it however, it is usually
wise to evaluate each situation on its own
merits, as the benefits of a program may well
exceed the costs.
• What is common to all of these situations,
however, is that the outcomes can be
achieved only at the cost of interfering with
the market.
Introduction (cont.)
• After all, the person who receives a subsidy is
more likely to support it than is the taxpayer who
pays for it.
• In general, it is usually wise to evaluate each
situation on its own merits, as the benefits of a
program may well exceed the costs.
• What is common to all of these situations,
however, is that the outcomes can be achieved
only at the cost of interfering with the market.
Distorting Market Outcomes
• Achieving equity and security (two of the seven
broad economic and social goals) usually requires
policies that distort market outcomes.
• One way to achieve these goals is to set “socially
desirable” prices, which interferes with the
pricing system.
• Setting price ceilings affects the allocation of
resources.
• The minimum wage is an example of a price floor.
Distorting Market Outcomes (cont.)
Figure 6.5a
Distorting Market Outcomes (cont.)
Figure 6.5b
Agricultural Price Supports
• Government loan support was offered in the 1930s through
Commodity Credit Corporation to help stabilize agricultural
prices. The CCC loan program led to food surpluses.
• The CCC switched to deficiency payments, which prevented
the government from holding surplus food and had farmers
sell their crops on the open market. Figure 6.6a
Agricultural Price Supports (cont.)
• In 1996, Congress passed
FAIR—Federal Agricultural
Improvement and Reform
Act. Cash payments
replaced price supports
and deficiency payments.
The payments ended up
costing as much. In 2002,
farmers will no longer
receive any kind of
payments.
Figure 6.6b
When Markets Talk
• Markets “talk” when prices move up or down
dramatically.
• Buyers and sellers respond to changes in the
market through their decisions.
Key Terms
• Price
• Rationing
• ration coupon
• Rebate
• economic model
• market equilibrium
• surplus
• shortage
• equilibrium price
• price ceiling
•
•
•
•
•
minimum wage
price floor
target price
nonrecourse loan
deficiency payment