Prices and Decision
Making
Chapter 6
Prices As Signals
Price – monetary value of a product est. by supply and demand –
“Signal”
Prices help producers and consumers decide the 3 basic
questions:
1.
2.
3.
WHAT to produce
HOW to produce it
FOR WHOM to produce
What would life be like without
prices?
• Intelligence? good looks? political connections?
• Communist countries often answer the 3 basic questions in
economics.
• Rationing
• Usually unfairly distributed
• Cost of distributing, enforcing, issuing coupons
• Negative impact on the incentive to produce
Prices as a system
• Non price allocation systems are typically corrupt
• The price systems help individuals make decision and serve as
a signal for suppliers
• Ex. Ebay; Craigslist
Ch.6 Sec.2
Price System at Work
Price of pizza
Quantity of pizza
demanded
(per week)
Quantity of pizza
supplied
(per week)
$25
100
800
$20
210
700
$15
300
625
$10
500
500
$5
650
300
Market Equilibrium Price
Changes In Equilibrium
Example 1: Suppose that the price of Chinese food delivery rises. What happens to the market for pizza? Let's figure this
out with a 3 step approach:
Step 1: Will this affect the demand or supply curve?
• Chinese food is a substitute for pizza, so the price of chinese food affects the demand curve
Step 2: In what direction will the affected curve move?
• The price of chinese food, a substitute, INCREASES, so the demand for pizza INCREASES, or the demand curve shifts
right.
Step 3: What is the resulting impact on the equilibrium price and quantity?
• This is easiest to answer with a graph. If you look at the graph below you will see that the new equilibrium has a higher
price and larger quantity. An increase in demand results in an increase in price and quantity.
Example 2: Suppose instead that the Chinese food business is incredibly popular and profitable. What happens to the market
for pizza? Again, we use the same three step approach:
Step 1: Will this affect the demand or supply curve?
• The chinese food business is an alternative to the pizza business, affecting the supply curve
Step 2: In what direction will the affected curve move?
• The profitability of chinese food means that some pizza places will switch to chinese food places, so the supply of pizza
DECREASES, or the supply curve shifts left.
Step 3: What is the resulting impact on the equilibrium price and quantity?
• This is easiest to answer with a graph. If you look at the graph below you will see that the new equilibrium has a higher price
and smaller quantity. An decrease in supply results in an increase in price and a decrease in quantity.
Market Equilibrium
Changes In Equilibrium
Bad News for Orange
Juice Fanatics
Orange Juice Prices Could
Skyrocket After Freeze Destroys
Most of California Output
City News
Price Ceilings & Floors
• A price ceiling is a legal maximum that can be charged for a good.
• Results in a shortage of a product
• Common examples include apartment rentals and credit cards interest
rates.
Price Ceilings
Price Ceilings
are always
below
Equilibrium
Price
Price Floors and Ceilings
A shortage occurs when quantity demanded exceeds quantity supplied.
A shortage implies the market price is too low.
Example:
Many cities have rent control laws to make sure that poor people
can find apartments they can afford. But landlords do not find it
profitable to rent at these prices and sometimes convert their
buildings to condominium or cooperative ownership. This reduces
the number of apartments available: it creates a shortage.
A surplus occurs when quantity supplied exceeds quantity demanded.
• A surplus implies the market price is too high.
Example:
The prices of many agricultural commodities, such as milk for
instance, are subject to government price support. This higher
price encourages farmers to produce too much: this creates
surpluses. For instance, in the 1980's, the government has been
forced to make cheese from milk surplus and to distribute that
cheese free to poor people.
Price Ceiling
A price ceiling is set at $2 resulting in a shortage of
20 units.
Rent Control -NYC
Price Floor
A price floor is a legal minimum that can be charged
for a good.
• Results in a surplus of a product
• Common examples include soybeans, milk,
minimum wage
A price floor is set at $4 resulting in a surplus of 20
units.