The Role of Prices in a Free Market
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The Role of Prices in a Free Market
• Prices serve a vital role in a free
market economy.
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• Prices help move land, labor, and
capital into the hands of producers,
and finished goods in to the hands
of buyers.
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• Prices create efficient resource
allocation for producers and a
language that both consumers
and producers can use.
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Advantages of Prices
PRICES PROVIDE A LANGUAGE FOR BUYERS
AND SELLERS.
1. Prices as an Incentive
Prices communicate to both
buyers and sellers whether
goods or services are scarce or
easily available. Prices can
encourage or discourage
production.
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2. Signals
Think of prices as a traffic
light. A relatively high price is
a green light telling producers
to make more. A relatively
low price is a red light telling
producers to make less.
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Prices as Signals
• Price is a signal, giving information to
buyers and sellers.
– High prices—buyers buy less and
producers produce more.
– Low prices—buyers buy more and
producers produce less.
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3. Flexibility
In many markets, prices are
much more flexible than
production levels. They can be
easily increased or decreased to
solve problems of excess supply
or excess demand.
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4. Price System is "Free"
Unlike central planning, a
distribution system based on
prices costs nothing to
administer.
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Efficient Resource Allocation
• Resource Allocation
–A market system, with its fully
changing prices, ensures that
resources go to the uses that
consumers value most highly.
• Market Problems
–Imperfect competition between
firms in a market can affect prices
and consumer decisions.
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–Spillover costs, or externalities,
are costs of production, such
as air and water pollution, that
“spill over” onto people who
have no control over how much
of a good is produced.
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–If buyers and sellers have
imperfect information on a
product, they may not make the
best purchasing or selling
decision.
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Section 1
•Do you think eBay buyers and
sellers arrive at the perfect price?
•A.
Definitely
•B.
Possibly
•C.
Definitely not
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Advantages of Prices
•Prices help the economy run
smoothly by providing a good
way to allocate resources.
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Advantages of Prices
• Prices help consumers and producers
make decisions on WHAT, HOW, and FOR
WHOM:
– In a competitive market, prices are
neutral.
– Prices in a market economy are flexible.
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Advantages of Prices
– Prices are familiar and easy to understand.
– Prices have no cost of administration.
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Advantages of Prices
•The Global
Economy &
YOU
Average
Laptop
Prices
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Allocations Without Prices
•Rationing has disadvantages
that are not present in the
price system.
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Allocations Without Prices
• Without a price system, a rationing
system might be used.
• Individuals receive a ration coupon to
obtain a product.
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Allocations Without Prices
• Problems with rationing
– Difficult to allocate in fair way
– Administrative cost of rationing
– Negative incentive to produce
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Prices as a System
•Prices connect all markets in
an economy.
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Prices as a System
• Prices help individuals make decisions and
serve as signals in allocating resources
between markets.
– Higher oil prices have affected producer
and consumer decisions.
– Oil is inelastic; higher costs leave
individuals with less to spend.
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Prices as a System
– SUV sales dropped; manufacturers offered
a rebate.
– Manufacturers reduced production, closed
plants, laid off workers.
– Employees find jobs in new industries.
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Prices as a System
• The adjustment process was a natural and
necessary shift of resources for a market
economy.
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Balancing the Market
The point at which quantity
demanded and quantity supplied
come together is known as
equilibrium.
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Market Disequilibrium
If the market price or
quantity supplied is
anywhere but at the
equilibrium price, the
market is in a state
called disequilibrium.
There are two causes
for disequilibrium:
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Excess Supply
• Excess supply occurs when quantity
supplied exceeds quantity
demanded.
Excess Demand
• Excess demand occurs when
quantity demanded is more than
quantity supplied.
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• Interactions between buyers and
sellers will always push the
market back towards equilibrium.
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Price Ceilings
In some cases the government
steps in to
control prices. These
interventions appear as
price ceilings and price floors.
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• A price ceiling is a maximum price
that can be legally charged for a
good.
• An example of a price ceiling is rent
control
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Price Floors
• A price floor is a • One well-known
minimum price,
price floor is the
set by the
minimum wage,
government,
which sets a
that must be
minimum price
paid for a good
that an employer
or service.
can pay a
worker for an
hour of labor.
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Shifts in Supply
• Understanding a Shift
–Since markets tend toward
equilibrium, a change in supply
will set market forces in motion
that lead the market to a new
equilibrium price and quantity
sold.
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• Excess Supply
–A surplus is a situation in which
quantity supplied is greater than
quantity demanded. If a surplus
occurs, producers reduce prices to
sell their products. This creates a
new market equilibrium.
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• A Fall in Supply
–The exact opposite will
occur when supply is
decreased. As supply
decreases, producers will
raise prices and demand will
decrease.
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Shifts in Demand
• Excess Demand
–A shortage is a situation in
which quantity demanded is
greater than quantity supplied.
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• Search Costs
–Search costs are the financial
and opportunity costs
consumers pay when
searching for a good or
service.
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• A Fall in Demand
–When demand falls, suppliers
respond by cutting prices, and a
new market equilibrium is found.
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