Prices and Decision Making
Price
• The monetary value of a product as
established by supply and demand
• Signals:
– High prices: producers to produce more
and for buyers to buy less
– Low prices: producers to produce less
and for buyers to buy more
Advantages of Prices
• Prices
– help decide: WHAT, HOW, AND FOR WHOM
• Prices are neutral in a competitive market
economy
– Result of competition b/w buyers and sellers:
• More competitive = more efficient price adjustment
process
Advantages of Prices
• Prices are flexible in a market economy
– Think about computers THEN and NOW
– Allows for the “SHOCK” of unforeseen events
and changes in the market
• Prices have no administration cost
– Competitive markets find their own prices
w/out interference
– Prices change from one level to another
gradually
Advantages of Prices
• Prices are familiar and easily understood
– Mommy “I want a candy bar!”
– You “Can I purchase that TV?”
– No ambiguity: if it is $1 then you know you will
pay $1 (plus tax in some states)
– Make quick decisions
– Minimum effort
Allocations Without Prices
• Help us make economic decisions that
“allocate” scarce resources and the
product made from them
• What if the PRICE SYSTEM did not exist?
– Like command economies
– Use another system right?
Allocations Without Prices
• Rationing:
– System where the government decides
everyone’s “FAIR” share
– RATION COUPON:
• Obtain a certain allotted amount
• Widely used during wartime
– Questions of Fairness?
– High Administrative cost
– Diminishes incentives
Price as a System
• Economists favor the price system
• Serve as signals that help allocate resources
between markets
–
–
–
–
–
Oil ($5 to $40 a barrel in 1970’s)
Oil is inelastic
Higher energy cost = less money to spend elsewhere
1ST affected full size automobiles
Gave rebates: a partial refund of the original price of
the product
– Closed plants, laid off workers, started to change to
small production
Price as a System
• Higher prices on oil = shift in productive
resources
• Prices help buyers and sellers allocate
resources b/w markets
• Economist think of the price as a system
– Part of an informational network
– Links all markets in the economy
The Price System at Work
The Price Adjustment Process
• Appealing feature of a Competitive Market
Economy
– EVERYONE who participates has a hand determining
PRICES
– Makes prices neutral and impartial
• Buyers and sellers have exactly the OPPOSITE
hopes and desire
– Buyers = find good buys at low price
– Sellers = high prices and large profits
– Neither can get what they WANT so adjustments must
be made
The Price Adjustment Process
• Compromise needs to benefit BOTH
parties
• 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
• See figure 6.1
Figure 6.1a
Reflects the LAW OF DEMAND:
Consumers will buy more at
lower prices and less at higher
prices
Reflects the LAW OF SUPPLY:
Suppliers will offer more for sale
at higher prices and less at
lower ones
Figure 6.1a
SURPLUS= occurs
when supply
EXCEEDS demand
EQUILIBRIUM PRICE
= occurs when supply
MEETS demand
SHORTAGE= occurs
when demand
EXCEEDS supply
Surplus
• Shows up as UNSOLD products on
suppliers shelves
• Takes up space
• Know that the price is TOO high
• NEED to LOWER the price to attract
buyers
• PRICES tend to go DOWN when there is a
surplus
Shortage
• Suppliers have no more product to SELL
• Wished they would have charged a higher
price
• Result = BOTH price and quantity supplied
will go UP
• We do not know how much PRICE will go
up
Equilibrium Price
• “Clears the market” neither a surplus nor a
shortage at the end of the trading period
• Economic Model of the market
– CANNOT know how long it will take to reach
• Price is set TOO HIGH the surplus will
tend to force price down
• Price is set TOO LOW the shortage will
ten to force price up
Explaining and Predicting Prices
• A change in price is the result of a
– Change in Supply
– Change in Demand
– Or BOTH
• Elasticity of Demand is also important
when predicting prices
Explaining and Predicting Prices:
Change in Supply
• What causes change of supply with Agriculture?
– Answer: ____________________________
• See figure 6.3
– SS = curve the farmer predicted
– S1S1 = curve would move to if there was a record
harvest
– S2S2 = curve would move to if there was bad weather
• Food is INELASTIC a small change in supply =
large change in PRICE
Change in Supply
Figure 6.3a
Explaining and Predicting Prices:
Importance of Elasticity
• Demand curve is MORE elastic
• When a given change in supply occurs with an
INELASTIC demand curve
– PRICES change dramatically
• When a change in supply occurs with an
ELASTIC demand curve
– Price change is smaller
• BOTH supply and demand are INELASTIC =
wider change in price
• BOTH supply and demand are ELASTIC = less
change in price
Explaining and Predicting Prices:
Change in Demand
• Changes in income,
taxes, prices of
related goods,
expectations, and
number of
consumers
• Example: GOLD
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
• Competitive market allocates resources
efficiently
• To be competitive:
– Sellers are forced to lower prices
– Find ways to keep cost down
• Competition among buyers keeps prices from
falling TOO far
Social Goals vs. Market
Efficiency
Distorting Market Outcomes
• Seven Economic goals compatible with the
market economy
–
–
–
–
–
Freedom
Efficiency
Full employment
Price stability
Economic growth
• Two others: Equity and Security
– Usually distort market outcomes
– One way to achieve these goals is to set “socially
desirable” prices, which interferes with the pricing
system.
Price Ceilings
• A maximum legal
price that can be
charged for a product
– New York City does
this with rent control to
make housing more
affordable.
– This can create a
shortage. How?
• Affects allocation of
resources
Figure 6.5a
Price Floors
• Lowest legal price
that can be paid for a
good or service
– Minimum wage
• Lowest legal wage that
can be paid to most
workers
• at 7.25
– This can create a
surplus. How?
Figure 6.5b
Agricultural Price Supports
• 1930’s est. Commodity Credit Corporation
– Help stabilize agricultural prices
– Used loan supports and deficiency payments
– BOTH used target price: a price floor for farm
products
Loan Support
• Borrowed money from
CCC at the target price
and pledged his crops in
return
• Led to food surpluses
• Nonrecourse loan: a loan
that carries neither a
penalty nor further
obligation to repay if not
paid back
Figure 6.6a
Deficiency payments
• Check sent to producers
that makes up the
difference between the
actual market price and
the target price
• Prevented the gov’t from
holding surplus foods
• Had farmers sell crops on
the open market
Figure 6.6b
Federal Agricultural Improvement
and Reform Act (FAIR)
• Cash payments replaced price supports
and deficiency payments
• Cost just as much
• 2002, farmers no longer receive any kind
of payments
When Markets Talk
• Markets “talk” when prices move up or
down dramatically
• Buyers and sellers respond to changes in
the market through their decisions