How Prices are Determined
Prices play an important role in our
economy. Everyone who participates in
the economy jointly determines prices.
Prices are considered neutral and
impartial.
The Adjustment Process
Buyers and sellers have exactly the opposite
hopes and intentions.
Buyers want good buys at low prices.
Sellers want high prices and profits.
The Adjustment Process
To understand how prices are set, we can look at a
new product, called a gadget
, being
introduced.
Because it’s new, producers can’t be sure what to
charge for it.
An adjustment process takes place.
To demonstrate how prices are set, economists use
an economic model, a set of assumptions listed as
a table, graph, or equation.
The Supply and Demand
Schedule for Gadgets
Market Equilibrium
The adjustment
process moves toward
market equilibrium – a
situation where prices
are stable and the
quantity supplied is
equal to the quantity
demanded.
Market Equilibrium
Why does the market find the
equilibrium price of $5 on its own
and why is the quantity supplied
exactly equal to the quantity
demanded at this price?
Why did the price not reach
equilibrium at $7, or $6, or at
some other price?
In order to answer these
questions, we have to examine
the reactions of the buyers and
sellers to various market prices.
Surplus
If suppliers guess that
the price will be $7, they
will want to produce
1400 gadgets.
However, consumers
will only buy 990 units
at at a price of $7,
leaving a surplus of 410
gadgets.
Surplus
A Surplus is a situation in
which the quantity supplied is
greater than the quantity
demanded at a given price.
A surplus causes prices to go
down, the quantity demanded
to rise, and the quantity
supplied to go down.
As long as price is flexible, the
surplus will only be temporary.
Shortage
If $7 is too high,
producers might consider
$4.
At that price, the quantity
supplied changes to
1,250 gadgets.
However, at $4,
consumers would buy
1,470 gadgets
,
resulting in a shortage of
220.
Shortage
A shortage is a situation
in which the quantity
demanded is greater
than the quantity
supplied at a given price.
A shortage causes prices
to go up and the quantity
supplied to increase.
Price Adjustment
We can assume that the
next price will be less than
$7, which we already know
is too high.
If the new price is $6, a
surplus of 210 will result.
The surplus will cause the
price to drop but probably
not below $4 which already
proved to be too low.
Equilibrium Price
When the price drops to $5,
the market finds its equilibrium
price.
The equilibrium price is the
price where quantity supplied
equals the quantity
demanded, - there is neither a
surplus nor a shortage.
The equilibrium price will
maintain until something
disturbs the market.
Equilibrium Price
This theory is set in ideal conditions.
Price represents the balancing forces of demand and
supply.
The great advantage of competitive markets is that they
allocate resources efficiently.
As sellers compete to meet consumer demands, they
are forced to lower costs and prices.
At the same time, competition among buyers helps
prevent prices from falling too far, and helps allocate
goods and serves to those willing and able to pay.
Price Adjustment
Bookstores and other
businesses often
price certain goods
below cost to attract
customers.
What may result if the
price for a given
product is set too
low?
Loss Leader
Fixed Prices
Up to now, we have
assumed that the market
was reasonably
competitive, and that prices
and quantities were
allowed to fluctuate.
What happens when
government policies fix the
prices people either receive
or pay?
Fixed Prices
Some cities, especially
New York City, have
experimented with rent
controls to make housing
more affordable.
When rents are capped
at artificially low rates,
housing shortages
usually result.
Fixed Prices
Price ceilings set
the maximum legal
price that can be
charged for a
product. This often
creates a shortage.
Who would love
the lower price?
Who would not?
Fixed Prices
Occasionally, prices are
considered too low, and
some people believe
they should be kept
higher.
The minimum wage, the
lowest legal wage that
can be paid to most
workers, is a case in
point.
Fixed Prices
Price floors set the lowest
legal price that can be paid
for a good or service. This
often leads to a surplus.
Is the current minimum
wage higher or lower than
the wage that would prevail
in its absence?
Do you think that your
employer would pay you
less if he or she were
allowed to do so?
Assignment!!
Construct demand and supply schedules and an
economic model for a brand of blue jeans, using the
information below. Then show at what prices surpluses,
shortages, and price equilibrium appear.
Price
Demand
Supply
$22
60,000
20,000
$24
50,000
28,000
$26
44,000
32,000
$28
36,000
36,000
$30
30,000
40,000
$32
24,000
46,000