How Prices are Determined
In a free market economy, supply and
demand are coordinate through the price
system. Everyone who participates in the
economy jointly determines prices. Prices
are considered neutral and impartial.
How the Price System Works
The Market Economy Price System has four key
characteristics
1. It is neutral: prices don’t favor the producers nor the
consumers
2. It is market driven: market forces determine prices, there
are no administrative decisions.
3. It is flexible: prices can change to respond quickly to
changing market conditions.
4. It is efficient: prices will adjust until the maximum number
of goods and services are sold.
The Price system also serves several
functions:
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Information Function: The price system provides vital information
to producers, resource providers and consumers
Producers need to know if it is good time to enter a market and
what to produce at what prices
Resource providers need to know what resources to provide, how
much and at what price
Consumers need to know what they are willing and able to buy
Incentive Function: The price system motivates providers and
consumers to act in different ways
Producers are motivated to make money
Resource Providers are motivated to allocate natural resources
Consumers are motivated to buy products at the best possible
prices.
PRICES ACT AS SIGNALS
How Prices are Determined
●Buyers and sellers have exactly the
opposite hopes and intentions.
●Buyers want good buys at low prices.
●Sellers want high prices and profits.
Fundamental Conflict
• The Law of Supply says that suppliers will
produce more when price is high and less
when price is low .
• The Law of Demand says that consumers will
buy more when price is low and less when
price is high
The Compromise
• Producers must be able to charge enough to cover
costs and earn a reasonable profit
• Consumers can only pay prices they are willing and
able to pay
• Market Equilibrium (the compromise): occurs when
the quantity demanded and the quantity supplied are
a particular price are equal.
• Equilibrium Price ($): The price at which quantity
demanded and quantity supplied are equal.
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 (Quantity Supplied > Quantity Demanded)
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Producers do not know
what price they should
charge to hit the market
equilibrium price, so they
must adjust their prices
in an attempt to reach
equilibrium
A surplus occurs when
the price is set too high
A surplus occurs
because the producers
are willing to supply more
product than consumers
are willing to buy
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 (it’s the only way for
suppliers to fix a surplus), 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 (Quantity Supplied < Quantity Demanded)
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A shortage occurs when
price is set too low
A shortage occurs
because consumers are
willing to buy more
product than producers
are willing to supply at a
given price.
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.
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.
Market Equilibrium Can Change
Market Equilibrium is the point at which the supply curve and
the demand curve intersect. Therefore if either curve shifts,
then the market is in:
Disequilibrium: When the quantity demanded and the
quantity supplied are not in balance.
A Change in Demand and the Equilibrium Price
Remember, a change in demand causes the curve to shift and
is determined by one of six non-price determinants which
are:
1.) Consumer Tastes
2.) Consumer Income
3.) Market Size (# customers)
4.) Consumer Expectations
5.) Price of Related Goods
A change in demand and equilibrium price
A change in supply and equilibrium price
Remember, a change in supply causes the supply curve to shift and
is determined by one of 7 non-price determinants of supply
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
●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?
Examples of Price Ceilings
Price Ceilings on ticket
prices for Syracuse
University Men’s basketball
tickets.
Ticket prices are kept low so
students can afford them,
but this lower price leaves
demand very high and
causes a shortage
scalpers
Example: Rent Control
● Some cities, especially New York City, have
rent control laws to keep housing affordable.
The laws control when rents can be raised
and by how much, however there are
unexpected consequences:
● Shortages: no incentive to increase the
supply of rentals b/c as market prices rise
and rent remains the same, landlords make a
smaller profit.
● Devalued Property: no incentive for landlords
to keep property looking nice so they don’t
and the property loses value
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 an employer
would pay you less if he or
she were allowed to do so?
Consequences of price floors
Minimum Wage (first set in 1938)
• If the minimum wage is set above the
equilibrium price, the number of jobs is
less than the number of workers so
employers may decide that paying high
wages is no longer profitable and they
will employ fewer people