6.3 MARKET EFFICIENCY AND THE GAINS FROM EXCHANGE Key …dsfepf2015.weebly.com/uploads/2/8/2/5/28251693/ch_6.36.4.pdf · UNIT 2 THE MARKET ECONOMY MARKET EFFICIENCY AND THE GAINS

UNIT 2 THE MARKET ECONOMY

M A R K E T E F F I C I E N C Y A N D T H E G A I N S F R O M E X C H A N G E

6.3Key Termsproductive effi ciency 184

allocative effi ciency 185

disequilibrium 185

price fl oor 186

price ceiling 187

consumer surplus 189

Learning Objectives

L 1 Distinguish between productive effi ciency and allocative effi ciency.

L 2 Explain what happens when government imposes price fl oors and price ceilings.

L 3 Identify the benefi ts that consumers get from market exchange.

In Your WorldAs you have learned, demand and supply are the foundations of a market econ-omy. Although a market usually involves the interaction of many buyers and sell-ers, few markets are consciously designed. Just as the law of gravity works whether or not you understand Newton’s principles, market forces operate whether or not buyers and sellers understand the laws of demand and supply. Market forces arise naturally without central coordination, much the way car dealers gather together on the city’s outskirts, or the way fruits and vegetables from all over the world fi nd their way to the produce section of your local grocer.

COMPETITION AND EFFICIENCYHow do competitive markets stack up in terms of effi ciency? To judge market performance, economists employ two measures of effi ciency. Th e fi rst, called productive effi ciency, refers to producing output at the lowest possible cost. Th e second, called allocative effi ciency, refers to producing the goods that consumers value the most. Market competition promotes both productive effi ciency and allocative effi ciency.

Productive Effi ciency: Making Stuff RightProductive effi ciency occurs when a fi rm produces at the lowest possible cost

per unit. Th e fi rms that survive and thrive in a competitive market are those that supply the product at the lowest cost. Competition ensures that fi rms produce at the lowest possible cost per unit. Firms that are not effi cient must either shape up or leave the market.

Allocative Effi ciency: Making the Right StuffProducing at the lowest possible cost per unit is no guarantee that fi rms are

producing what consumers most prefer. Th is situation is like the airline pilot who announces to passengers that there’s some good news and some bad news: “Th e good news is that we’re making record time. Th e bad news is that we’re lost!” Like-

productive effi ciency Occurs when a fi rm produces at the lowest possible cost per unit

L 1Distinguish

between

productive

effi ciency

and allocative

effi ciency.

184

80186_ch06_ptg01_hr_167-201.indd 18480186_ch06_ptg01_hr_167-201.indd 184 2/11/12 7:26 AM2/11/12 7:26 AM

Chapter 6 M a r ke t Fo r ce s

wise, fi rms may be producing goods effi ciently but producing the wrong goods—that is, making stuff right but making the wrong stuff .

Allocative effi ciency occurs when fi rms pro-duce the output that is most valued by consumers. How do economists know that market competition guarantees allocative effi ciency? Th e answer lies with the market demand and supply curves. Th e demand curve refl ects the marginal benefi t that consumers attach to each unit of the good, so the market price is the amount of money people are willing and able to pay for the fi nal unit they purchase.

In like fashion, equilibrium price equals the marginal cost of supplying the fi nal unit sold. Marginal cost measures the opportunity cost of resources employed by the fi rm to produce that fi nal unit sold. Th us the supply curve refl ects the opportunity cost of producing the good.

Th e supply and demand curves intersect at the combination of price and quan-tity at which the marginal benefi t that consumers attach to the fi nal unit purchased just equals the marginal cost of the resources employed to produce that unit.

As long as marginal benefi t equals marginal cost, that last unit purchased is worth as much as, or more than, any other good that could have been produced using those same resources. Th ere is no way to reallocate resources to increase the total value of output to society. Th us, there is no way to reallocate resources to increase the total benefi t consumers reap from production.

When the marginal benefi t that consumers derive from a good equals the marginal cost of producing that good, that market is said to be allocatively effi cient. Competition among sellers encourages producers to supply more of what consumers value the most. Firms not only are making stuff right, they are also making the right stuff .

Distinguish between productive effi ciency and allocative effi ciency.

DISEQUILIBRIUMOne way to understand markets is to examine instances when they are slow to adjust or where they are not free to work. A sur-plus of goods exerts downward pressure on price, and a short-age of goods exerts upward pressure. But markets don’t always reach equilibrium quickly. During the time required to adjust, the market is said to be in disequilibrium. Disequilibrium is usually a temporary condition when the plans of buyers do not match the plans of sellers. Sometimes, usually as a result of

government intervention in markets, disequilibrium can last a while, even years.

allocative effi ciency Occurs when a fi rm produces theoutput most valued by consumers

disequilibrium Amismatch between quantity demanded and quantity suppliedas the market seeks equilibrium;usually temporary, except when government intervenes to setthe price

Competition in the music industry encourages companies to supply the types of music that consumers want to hear. What type of effi ciency does this statement suggest?

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L 2Explain what

happens

when

government

imposes price

fl oors and

price ceilings.

185



Price FloorAt times public offi cials set the price above its equilibrium level. For example,

the federal government often regulates the prices of agricultural products in an attempt to ensure farmers a higher and more stable income than they would earn otherwise. To achieve higher prices, the federal government establishes a price fl oor for a product, such as a gallon of milk, making it illegal to sell below the fl oor price. A price fl oor is a minimum legal price. To have an impact, the price fl oor must be set above the equilibrium price. Price fl oors distort markets and reduce economic welfare.

Mongolian Goats and the Price of Cashmere SweatersDo you think there is a connection between the price tag on a four-ply cash-mere sweater and a herd of Mongolian goats? You bet there is. A decade ago there were fewer goats, and a cashmere sweater could cost as much as $500. Today you can purchase a cashmere sweater at Walmart for as little as $19.95. So why has the price of this product, which is diffi cult to produce, dropped so drastically?

Cashmere comes from the hair of Kashmir goats, the majority of which are raised in Mongolia and northern China. It takes two or three goats to produce enough usable cashmere fi ber to make a sweater. The fi ber must go through a labor-intensive process of cleaning and de-hairing. As a result of inexpensive Chinese cashmere fl ooding the market, the price has dropped, making what was formerly a luxury item one for the masses. China’s dominance of the cashmere market has forced the Mongolian sellers to accept far less than what they could demand in a more diverse market. This, in turn, depresses the income of the herders. Unfor-tunately for the Mongolian people, a product that once commanded a price of $27.50 a pound is down to half that fi gure.

To try and make up for the loss, the herders have increased the number of goats from 10 million in 2002 to nearly 20 million in 2010. The Mongolian government has set up a marketing agency to help producers compete on quality and brand, not price.

Think Critically Why might a Mongolian herder believe that increasing his goat herd will make up for lower prices? Is he correct? How can the Mongolian government’s approach aff ect both supply and demand?

Sources: Wachter, Sarah J., “Pastoralism Unraveling in Mongolia,” The New York Times, December 8, 2009; Gibbs, Susan, “The True Cost of Cheap Cashmere,” Huffi ngton Post, April 12, 2010

price fl oor A minimumlegal price below which a product cannot be sold

186



Panel (A) of Figure 6.6 shows the eff ect of a $2.50 per gallon price fl oor for milk. At that price, farmers supply 24 million gallons per week, but consumers demand only 14 million gallons. Th us, the price fl oor results in a surplus of 10 million gallons. Th is surplus milk will accumulate on store shelves and eventu-ally sour. So, as part of the price-support program, the government usually agrees to buy up the surplus milk to take it off the market. Th e federal government, in fact, has spent billions buy-ing and storing surplus agricultural products.

Price CeilingSometimes public offi cials try to keep a price below the equilibrium level by

establishing a price ceiling, or a maximum legal price. For example, concern

FIGURE 6.6 Effects of a Price Floor and a Price Ceiling

S

D

0

$2.501.90

Millions of gallons per month

Pric

e pe

r gal

lon

Surplus

241914

(A) PRICE FLOOR FOR MILK

If a price fl oor is established above the equilibrium price as in panel (A), a permanent surplus results. A price fl oor established at or below the equilibrium price has no eff ect. If a price ceiling is established below the equilibrium price as in panel (B), a permanent shortage results. A price ceiling established at or above the equilibrium price has no eff ect.

S

D

0

$1,000

600

Thousands of rental units per month

Mon

thly

rent

al p

rice

50 6040

(B) PRICE CEILING FOR RENT

Shortage

price ceiling A maximumlegal selling price above which aproduct cannot be sold

The minimum wage is a price fl oor in the market for labor. The govern-ment sets a minimum price per hour of labor in certain markets, and no employer is permitted to pay a wage lower than that. Access the Department of Labor website through the website shown below to learn more about the mechanics of the program. Then use a supply and demand graph to illustrate the eff ect of a minimum wage above equilibrium on a particular labor market. What happens to quantity demanded and quantity supplied as a result?

www.cengage.com/school/contecon

187


UNIT 2 THE MARKET ECONOMY188

about the rising cost of rental housing in some U.S. cities prompted local offi cials to impose rent ceilings, making it illegal to charge more than the ceiling price. Panel (B) of Figure 6.6 represents the demand and supply for rental housing. Th e vertical axis shows the monthly rent, and the horizontal axis shows the quantity of rental units. Th e equilibrium, or market-clearing, rent is $1,000 per month. Th e equilibrium quantity is 50,000 housing units.

Suppose city offi cials are concerned that rents of $1,000 per month are not aff ordable to enough households. Th ey pass a law setting a maximum legal rent of $600 per month. At that ceiling price, 60,000 rental units are demanded, but only 40,000 are supplied, resulting in a housing shortage of 20,000 units. Th us, the price ceiling creates a housing shortage.

Because of the price ceiling, the rental price no longer allocates housing to those who value it the most. Other devices must emerge to ration housing, such as waiting lists, personal connections, and the willingness of renters to make under-the- table payments, such as “key fees,” “fi nder’s fees,” high security deposits, and the like.

To have an impact, a price fl oor must be set above the equilibrium price, and a price ceiling must be set below the equilibrium price. A fl oor price above the equilib-rium price creates a surplus, and a ceiling price below the equilibrium price cre-ates a shortage. Various nonprice devices must emerge to cope with the disequilib-rium resulting from the market interference.

Price controls distort market prices and interfere with the market’s ability to allo-cate resources effi ciently. Prices no longer provide consumers and producers accurate information about the relative scarcity of goods. Th e good intentions of government offi cials create shortages and surpluses that often are economically wasteful.

Other Sources of DisequilibriumGovernment intervention in the market is not the only source of disequilib-

rium. Sometimes, when new products are introduced or when demand or supply changes suddenly, the market takes a while to adjust. For example, popular toys, bestselling books, the latest smartphone, and chart-busting CDs often sell out and are temporarily unavailable while suppliers produce more. In these cases, there are temporary shortages.

On the other hand, some new products attract few buyers and pile up unsold on store shelves. In these cases, there are temporary surpluses, awaiting a “clearance sale.”

What happens when governments impose price fl oors and price

ceilings?

CONSUMER SURPLUSIn equilibrium, the marginal benefi t of pizza just equals its mar-ginal cost. Th e cost to the economy of bringing that fi nal pizza onto the market just equals the marginal benefi t that consumers get from that pizza. Does this mean that consumers get no net benefi t from the good? No. Market exchange usually benefi ts both consumers and producers.

L 2Identify the

benefi ts that

consumers get

from market

exchange.



Market Demand and Consumer SurplusA demand curve shows the marginal benefi t consumers attach to each unit of

the good. For example, based on the demand curve for pizza presented earlier, consumers demand 8 million pizzas at a price of $15. Apparently, those con-sumers believe the marginal benefi t of a pizza is worth at least $15. Consumers demand 14 million at a price of $12. At a price of $9, consumers demand 20 mil-lion, even though some are willing to pay $15 each for 8 million pizzas and $12 each for 14 million pizzas.

If the price is $9 per pizza, consumers enjoy a surplus, or a bonus, because they get to buy all 20 million pizzas for $9 each, even though some are willing to pay more for lesser amounts. Consumer surplus is the diff erence between the most that consumers would be willing and able to pay for a given quantity and the amount they actually do pay.

To get a clearer idea of consumer surplus, refer to the demand curve in Figure 6.7. If the price is $2 per unit, each person adjusts his or her quantity demanded until the marginal benefi t of the fi nal unit he or she purchases equals at least $2. Each consumer gets to buy all other units for $2 each as well. Th e dark-shaded area bounded above by the demand curve and below by the price of $2 depicts the consumer surplus if the price is $2.

Th e lighter-shaded area shows the increase in consumer surplus if the price drops to $1. If this good were free, the consumer surplus would be the entire area under the demand curve. Notice that at a price of zero, the consumer surplus is not that much greater than when the price is $1. Competitive markets maximize the amount of consumer surplus in the economy.

consumer surplus The diff erence between the most thatconsumers are willing and able to pay for a given quantity of a goodand what they actually pay

FIGURE 6.7 Market Demand and Consumer SurplusConsumer surplus at a price of $2 is shown by the darker green area. If the price falls to $1, con-sumer surplus increases to include the lighter green area between $1 and $2. If the good is free, consumer surplus would increase by the lightest green area under the demand curve.

D

0

$2

1

Quantity per period

Pric

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r uni

t

189


UNIT 2 THE MARKET ECONOMY190

An Application of Consumer Surplus: Free Medical CareCertain Americans, such as the elderly and those receiving public assistance, are pro-

vided government-subsidized health care. As shown in Figure 6.8, taxpayers spent more than $750 billion in 2011 providing health care to 94 million Medicare and Medicaid recipients, for an average annual cost of more than $8,000 per benefi ciary. Medicaid is the largest and fastest-growing spending category in most state budgets. Th e dollar cost to most benefi ciaries is usually little or nothing. Th e problem with giving something away is that benefi ciaries consume it to the point where their marginal benefi t from the fi nal unit is zero. However, the marginal cost to taxpayers can be substantial.

Th is is not to say that benefi ciaries derive no benefi t from free health care. Although they may not value the fi nal unit consumed all that much, most de-rive a large consumer surplus from the other units they consume. For exam-ple, suppose that Figure 6.7 represents the demand for health care by Med-icaid benefi ciaries. Because the dollar price to them is zero, they consume medical care up to the point where the demand curve intersects the horizontal axis. Th eir consumer surplus is the entire area under the demand curve.

Th e cost to taxpayers of providing that fi nal unit of health care may be $100 or more. One way to reduce the cost to taxpayers of such programs without really harming benefi ciaries is to charge a small price—say, $1 per physician visit. Benefi ciaries would eliminate visits they value less than $1. Th is would yield signifi cant savings to

taxpayers but would still leave those in the program with good health care and a substantial consumer surplus. Th is is measured in Figure 6.7 as the area under the demand curve but above the $1 price.

Medical care, like other goods and services, is also sensitive to a time price. For example, a 10 percent increase in the average travel time required to visit a free outpatient clinic reduced visits by 10 percent.

Th ese fi ndings do not mean that certain groups shouldn’t receive low-cost health care. Th e point is that when something is provided for free, people consume it until their marginal benefi t is zero—that is, until their marginal cost equals their marginal benefi t. Even a modest money cost or time cost would reduce program costs yet still leave benefi ciaries with a substantial consumer surplus.

FIGURE 6.8 Medicaid/Medicare Average Annual Cost per Benefi ciaryWhy would the average annual cost of Medicaid or Medi-care decrease if benefi ciaries were required to pay a small amount for each service they receive?



6.3 ASSESSMENT

Think Critically 1. How does market competition ensure that consumers will be offered a selection of low-priced

foods?

2. How does market competition ensure that a fi rm is making the products that consumers value the most?

3. If the minimum wage were increased to $20 per hour, how many of your classmates do you think would look for a job? How many jobs do you expect they would fi nd? How is this an example of a price fl oor?

4. If the government set a price ceiling of $5 per month to subscribe to an Internet Service Provider (ISP), what would happen to the number of ISPs that offer Internet access and the number of people who wished to purchase their service?

5. Suppose you buy a salad for lunch every day for $2.75. This is the most you would be willing to pay for that salad. One week there is a special on salads and the price is reduced to $2.00.

What is the value of the consumer surplus you will receive if you buy fi ve salads during that week?

Graphing Exercises 6. Suppose the government became concerned about the high

price of running shoes and imposed a price ceiling of $40 per pair. Given the demand and supply schedules shown here, what would the results of such a regulation be? Why would many consumers and producers be upset with this result? Draw a graph that demonstrates the result of such a regulation.

Make Academic Connections 7. History In the early 1900s, many businesses produced horse-drawn wagons at very

low cost. Still, many of these fi rms were forced out of business due to a lack of consumer demand. Many people chose to purchase automobiles instead of wagons. Explain how this fact demonstrates the importance of allocative effi ciency.

In small teams, discuss the pros and cons of “clearance sales” with regard to consumers and sup-pliers. Who wins? Who loses? What impact do you think these sales have on the prices of other goods the store sells? Compare your team’s answers with those of other teams.

TeamWork

191

DEMAND AND SUPPLY SCHEDULES FOR RUNNING SHOES

(THOUSANDS OF PAIRS PER MONTH)

PriceQuantity

DemandedQuantity Supplied

$70 40 100

$60 50 80

$50 60 60

$40* 70 40

$30 80 20

(* government price ceiling)

How do consumers benefi t from market exchange?



PEOPLE AREN’T ROBOTSViewing people as robot-like maximizers is a simplifying assumption that can be defended on the grounds that this approach is easy to spell out in a theoretical model and is sup-ported by many empirical studies. On the other hand, psycholo-gists have come to believe that people are not as good at making decisions as economists assume. Psychologists have found that

people are prone to mistakes, are fi ckle and inconsistent, and often do not get the best deal for themselves when making choices. Psychologists have investigated the biases, faulty assumptions, and errors that aff ect how people make decisions in all aspects of life.

In recent decades, some economists have begun to draw on fi ndings from psychology to reconsider instances where people do not act according to stan-dard economic theory. Th e convergence of economics and psychology eventually created a new fi eld of study called behavioral economics, a fi eld pursued by a small but growing band of economists. Behavioral economics borrows insights from psychology to better explain some economic decisions. Th is approach questions some assumptions of traditional economics, particularly the assumptions of unbounded rationality and unlimited willpower.

6.4 B E H AV I O R A L E C O N O M I C S

Key Termsbehavioral economics 192

bounded rationality 193

limited willpower 194

neuroeconomics 195

Learning Objectives

L 1 Understand the limits of rational self-interest.

L 2 Explain the effects of bounded rationality on making economic decisions.

L 3 Understand the effects of limited willpower on making economic decisions.

L 4 Explain why some economists are mapping brain activity in the laboratory.

In Your WorldEconomists generally assume that you and other economic decision makers act rationally to maximize your overall well-being. You know what you want, you respond to incentives, and you follow through with those choices. In short, the stan-dard economic approach assumes that you and others pursue your rational self-interest. According to Adam Smith, the pursuit of self-interest in competitive markets pro-motes the general good. In the extreme, this standard approach views the economy as populated by calculating, unemotional maximizers who make choices consistent with rational self-interest and then follow through on those choices. Th is standard approach has limitations, however.

L 1Understand

the limits

of rational

self-interest.

behavioral economics An approachthat borrows insights frompsychology to help explaineconomic choices

192



What problem with standard economics does behavioral economics

try to address?

BOUNDED RATIONALITYPsychologists have long argued that people have limited information-processing capabilities. Th e term bounded rationality describes a more realistic conception of human problem- solving ability. Bounded rationality is the idea that there are limits on the amount of information people can comprehend and act on. Because humans have only so much brainpower and only so much time, they cannot be expected to solve complex production or consumption problems opti-

mally. When faced with lots of information that they aren’t sure how to process, most people rely on simple rules of thumb for guidance.

Psychologists fi nd that people, when facing complex fi nancial decisions, are prone to inertia, even when making no decision may cost them money. Th e simplest rule of thumb in the face of a diffi cult decision is to avoid making it. In the face of uncertainty, doing nothing or doing little also means that people are inclined to accept whatever option is presented to them. For example, employees have a strong tendency to stick to whatever retirement savings option an employer presents, even when they are free to choose better options.

L 2Explain the

effects of

bounded

rationality

on making

economic

decisions.

What do psychologists suggest as the reason people do not always make wise economic decisions?

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bounded rationality There are limits to the amount of information people can compre-hend and act on

193



Companies are trying to help their employees overcome inertia about retire-ment savings. Under the old system, the company would send a letter to employ-ees inviting them to participate in the retirement program, whereby the company would match a certain amount of employee savings. To participate, the employee would have to fi ll out and return a form choosing an option. An employee who failed to act would not be enrolled. Many failed to act, thus passing up free matching money from the company. To help their employees overcome this inter-tia, most companies now automatically enroll an employee in the program unless that employee explicitly opts out. By simply switching the default option—that is, what happens if you do nothing—companies increased employee participation dramatically.

Inertia is also why, once people make a decision or allow a decision to be made for them, they tend to stick with that option even when circumstances change. In short, people try to avoid making hard choices even when the consequences of no decision are costly to them. In that regard, people do not seem to be pursuing their rational self-interest.

What rule of thumb do some people follow when faced with a

complex and diffi cult decision?

LIMITED WILLPOWERA second assumption of traditional economics is that people, once they make a decision, have unlimited willpower. Th is means they have complete self-control and can follow through with every decision. But even when they know what’s best for them, people often lack the discipline to follow through. People have limited willpower, which is limited self-discipline in following through with decisions that are in their self-interest, especially in their long-term interest.

Most people, despite their best intentions, end up eating, drinking, or spend-ing too much, and exercising, saving, or studying too little. For example, nearly two-thirds of American adults are overweight. You may fi nd yourself watching TV instead of studying for an exam or spending impulsively now rather than saving for something that really matters.

Market and nonmarket solutions have evolved to help people overcome self-discipline problems. From morning weigh-ins to New Year’s resolutions, people use devices to help boost their willpower. Th ose who want to study more, save more, exercise more, quit smoking, lose weight, quit drinking, shop less impul-sively, get off drugs, or stop gambling often are willing to pay time and money for help, as with tutors and enforced study hours, payroll-savings plans, fi tness trainers and club memberships, nicotine gum and patches, diet plans and weight-loss surgery, Alcoholics Anonymous, Shopaholics Anonymous, drug rehab treat-ment, and Gamblers Anonymous. Some casinos allow problem gamblers to ban

limited willpowerLimited self-discipline infollowing through with decisions that are in one’s self-interest, especially one’s long-term interest

L 3Understand

the effects

of limited

willpower

on making

economic

decisions.

194



themselves from the premises. Th ey will be turned away if they show up and can be denied any winnings if they do manage to gamble and win.

To pursue long-term goals, people must be able to postpone at least some immediate gratifi cation. More economists are now looking at willpower issues.

What are some market and nonmarket approaches to help people

overcome self-discipline problems to achieve their goals?

NEUROECONOMICSTraditional economics looks at how people react to a change in their incomes, in prices, or in some other factor aff ecting their choices. Th us, traditional economics is based on what people do in response to a change in circumstances. Some behavioral econ-omists are now digging deeper into economic choices by draw-ing on advances in brain imaging technology. Th is new subfi eld of behavioral economics, called neuroeconomics, examines how economic decision-making aff ects areas of the brain.

In a typical experiment, a test subject is asked to make an economic decision. Th e experimenter, using magnetic resonance imaging (MRI), then measures activ-ity in the parts of the brain associated with that choice. By mapping brain activity, these researchers hope to develop more realistic models of economic decision-making.

Here are three types of choices test subjects have been asked to make:

1. Choices involving uncertainty and risk (for example, would you prefer hav-ing $100 for certain or, instead, having a 50 percent chance of $300 and a 50 percent chance of zero)

2. Choices involving present versus future outcomes (for example, would you prefer receiving $100 today or $125 one year from today)

3. Social choices involving strategic interactions with other people (for exam-ple, how much of a $100 reward would you be willing to share with some-one you didn’t know)

Th e fi ndings of neuroeconomists have challenged the traditional view that economic choices boil down to a simple process of utility maximization. Th eir laboratory results suggest a more complex interaction among competing objec-tives. For example, your rational self-interest is sometimes in confl ict with your ethical sense of fairness. You often feel concern for others and may try to help them even if that confl icts with your rational self-interest.

How does neuroeconomics explore economic decision making?

neuroeconomics Themapping of brain activity whilesubjects make economic choicesto develop better models of economic decision making

L 4Explain

why some

economists

are mapping

brain activity

in the

laboratory.

195



Working in small teams, make a list of shopping decisions that members of your team have made that they later came to regret. Identify reasons why each decision was made and how similar deci-sions could be avoided in the future. Compare your work with that of other teams.

TeamWork Working in small teams make a list of shopping decisions that members of your team have madeT WW k

Think Critically 1. Gina always wants to wear the latest fashions. She subscribes to several fashion magazines

and dresses as much like the models as her budget will allow. Explain why she is likely to make decisions that are not in her best economic interest.

2. Gina does almost all of her clothing shopping at her favorite boutique. Although she some-times learns that she could have purchased the same garments at a lower price somewhere else, she continues to shop at the boutique. Explain what inertia may have to do with her choice of where to shop.

3. Gina almost always spends more for clothing than she intends to spend. As a result, she can’t buy other things she needs and has run up a substantial balance on her credit card. Explain how this demonstrates her limited willpower.

Graphing Exercise 4. An entrepreneur has operated a shoe store in a mall for many years. Last year she opened

another store at a mall in a different community. The two communities are similar in terms of population, income, and shopping habits. Still, the new store’s sales were much lower. The owner commisioned a market survey to determine the quantity of shoes that would be demanded per week at each store at differ-ent prices. Use these data to construct a graph showing the demand curves for each of the stores. Explain what bounded rationality may have to do with the greater quantities demanded at the old store.

Make Academic Connections 5. Entrepreneurship You own the boutique where Gina likes to shop. You would like to

encourage Gina and other shoppers to buy many of your garments but not so many that they are unable to pay their bills. How would you encourage your salespeople to deal with Gina?

6.4 ASSESSMENT

DEMAND SCHEDULE FOR SHOES

PriceOld Store

Quantity DemandedNew Store

Quantity Demanded

$60 400 125

$70 390 100

$80 390 75

$90 370 50

196


On March 20, 1823, an ad appeared in the Missouri Republican:

This call for young men began the era of the Mountain Men and the fur trade in the American Far West. To the north, the French and the British had long established a profi table fur trade in North America. However, Ameri-cans did not reach the Far West until after the Lewis and Clark expedition. The trade was driven by the demand for furs in the eastern United States and in Europe, but the Napoleonic Wars and the War of 1812 closed many

of these markets. When the wars ended, the demand once again rose in the United States and Europe.

With the establishment of trading posts, most furs were obtained by trading with Native Americans. Some were obtained by company-employed hunt-ers and trappers. Furs also could be purchased from independent hunters and trappers. The Rocky Moun-tain Fur Company cut costs by taking an innovative approach that would send groups of trappers into the wilderness. Each would trade or trap furs and then meet at the end of the season at a predetermined location. At that rendezvous, the Mountain Men would sell their furs and obtain supplies for the next season. This method allowed the company to avoid the cost of building and maintaining of expensive trading posts.

Think CriticallyUsing supply and demand curves, demonstrate the fol-lowing situations:

1. The eff ects of the end of the War of 1812 on the market for fur

2. The eff ects of depleting the stock of fur-bearing animals on the supply of furs

3. The eff ect of substituting wool for fur in men’s hat

The Rocky Mountain Fur Company

Chapter 6 M a r ke t Fo r ce s 197

Sources: Ann M. Carlos, The North American Fur Trade, 1804–1821: A Study in the Life-Cycle of a Duopoly, New York: Garland Publishing, Inc., 1986; Hiram Martin Chittenden, American Fur Trade of the Far West, Vols. 1 & 2, Lincoln, Nebraska: University of Nebraska Press, 1987; Victor R. Fuchs, The Economics of the Fur Industry, New York: Columbia University Press, 1957; Jon E. Lewis, The Mammoth Book of the West, New York: Carrol & Graf Publishers, Inc., 1996; and Oxford History of the American West, Clyde A. Milner, Carol A. O’Connor, Martha A. Sandweiss, eds., New York: Oxford University Press, 1994.



Chapter 6 Summary

6.1 Price, Quantity, and Market EquilibriumA. In a competitive market, the forces of demand and supply push the price to its equilibrium level,

where quantity demanded equals quantity supplied.

B. Any price above the equilibrium level creates a surplus, which forces the price down to its equilib-rium level. Any price below the equilibrium level creates a shortage, which forces the price up to its equilibrium level.

C. In competitive markets, buyers and sellers are free to exchange goods for money. Because this exchange is voluntary, neither party would bother unless it expected to gain.

D. Transaction costs are the costs of time and information involved in carrying out market exchanges—that is, the costs of bringing together buyers and sellers and working out a deal. By reducing transaction costs, markets promote exchange.

6.2 Shifts of Demand and Supply CurvesA. A change in any one of fi ve factors can shift the demand curve for a product: (1) the money income

of consumers, (2) the prices of substitute or complementary products, (3) consumer expectations, (4) consumer population, and (5) consumer tastes.

B. A change in any one of fi ve factors can shift the supply curve for a product. These factors are (1) cost of a resource used to make the product, (2) prices of other goods that these resources could make, (3) technology, (4) producer expectations, and (5) number of producers.

C. A shift of the demand curve or the supply curve changes the equilibrium price and quantity.

6.3 Market Effi ciency and the Gains from ExchangeA. Competitive markets result in productive and allocative effi ciency. Productive effi ciency occurs

when goods are produced at the lowest possible cost per unit. Allocative effi ciency occurs when fi rms produce the goods consumers most value.

B. Disequilibrium occurs when the quantity consumers demand does not equal the quantity producers supply. Government-imposed price fl oors are likely to create product surpluses, while government-imposed price ceilings usually create shortages.

C. Consumer surplus is the difference between the most that consumers would have been willing to pay for a product and what they actually pay for it. Competitive markets typically maximize consumer surplus, which is good for consumers.

6.4 Behavioral EconomicsA. Behavioral economics uses insights from psychology to explain some economic decisions. Psycholo-

gists have found that people are prone to mistakes, are fi ckle and inconsistent, and often do not seek the best deal when making choices.

B. Bounded rationality is the idea that there are limits to the amount of information that people can comprehend and act on.

C. Because of limited willpower, many people have diffi culty following through with decisions that are in their self-interest, especially their long-term interest.

D. To develop better models of how people make economic decisions, neuroeconomists map brain activity as test subjects make such choices.

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Why do some prices adjust more slowly?

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