Copyright © Pearson Education, Inc.Slide 1 Chapter 6, Section 3 Essential Question Ch 6: What is the right price? Section 3: What role do prices play in

Copyright © Pearson Education, Inc. Slide 1Chapter 6, Section 3

Essential QuestionEssential QuestionCh 6: What is the right price?

• Section 3: What role do prices play in a free market economy?


ObjectivesObjectives

1. Identify the many roles that prices play in a free market.

2. List the advantages and disadvantages of a price-based system.

3. Describe the relationship between prices and the profit incentive.


IntroductionIntroduction

• What roles do prices play in a free market economy?– In a free market economy, prices are used to

efficiently distribute goods and resources throughout the economy

– Prices play other roles, including:• Serving as a language for buyers and sellers• Serving as an incentive for producers• Serving as a signal of economic conditions


Advantage of Prices:Incentive and SignalsAdvantage of Prices:Incentive and Signals• Prices can act as a signal to both producers and

consumers:

Producers

– high price tells producers there is high demand and they should make more.

– low price tells producers there is too much supply

Consumers

– high price tells consumers to think about their purchases more carefully.

– low price tells consumers to buy more of the product.


Advantage of Prices:Flexibility of PricesAdvantage of Prices:Flexibility of Prices

• Prices are flexible

– Prices increased to solve problems of shortage

– Prices decreased to solve problems of surplus.


Advantage of Prices:Consumer ChoicesAdvantage of Prices:Consumer Choices

• How do prices provide more consumer choice?– Prices help consumers choose among similar

products– Allow producers to target customers specific

products– We all want different things


Advantage of Prices: Efficient Resource AllocationAdvantage of Prices: Efficient Resource Allocation

• Prices allow for efficient resource allocation– the factors of production (land, labor, capital)

will be used for their most valuable purposes.

• Price and profit incentive– Efficient use of resources means profit will be

maximized (MR = MC)


Advantage of Prices: The Profit IncentiveAdvantage of Prices: The Profit Incentive

• Financial rewards motivate people. How have you provided or benefited from the profit incentive?


Disadvantage of Prices:Shortage and RationingDisadvantage of Prices:Shortage and Rationing

• During wartime, famine or an emergency (Oil crisis, Katrina, Haiti earthquake), supply shocks are common

• The market would result in higher prices for essential goods: water, food, gas

• One response to shortages is rationing

– Government, UN or NGO controls how much everyone consumes


Disadvantage of Prices:Shortage and Black MarketsDisadvantage of Prices:Shortage and Black Markets

• Shortage leads to higher prices

• Black markets develop (especially during rationing)

– They provide more supply (at higher prices)

• Some examples of Black Market shortages?

– Illegal drug markets

– Scalpers/Stubhub tickets for soldout events

– Fuel and food in many developing countries and places going through war and revolution


Disadvantage of Prices:Market Failure: Public GoodsDisadvantage of Prices:Market Failure: Public Goods

• Public goods

– Wouldn’t get supplied by the market because people are unwilling to pay for the goods or services

– Market doesn’t provide because

• Free rider problem

• Nonrival goods


Disadvantage of Prices:Market Failure: Negative ExternalitiesDisadvantage of Prices:Market Failure: Negative Externalities• Negative externalities are social costs that no

one pays for– When we consume gas, buyers and sellers don’t pay

the extra cost of pollution

– When a BBQ-joint sells food, it doesn’t pay the extra cost of making all the dry cleaners clothes smell like BBQ

• Negative externalities lead to:– Too much supply

– Too much demand

– More output than is socially optimal


Disadvantage of Prices:Imperfect Competition and InformationDisadvantage of Prices:Imperfect Competition and Information

• Imperfect competition

– All sellers may not be equal, which may affect prices (the Wal-Mart effect)

• Imperfect information

– All buyers may not have equal information, which may affect demand and prices

– What if you could buy the newest Xbox before everyone else?

– What if you were told there would be a shortage of gasoline starting tomorrow?


Advantages of PricesAdvantages of Prices

• What are the Advantages of Prices?

– Signals to producers/consumers

– Incentives to producers

– Flexibility in shortages/surplus

– Efficient use of resources

– Profit maximization


Disadvantages of PricesDisadvantages of Prices

• What are the Disadvantages of Prices?

– Shortages lead to rationing/black market

– Public goods aren’t provided by the market

– Negative externalities lead to too much output

– Imperfection competition affects prices

– Imperfect information affects demand


Key TermsKey Terms• supply shock: a sudden shortage of

a good• rationing: a system of allocating scarce goods and

services using criteria other than price• black market: a market in which goods are sold

illegally, without regard for government controls on price quantity

• Socially optimal output: equilibrium output if negative externalities were accounted for

• Imperfect information: when all buyers don’t have the same information

• Imperfect competition: when all sellers aren’t equal

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Copyright © Pearson Education, Inc.Slide 1 Chapter 6, Section 3 Essential Question Ch 6: What is the right price? Section 3: What role do prices play in