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

• 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

Advantages of Prices

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?

• 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

Allocations Without Prices

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

• 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

Price as a System

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

• 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

The Price Adjustment Process

Figure 6.1aFigure 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 6.1aFigure 6.1aSURPLUS= occurs

when supply EXCEEDS demand

SHORTAGE= occurs when demand

EXCEEDS supply

EQUILIBRIUM PRICE = occurs when supply

MEETS demand

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

• 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

Explaining and Predicting Prices: Change in Supply

Figure 6.3aFigure 6.3a

Change in Supply

• 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: Importance of Elasticity

• Changes in income, taxes, prices of related goods, expectations, and number of consumers

• Example: GOLD

Explaining and Predicting Prices: Change in Demand

Figure 6.4Figure 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 6.5aFigure 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 6.5bFigure 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 6.6aFigure 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 6.6bFigure 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