Prices and Decision Making Prices as Signals Price: The monetary value of a product as established by supply and demand. Advantages of prices They help decide the three basic questions of WHAT, HOW and WHOM They perform the allocation function in four ways. Prices are neutral: They are the result of competition between buyers and sellers. They represent compromises by both sides. They favor neither the producer nor the consumer. Prices in a market economy are flexible: Things such as natural disasters affect the prices of products. Flexibility allows for a market economy to accommodate change. Prices have no cost of administration; Competitive markets find their prices without outside help or administration. When prices change, there is no need to get clearance from an outside agency or committee. When prices change from one level to another, the change is usually gradual enough that people hardly notice. Prices are easily understood: We have known about them all of our lives. If we know the price of something, there is little question of how much we have to pay for something. This concept allows people to make quick decisions about whether or not they want to buy an item. What if we didnt have prices? How would we know how to get things we needed? Intelligence? Good looks? Political connections? Rationing: A system in which the government or some other agency decides who gets what. Ration Coupon: A ticket or coupon that entitles the holder to obtain a certain amount of a product. Has been used in situations such as wartime. Fairness: Everybody thinks that their share is too small. How does a government allot the products? High administration cost: Someone has to pay for the distribution and the printing of the ration coupons. But, no matter how carefully this process is done, there will always be stolen, sold, or counterfeited and used to get additional amounts of a product. Diminishing incentive: People gain less and less of an incentive to work and produce. If you knew that, no matter how hard you worked, you were always going to get the same amount of coupons for a certain product, how would you react? Prices link all markets in the economy: Oil crisis of the 1970s: Price per barrel went from $5 to $40 The full-size automobile market was one of the first to feel the effects. Auto makers thought the increase was temporary, so they offered a rebate. This didnt completely work, so they had to cut production. This meant closing factories and laying off employees. The Price System at Work The price adjustment process shows five things: 1. Economic model 2. Market equilibrium 3. Surplus 4. Shortage 5. Equilibrium Price This is one of the more popular tools used in economics. It can be shown on a chart as a combination of market supply and demand schedules. Or it can be shown graphically with supply and demand curves. This is reached when the quantity of goods and services is equal to the quantity demanded. Prices must be stable in order for this to take place. This is a situation in which the quantity supplied is greater than the quantity demanded at a given price. In a store, a surplus shows up as unsold products on suppliers shelves. When there is a surplus, the price tends to drop. This is a situation in which the quantity demanded is greater than the quantity supplied. When this happens, stores shelves are usually empty, and producers should have charged more for their product. As a result, both the price and the quantity supplied will go up the next time. This is the price that clears the market. There is neither a shortage or a surplus. This happens as a result of the pressure that shortages and surpluses put on a products price. This shows how the importance of changes in supply and demand, as well as a products elasticity, affect the price for an item. This represents an ideal set of conditions and circumstances. Competitive markets allocate resources efficiently. As sellers compete to meet demands, prices will stay low. But competition among buyers helps prevent prices from falling too low. Social Goals vs. Market Efficiency Price Ceilings: Landlords Rent control: Setting a price ceiling to create a permanent shortage. Why would they want to do this? Price Floors Minimum wage: Creates a surplus of labor.