CHAPTER 6 Prices and Decision Making

Section 1: Prices as Signals

• Main Idea: Competitive markets and prices are important to capitalism.

• Objectives: • Explain how prices act as signals.• Describe the advantages of using prices as a way to

allocate economic products.• Understand the difficulty of allocating scarce goods and

services without using prices.

Section 1 Introduction

• Life is full of signals that help us make decisions.

• For example, when we pull up to an intersection, we look to see if the traffic light is green, yellow, or red.

• We look at the other cars to see if any have their blinkers on, and in this way we receive signals from other drivers regarding their intentions to turn.

• Doctors even tell us that pain is a signal that something is wrong with our body and may need attention.

• But have you ever thought about the signals that help us make our everyday economic decisions?

• It turns out something as simple as a price–the monetary value of a product as established by supply and demand–is a signal that helps us make our economic decisions.

Section 1 Introduction (cont.)

• Prices communicate information and provide incentives to buyers and sellers.

• High prices are signals for producers to produce more and for buyers to buy less. Low prices are signals for producers to produce less and for buyers to buy more.

Section 1 Introduction (cont.)

• Prices are neutral because they do not favor the buyer or the consumer. They are the result of competition.

• Prices are flexible, allowing for the “shocks” of unforeseen events and changes in the market.

• Prices have no administration costs.• Prices are familiar and easily understood.

Advantages of Prices

• Rationing, or the system where the government decides everyone’s “fair” share, leads to the question of fairness.

• Rationing leads to high administrative costs.• Rationing leads to fewer incentives to work

and produce.

Allocations Without Prices

• Together, prices comprise a system that helps buyers and sellers allocate resources between markets, linking all markets in the economy.

Prices as a System

Section 2: The Price System at Work

• Main Idea: Changes in demand and supply cause prices to change.

• Objectives: • Understand how prices are determined in competitive

markets.• Explain how economic models can be used to predict

and explain price changes.• Apply the concepts of elasticity to changes in prices.

Section 2 Introduction

• One of the most appealing features of a competitive market economy is that everyone who participates has a hand in determining prices.

• This is why economists consider prices to be neutral and impartial.

• The process of establishing prices is remarkable because buyers and sellers have exactly the opposite hopes and desires.

• Buyers want to find good buys at low prices. Sellers hope for high prices and large profits.

• Neither can get exactly what they want, so some adjustment is necessary to reach a compromise.

Introduction (cont.)

• Together, 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.

The Price Adjustment Process

Figure 6.1aFigure 6.1a

The Price Adjustment Process (cont.)Figure 6.1bFigure 6.1b

• Surpluses occur when supply exceeds demand.

The Price Adjustment Process (cont.)Figure 6.2aFigure 6.2a

• Shortages occur when demand exceeds supply.

The Price Adjustment Process (cont.)Figure 6.2bFigure 6.2b

• The equilibrium price is the price at which supply meets demand.

The Price Adjustment Process (cont.)

Figure 6.2cFigure 6.2c

The Price Adjustment Process (cont.)Figure 6.2dFigure 6.2d

• A change in price is normally the result of a change in supply, a change in demand, or both.

Explaining and Predicting PricesFigure 6.3aFigure 6.3a

• Even small changes in an inelastic supply can create big changes in price.

Explaining and Predicting Prices (cont.)

Figure 6.3bFigure 6.3b

• Elastic supply and demand help keep prices from changing dramatically.

Explaining and Predicting Prices (cont.)Figure 6.4Figure 6.4

• The theory of competitive pricing represents a set of ideal conditions and outcomes; it serves as a model to measure market performance.

• In theory, a competitive market allocates resources efficiently.

• To be competitive, sellers are forced to lower prices, which makes them find ways to keep their costs down.

• Competition among buyers keeps prices from falling too far.

The Competitive Price Theory

Section 3: Social Goals vs. Market Efficiency

• Main Idea: To achieve one or more of its social goals, government sometimes sets prices.

• Objectives: • Describe the consequence of having a fixed price in a

market.• Explain how loan supports and deficiency payments

work.• Understand what is meant when “markets talk.”

Section 3 Introduction

• Chapter 2 examined seven broad economic and social goals that most people seem to share.

• We also observed that these goals, while commendable, were sometimes in conflict with one another.

• These goals were also partially responsible for the increased role that government plays in our economy.

• The goals most compatible with a market economy are freedom, efficiency, full employment, price stability, and economic growth.

• Attempts to achieve the other two goals—equity and security—usually require policies that distort market outcomes.

• In other words, we may have to give up a little efficiency and freedom in order to achieve equity and security.

• Whether this is good or bad often depends on a person’s perspective.

Section 3 Introduction (cont.)

• After all, the person who receives a subsidy is more likely to support it however, it is usually wise to evaluate each situation on its own merits, as the benefits of a program may well exceed the costs.

• What is common to all of these situations, however, is that the outcomes can be achieved only at the cost of interfering with the market.

Introduction (cont.)

• After all, the person who receives a subsidy is more likely to support it than is the taxpayer who pays for it.

• In general, it is usually wise to evaluate each situation on its own merits, as the benefits of a program may well exceed the costs.

• What is common to all of these situations, however, is that the outcomes can be achieved only at the cost of interfering with the market.

Introduction (cont.)

• Achieving equity and security (two of the seven broad economic and social goals) usually requires policies that distort market outcomes.

• One way to achieve these goals is to set “socially desirable” prices, which interferes with the pricing system.

• Setting price ceilings affects the allocation of resources.

• The minimum wage is an example of a price floor.

Distorting Market Outcomes

Distorting Market Outcomes (cont.) Figure 6.5aFigure 6.5a

Distorting Market Outcomes (cont.) Figure 6.5bFigure 6.5b

• Government loan support was offered in the 1930s through Commodity Credit Corporation to help stabilize agricultural prices. The CCC loan program led to food surpluses.

• The CCC switched to deficiency payments, which prevented the government from holding surplus food and had farmers sell their crops on the open market.

Agricultural Price Supports

Figure 6.6aFigure 6.6a

• In 1996, Congress passed FAIR—Federal Agricultural Improvement and Reform Act. Cash payments replaced price supports and deficiency payments. The payments ended up costing as much. In 2002, farmers will no longer receive any kind of payments.

Agricultural Price Supports (cont.)Figure 6.6bFigure 6.6b

• Markets “talk” when prices move up or down dramatically.

• Buyers and sellers respond to changes in the market through their decisions.

When Markets Talk

Key Terms • Price• Rationing• ration coupon • Rebate• economic model• market equilibrium • surplus • shortage • equilibrium price• price ceiling

• minimum wage • price floor • target price • nonrecourse loan • deficiency payment