How Prices are Determined

In a free market economy, supply and

demand are coordinate through the price

system. Everyone who participates in the

economy jointly determines prices. Prices

are considered neutral and impartial.

How the Price System Works

The Market Economy Price System has four key characteristics1. It is neutral: prices don’t favor the producers nor the

consumers2. It is market driven: market forces determine prices, there

are no administrative decisions.3. It is flexible: prices can change to respond quickly to

changing market conditions.4. It is efficient: prices will adjust until the maximum number

of goods and services are sold.

The Price system also serves several functions:• Information Function: The price system provides vital information

to producers, resource providers and consumers• Producers need to know if it is good time to enter a market and

what to produce at what prices• Resource providers need to know what resources to provide, how

much and at what price• Consumers need to know what they are willing and able to buy

• Incentive Function: The price system motivates providers and consumers to act in different ways

• Producers are motivated to make money• Resource Providers are motivated to allocate natural resources• Consumers are motivated to buy products at the best possible

prices.PRICES ACT AS SIGNALS

How Prices are Determined

●Buyers and sellers have exactly the

opposite hopes and intentions.

●Buyers want good buys at low prices.

●Sellers want high prices and profits.

Fundamental Conflict

• The Law of Supply says that suppliers will produce more when price is high and less when price is low .

• The Law of Demand says that consumers will buy more when price is low and less when price is high

The Compromise

• Producers must be able to charge enough to cover costs and earn a reasonable profit

• Consumers can only pay prices they are willing and able to pay

• Market Equilibrium (the compromise): occurs when the quantity demanded and the quantity supplied are a particular price are equal.

• Equilibrium Price ($): The price at which quantity demanded and quantity supplied are equal.

Market Equilibrium

●The adjustment

process moves

toward market

equilibrium – a

situation where prices

are stable and the

quantity supplied is

equal to the quantity

demanded.

Market Equilibrium●Why does the market find the

equilibrium price of $5 on its own and why is the quantity supplied exactly equal to the quantity demanded at this price?

●Why did the price not reach equilibrium at $7, or $6, or at some other price?

●In order to answer these questions, we have to examine the reactions of the buyers and sellers to various market prices.

Surplus (Quantity Supplied > Quantity Demanded)

• Producers do not know what price they should charge to hit the market equilibrium price, so they must adjust their prices in an attempt to reach equilibrium

• A surplus occurs when the price is set too high

• A surplus occurs because the producers are willing to supply more product than consumers are willing to buy

Surplus

●If suppliers guess that

the price will be $7,

they will want to

produce 1400 gadgets.

●However, consumers

will only buy 990 units

at at a price of $7,

leaving a surplus of

410 gadgets.

Surplus●A Surplus is a situation in which

the quantity supplied is greater

than the quantity demanded at a

given price.

●A surplus causes prices to go

down (it’s the only way for

suppliers to fix a surplus), the

quantity demanded to rise, and

the quantity supplied to go

down.

●As long as price is flexible, the

surplus will only be temporary.

Shortage (Quantity Supplied < Quantity Demanded)

• A shortage occurs when price is set too low

• A shortage occurs because consumers are willing to buy more product than producers are willing to supply at a given price.

Shortage

●If $7 is too high, producers might consider $4.

●At that price, the quantity supplied changes to 1,250 gadgets.

●However, at $4, consumers would buy 1,470 gadgets , resulting in a shortage of 220.

Shortage

●A shortage is a

situation in which the

quantity demanded is

greater than the

quantity supplied at a

given price.

●A shortage causes

prices to go up and the

quantity supplied to

increase.

Equilibrium Price

●The equilibrium price is the price where quantity supplied equals the quantity demanded, - there is neither a surplus nor a shortage.

●The equilibrium price will maintain until something disturbs the market.

Equilibrium Price●This theory is set in ideal conditions.

●Price represents the balancing forces of demand and supply.

●The great advantage of competitive markets is that they allocate resources efficiently.

●As sellers compete to meet consumer demands, they are forced to lower costs and prices.

●At the same time, competition among buyers helps prevent prices from falling too far, and helps allocate goods and serves to those willing and able to pay.

Market Equilibrium Can Change

Market Equilibrium is the point at which the supply curve and the demand curve intersect. Therefore if either curve shifts, then the market is in:Disequilibrium: When the quantity demanded and the quantity supplied are not in balance.

A Change in Demand and the Equilibrium Price

Remember, a change in demand causes the curve to shift and is determined by one of six non-price determinants which are:

1.) Consumer Tastes

2.) Consumer Income

3.) Market Size (# customers)

4.) Consumer Expectations

5.) Price of Related Goods

A change in demand and equilibrium price

A change in supply and equilibrium price

Remember, a change in supply causes the supply curve to shift and is determined by one of 7 non-price determinants of supply

Fixed Prices

●Up to now, we have assumed

that the market was

reasonably competitive, and

that prices and quantities

were allowed to fluctuate.

●What happens when

government policies fix the

prices people either receive

or pay?

Fixed Prices

●Price ceilings set

the maximum legal

price that can be

charged for a

product. This often

creates a shortage.

●Who would love

the lower price?

●Who would not?

Examples of Price Ceilings

Price Ceilings on ticket prices for Syracuse University Men’s basketball tickets.Ticket prices are kept low so students can afford them, but this lower price leaves demand very high and causes a shortage scalpers

Example: Rent Control

● Some cities, especially New York City, have

rent control laws to keep housing affordable.

The laws control when rents can be raised

and by how much, however there are

unexpected consequences:

● Shortages: no incentive to increase the

supply of rentals b/c as market prices rise

and rent remains the same, landlords make a

smaller profit.

● Devalued Property: no incentive for landlords

to keep property looking nice so they don’t

and the property loses value

Fixed Prices

●Occasionally, prices are considered too low, and some people believe they should be kept higher.

●The minimum wage, the lowest legal wage that can be paid to most workers, is a case in point.

Fixed Prices●Price floors set the lowest

legal price that can be paid for a good or service. This often leads to a surplus.

●Is the current minimum wage higher or lower than the wage that would prevail in its absence?

●Do you think an employer would pay you less if he or she were allowed to do so?

Consequences of price floors

Minimum Wage (first set in 1938)• If the minimum wage is set above the

equilibrium price, the number of jobs is less than the number of workers so employers may decide that paying high wages is no longer profitable and they will employ fewer people

• If the minimum wage is set below the equilibrium price there may be no workers who are willing to work at that price.