Prices and Decision Making Chapter 6

Chapter EQ 6-1:Why would it be difficult to allocate scarce goods and services without pricing? 6-2: How are prices determined in competitive markets? 6-3:What is the consequence of having a fixed price?

6.1 Prices as Signals

I. Prices As Signals A. Our life is full of signals. Green light, blinkers, pain in our body signals something is wrong. B. What about Economics? 1.Something as simple as Price can be a signal that helps us make our decisions. i. Price: Monetary value of a product as established by supply and demand.

Advantages of Prices #1: Price in a competitive economy are neutral because they favor neither the producer or consumer. a. Prices are the result of competition between buyers and sellers. #2: Prices are flexible. a. Ex: Personal Computers. In the early 90’s they were very expensive because they were scarce. New competitors came in and offered new technology. The more competition that came in the more the price dropped.

…More Advantages #3: Prices have no cost of administration therefore efficient a. You do not need committees, bureaucrats, or other outside help to set a price. You can find and set your own price. There is no law saying you have to set a certain price. #4: Prices are easy to understand offering clarity. a. If something cost $1.99 then we know what to pay.

III. Allocations Without Prices So, What would life be like without Prices? Try Cuba: There was an exhibition game against the Orioles in Cuba a couple years ago. Tickets were not for sale. They were given to Communist Party members and union members. A. Another system called Rationing - a system under which an agency such as the government decides who gets their “fair” share. Under this system people get a ration coupon, or a ticket, that entitles them to obtain a certain amount of product.

The Problem With This A. First Problem: Fairness - Everybody thinks their ration is too small. B. Second Problem: High Administrative Costs - Someone has to make the coupons. Pay somebody to make the coupons. Like our society, people will probably steal or counterfeit the coupons. C. Third Problem: Diminishing Incentive - People do not have much motivation to work. Human nature always tells us to strive for more and earn more. (Well, Most of us). How motivating is it that we will be working for the same coupon every week and never improve our wealth?

IV. Prices as a System A. Economists favor the price system because it works as a whole. - Ex: In the 1970’s a barrel of oil went from $5 to $40. This meant the gas prices went up. Oil is inelastic because people need to buy it. That meant they spent more money on oil and less on other things. B. Prices link all markets in the economy!

Discussion Question Q: Why do you think that rebates were not enough to reenergize the big-car market during the 1970’s oil crisis? The rebates did not solve the problems of getting paying for the additional gasoline larger cars required.

6.1 EQ Why would it be difficult to allocate scarce goods and services without pricing?

6.2 The Price System at Work

I. The Price Adjustment Process Establishing prices is remarkable because you have the buyer who does not want to spend a dime and the seller who wants to make “cash money” There must be a compromise. Ch. 6.2

The Economic Model Economic Model: set of assumptions that can be listed in a table or graph to help predict outcomes. Turn to Page 143. Demand curve from page 92 and Supply Curve from page 117. Both put on same graph.

A. Market Equilibrium 1. Market Equilibrium: situation in which prices are relatively stable and the quantities of goods supplied is equal to quantity demanded. Ex:Page 143: Equilibrium is reached when the price is $15.

B. Surplus 1. Day 1: Price set at $25. If you look at figure 6.1 you see suppliers will produce 11 units for sale at that price. Seller finds out that they only get one buyer leaving a surplus of 10. a. Surplus: situation in which the quantity supplied is greater than the quantity demanded. You can also see it on the graph on page 145. Panel A. i. Therefore the price must go down for seller to get rid of surplus.

C. Shortage 1. Day 2: The seller is more cautious. So he sells the CD’s for $10 a pop. For $10 a CD the seller will supply 3. Now 10 are demanded leaving a shortage of 7. a. Shortage: quantity demanded is greater than quantity supplied. See Panel B. i. Therefore prices will rise and more people willing to pay more.

D. Equilibrium Price 1. Day 3: Seller says alright lets try $15 for a CD. a. Finally reaches Equilibrium Price. i. Equilibrium Price: Price that clears the market by leaving neither a surplus nor a shortage at the end of the trading period.

II. Explaining and Predicting Prices A. Changes in Supply. Ex: Say you are a farmer and you know weather will be harmful or beneficial each year. Say you make an Economic Model of 3 different possibilities. →Turn to Page 146. “Bad Weather” – “Normal, What is Anticipated” – and “Good Weather”. Do not let the graph scare you. Just 3 different scenarios. Inelastic and Elastic Demand = If people need soybeans then farmer will make it inelastic. Prices higher. If people really don’t need soybeans then it elastic and farmer will make prices more reasonable.

...Continued B. Changes in Demand i. Demand changes by factors of consumer income, tastes, related products, etc. Ex: Look at Page 147. The demand of Gold has decreased over the years. Why? -Bling Bling …Ice! = Platinum/Silver/Diamonds are in now. -Gold is for Mr. T. He is old school.

III. Competitive Price Theory A. Represents a set of ideal conditions and outcomes. Pure competition helps set practical prices. →Check the grocery store. Milk, bread, flour, etc. are usually same prices because stores are right around the corner. →Go to a sporting event and a coke costs you $10. Why? There is no competition inside the ball park. They have you trapped. You have no where else to go. Same goes for gas stations in the middle of nowhere.

6.2 EQ How are prices determined in competitive markets? They are determined by the buyers and sellers. Sellers set the supply and buyers set the demand, eventually the 2 curves will cross at the point of equilibrium and a compromised price must be met.

6.3 Social Goals vs. Market Efficiency

I. Distorting Market Outcomes A. Achieving equity and security (2 of the economic goals- remember?) usually requires policies that distort market outcomes. B. One way to achieve these goals is to set ‘socially desirable’ prices, which interferes with the pricing system.

→Governments sometimes set a fixed prices at levels above or below equilibrium price to achieve social goals and unfair practice by seller. C. Price Ceilings: a maximum legal price that can be charged for a product. Ex: Housing and Utilities. Leaves seller with shortage. Ch. 6.3

D. Price Floors A. Other prices are considered too low so steps must be taken to keep them higher. Ex: Minimum wage is known as a price floor: lowest legal price that can be paid for a good or service. Is the minimum wage good or bad? Raise minimum wage = hire less employees?

II. When Markets Talk A. Markets ‘talk’ then prices move up or down dramatically. B. Buyers and sellers respond to changes in the market through their decisions.

Discussion Question Think of the last item you decided not to buy. What message did you send to the manufacturer?

6.3 EQ What is the consequence of having a fixed price?