Section 3: What role do prices play in a free market economy? Essential Question Ch 6: What is the right price? Section 3: What role do prices play in a free market economy? 1 1

Objectives Identify the many roles that prices play in a free market. List the advantages and disadvantages of a price-based system. Describe the relationship between prices and the profit incentive.

Introduction What roles do prices play in a free market economy? In a free market economy, prices are used to efficiently distribute goods and resources throughout the economy Prices play other roles, including: Serving as a language for buyers and sellers Serving as an incentive for producers Serving as a signal of economic conditions

Advantage of Prices: Incentive and Signals Prices can act as a signal to both producers and consumers: Producers high price tells producers there is high demand and they should make more. low price tells producers there is too much supply Consumers high price tells consumers to think about their purchases more carefully. low price tells consumers to buy more of the product.

Advantage of Prices: Flexibility of Prices Prices are flexible Prices increased to solve problems of shortage Prices decreased to solve problems of surplus.

Advantage of Prices: Consumer Choices How do prices provide more consumer choice? Prices help consumers choose among similar products Allow producers to target customers specific products We all want different things

Advantage of Prices: Efficient Resource Allocation Prices allow for efficient resource allocation the factors of production (land, labor, capital) will be used for their most valuable purposes. Price and profit incentive Efficient use of resources means profit will be maximized (MR = MC)

Advantage of Prices: The Profit Incentive Financial rewards motivate people. How have you provided or benefited from the profit incentive? Answer: Answers will vary.

Disadvantage of Prices: Shortage and Rationing During wartime, famine or an emergency (Oil crisis, Katrina, Haiti earthquake), supply shocks are common The market would result in higher prices for essential goods: water, food, gas One response to shortages is rationing Government, UN or NGO controls how much everyone consumes

Disadvantage of Prices: Shortage and Black Markets Shortage leads to higher prices Black markets develop (especially during rationing) They provide more supply (at higher prices) Some examples of Black Market shortages? Illegal drug markets Scalpers/Stubhub tickets for soldout events Fuel and food in many developing countries and places going through war and revolution

Disadvantage of Prices: Market Failure: Public Goods Wouldn’t get supplied by the market because people are unwilling to pay for the goods or services Market doesn’t provide because Free rider problem Nonrival goods

Disadvantage of Prices: Market Failure: Negative Externalities Negative externalities are social costs that no one pays for When we consume gas, buyers and sellers don’t pay the extra cost of pollution When a BBQ-joint sells food, it doesn’t pay the extra cost of making all the dry cleaners clothes smell like BBQ Negative externalities lead to: Too much supply Too much demand More output than is socially optimal

Disadvantage of Prices: Imperfect Competition and Information All sellers may not be equal, which may affect prices (the Wal-Mart effect) Imperfect information All buyers may not have equal information, which may affect demand and prices What if you could buy the newest Xbox before everyone else? What if you were told there would be a shortage of gasoline starting tomorrow?

Advantages of Prices What are the Advantages of Prices? Signals to producers/consumers Incentives to producers Flexibility in shortages/surplus Efficient use of resources Profit maximization Checkpoint Answer: During times of shortage or recession and depression.

Disadvantages of Prices What are the Disadvantages of Prices? Shortages lead to rationing/black market Public goods aren’t provided by the market Negative externalities lead to too much output Imperfection competition affects prices Imperfect information affects demand Checkpoint Answer: During times of shortage or recession and depression.

Key Terms supply shock: a sudden shortage of a good rationing: a system of allocating scarce goods and services using criteria other than price black market: a market in which goods are sold illegally, without regard for government controls on price quantity Socially optimal output: equilibrium output if negative externalities were accounted for Imperfect information: when all buyers don’t have the same information Imperfect competition: when all sellers aren’t equal