Chapter 6 Prices and Decision Making Economics Chapter 6 Prices and Decision Making

Prices as Signals Price- the monetary value of a product as established by supply and demand- is a signal that helps us make our economic choices.

Advantages of Prices Link between producers and consumers Prices are neutral- they favor neither the producer nor the consumer Result of competition Represent a compromise both sides can live with

Advantages of Prices Prices in a market economy are flexible Unforeseen events affect prices (war) Allows market to accommodate change Prices have no administrative cost Allows people to make decisions quickly and efficiently with minimum of time and effect

Allocations without Prices 1. without prices, another system must be used to decide who gets what 2. one method is RATIONING- a system under which an agency such as government decides everyone’s fair share- use a RATION COUPON

Allocations without Prices 3. Problem of fairness 4. High Administrative Cost 5. Diminishing incentive

Prices as a System 1. prices not only help individuals in specific markets, they serve as signals that help allocate resources between markets. 2. Example- High oil prices in the ‘70s Auto makers had to offer REBATES to get rid of big cars Shut down plants Started making small fuel-efficient cars Laid off workers who then when to work in other industries

Class/Homework Define: price, rationing, and rebate. List the advantages of using prices to distribute economic products. Explain the difficulties of allocating goods and services without a price system. From your own experience, describe a situation that required rationing. What criteria were used to allocate the good or service, and what were some of the problems with each of the criteria?

The Price System at Work Competitive market- everyone who participates has a hand in determining prices- that’s why economists consider prices neutral and impartial. Buyers and sellers have opposite hopes and desires. Sellers- hope for high prices and large profits Buyers- want good buys at low prices.

Price Adjustment Process Market Economy voluntary- compromise must benefit seller and consumer. 1. An economic Model- A set of assumptions that can be listed in a table, illustrated with a graph, or even stated algebraically- to help analyze behavior and predict outcomes.

Price Adjustment Process 2. market equilibrium- situation in which prices are relatively stable, and the quantity of goods and services supplied is equal to quantity demanded. 3. Surplus- situation is which the quantity supplied is greater than the quantity demanded at a given price. Prices will be reduced to get rid of the surplus

Price Adjustment Process Shortage- a situation in which the quantity demanded is greater than the quantity supplied at a given price Price and quantity will go up in the next trading period

Price Adjustment Process Equilibrium price- Is the price to “clear the market” by leaving neither a surplus or shortage at the end of the trading period It will remain at the price until something comes along to disturb the equilibrium- them new surplus and shortages will appear

Explaining and Predicting Prices 1. Changes in Supply: Weather has a large effect on supply, especially in agriculture Because both demand and supply for food is inelastic, a small change in supply is enough to cause a large change in the price.

Explaining and Predicting Prices Importance of Elasticity: When a given change in supply is coupled with an inelastic demand curve, price changes dramatically When the same change in supply is coupled with a very elastic demand curve, the change in price is much smaller

Explaining and Predicting Prices Changes in Demand: A change in demand can also affect the price of a good or service. Example- gold in the 1980s Rising prices Uncertain economic conditions High demand for gold

Class/Homework 1. Explain how a change in demand can affect prices. 2. Describe how prices are determined in a competitive market. 3. Explain why economic models are useful. Do your notecards.

Social Goals v. Market Efficiency Freedom Efficiency Full employment Price stability Economic growth Equity and security

Distorting Market Outcomes One way to achieve social goals involves setting prices at “socially desirable” levels. Price ceilings Price floors

Distorting Market Outcomes Price Ceilings: Maximum legal price that can be charged for a product. Example: New York City rent Didn’t work- landlords converted the apartments to condos and offices. Also quit the upkeep of the apartments needed to reduce costs

Distorting Market Outcomes Price Floors: Prices often considered too low and so steps are taken to keep them higher Example: minimum wage Actually increases the number of people without jobs Some argue that minimum wage is irrelevant anyways because it is actually lower than the lowest wages in many areas

Agricultural Price Supports 1930 federal gov’t established the Commodity Credit Corporation- to help stabilize agricultural prices by way of Loan supports Deficiency payments Both made use of a “target price”, which essentially is a price floor for farm products.

Loan Supports Farmer borrows money from CCC at target price and pledges his crops as security in return. Farmer can sell crop and repay CCC or let CCC take possession of the crop. Nonrecourse loan- a loan that carries neither penalty nor further obligation to repay if not paid back- the farmer could at least get the target price for his crops.

Deficiency Payments A. CCC loan program created problems because the Dept. of Agriculture soon had enormous stockpiles of food. B. Solution- have farmers sell their products for the best price then the CCC would make up the difference with deficiency payments- check sent to the producers that makes up the difference between the actual market price and target price.

Reforming Price Supports 1. in 1996 Congress passed the FAIR Act. 2. under FAIR, cash payments take the place of price supports and deficiency payments. 3. by 2002, program expires Cease to receive all payments Farmers will be use to supply and demand

Class/Homework Describe two effects of having a fixed price other than the equilibrium price forced on a market. Explain how loan supports and deficiency payments work. Would small businesses be more affected by a change in the minimum wage than large businesses. Explain your answer. Do your notecards.