1. 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

2. 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.

3. 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

4. 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.

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

6. 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

7. 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)

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

9. 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

10. 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

11. 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

12. 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

13. 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?

14. 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.

15. 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.

16. 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