Prices and Decision Making (Clayton pages )

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1 1 Prices and Decision Making (Clayton pages ) Prices as Signals Prices act as signals to consumers and producers Prices answer the three basic questions: 1. What goods and services to produce? 2. How to produce the goods and services? 3. For whom to produce the goods and services? Prices perform allocation function well: 1) Neutral prices do not favor consumers or producers 2) Flexible adjust to changes new products have a high price which encourages producers to supply more and to attract new producers. As supply increases, prices decrease 3) Freedom of Choice variety of products at a wide range of prices 4) No Administrative Cost competitive markets find their own prices without outside help 5) Efficient easily understood by everyone decisions made quickly and easily with a minimum of time and effort

2 2 Allocation without price Some other system must be used to allocate scarce resources 1. rationing a system under which a gov t agency determines how goods and services are to be distributed 2. problem is that people usually fear that their share as determined by rationing is too small 3. fairness of allocation how is this determined? 4. high administration cost cost of coupons cost of labor to administer opportunity cost of lost labor to other sectors 5. less incentive to work hard why should one work harder only to share equally? How Prices are Determined Buyers and sellers have exactly the opposite hopes and intentions In a competitive market, the price moves toward equilibrium where prices are relatively stable and the quantity of goods and services supplied is equal to the quantity of goods and services demanded. The Price of a good regulates the quantities demanded and supplied Shortage quantity demanded exceeds quantity supplied Surplus quantity supplied exceeds quantity demanded Equilibrium quantity demanded equals quantity supplied (see graphs in text on page 137 on surplus and shortage) Equilibrium Price price at which quantity demanded equals quantity supplied; the market clearing price Equilibrium Quantity quantity bought and sold at the equilibrium price

3 Price 3 Determination of Market Equilibrium P Shirts Markets only need to be competitive, not perfect, to work in allocating resources efficiently Allocate to those that are willing and able to pay Generally, prices in a particular area are similar Loss leader an item is sold at a very low price to attract consumers to a store The Price System at Work Prices serve as signals that allocate resources between markets Higher energy costs leave consumers with less money to spend in other markets If producers manufacture too many products, they need to lower the price in order to sell the extra production. This temporary reduction in price is accomplished by the producers giving a rebate a partial refund of the original price of the product.

4 Rent (US per month) 4 Special interest groups may get the government to intervene in a competitive market and fix a price. Price Ceiling the maximum legal price that can be charged price ceilings must be placed below equilibrium price to be effective; create shortages an example of a price ceiling would be rent control Price Ceiling for Apartment Rentals Apartments (Number of units) Results of having a price ceiling: Price ceilings result in shortages Prices no longer allocate apartments Consumers willing and able to pay a higher price cannot get housing Landlords have no incentive to provide more housing units Black market may also develop key money, illegal sublets

5 Wages (US per hour) 5 Price Floor the lowest legal price that can be paid for a good or service price floors must be placed above equilibrium price to be effective; create surpluses an example of a price floor would be minimum wage Minimum Wage in the United States 0 hr Labor (Number of hours) Results of having a minimum wage (price floor): A surplus of labor at the minimum wage Increased unemployment

6 Price (US/ounce) Price (US per ton) 6 What can affect a change in Price? 1. A change in Supply an example could be farming and how weather, a determinant of supply, can affect the Supply and the Price, assuming Demand remains the same World Demand and Supply for Wheat Wheat (millions of tons) 2. A change in Demand an example could be gold and how consumer preferences, a determinant of demand, can affect the Demand and the Price, assuming Supply remains the same Demand and Supply for Gold Gold (millions of ounces)

7 Price (US per ton) Price (US per ton) 7 3. Elasticity of Demand economists consider price elasticity of demand whenever a change in supply occurs Demand and Supply for Wheat in England Wheat (millions of tons) Agricultural Price Supports Target prices (a price band) price floor Demand and Supply for Wheat in US Wheat (millions of tons)

8 8 Methods of supporting farmers 1. non-recourse loan a loan secured by the crop and if the price of the crop is less than anticipated, the farmer does not pay the loan and the government takes the crop. Basically, the loan becomes an advance payment for the crop. If the price is higher than was anticipated, the farmer sells the crop, pays the loan, and keeps the difference (profit) 2. deficiency payment farmers sell their crop in the market and the government makes a payment to the farmer for the difference between the target price and the market price. 3. cash payments instead of price supports since 1996 in US which were to be eliminated by 2002 and market forces were to take over