Chapter 6: The Role of Prices

Transcription

1 Chapter 6: The Role of Prices What role do prices play in a free market system? What advantages do prices offer? How do prices allow for efficient resource allocabon?

2 The Role of Prices in a Free Market Prices serve a vital role in a free market economy. Prices help move land, labor, and capital into the hands of producers, and finished goods in to the hands of buyers. Prices create efficient resource allocabon for producers and a language that both consumers and producers can use.

3 Prices provide a language for buyers and sellers. 1. Prices as an IncenBve Prices communicate to both buyers and sellers whether goods or services are scarce or easily available. Prices can encourage or discourage producbon. 2. Signals Think of prices as a traffic light. A relabvely high price is a green light telling producers to make more. A relabvely low price is a red light telling producers to make less. 3. Flexibility Advantages of Prices In many markets, prices are much more flexible than producbon levels. They can be easily increased or decreased to solve problems of excess supply or excess demand. 4. Price System is "Free" Unlike central planning, a distribubon system based on prices costs nothing to administer.

4 Efficient Resource AllocaBon Resource AllocaBon A market system, with its fully changing prices, ensures that resources go to the uses that consumers value most highly. Market Problems Imperfect compebbon between firms in a market can affect prices and consumer decisions. Spillover costs, or externalibes, are costs of producbon, such as air and water pollubon, that spill over onto people who have no control over how much of a good is produced. If buyers and sellers have imperfect informabon on a product, they may not make the best purchasing or selling decision.

5 ConnecBng to Prices: Balancing the Market The point at which quanbty demanded and quanbty supplied come together is known as equilibrium. Finding Equilibrium Price per slice $3.50 $3.00 $2.50 $2.00 $1.50 $1.00 $.50 0 Equilibrium Price Supply Equilibrium Point a Equilibrium QuanBty Slices of pizza per day Demand Price of a slice of pizza Combined Supply and Demand Schedule Quan<ty demanded Quan<ty supplied $ $ $2.00 $2.50 $ Result Shortage from excess demand $ Equilibrium Surplus from excess supply

6 Market Disequilibrium If the market price or quan<ty supplied is anywhere but at the equilibrium price, the market is in a state called disequilibrium. There are two causes for disequilibrium: Excess Demand Excess demand occurs when quanbty demanded is more than quanbty supplied. Excess Supply Excess supply occurs when quanbty supplied exceeds quanbty demanded. Interac<ons between buyers and sellers will always push the market back towards equilibrium.

7 Price Ceilings In some cases the government steps in to control prices. These interven<ons appear as price ceilings and price floors. A price ceiling is a maximum price that can be legally charged for a good. An example of a price ceiling is rent control, a situabon where a government sets a maximum amount that can be charged for rent in an area. Price Floors A price floor is a minimum price, set by the government, that must be paid for a good or service. One well- known price floor is the minimum wage, which sets a minimum price that an employer can pay a worker for an hour of labor.

8 Changes in Market Equilibrium How do shi^s in supply affect market equilibrium? How do shi^s in demand affect market equilibrium? How can we use supply and demand curves to analyze changes in market equilibrium?

9 Shi^s in Supply Understanding a Shi^ Since markets tend toward equilibrium, a change in supply will set market forces in mobon that lead the market to a new equilibrium price and quanbty sold. Excess Supply A surplus is a situabon in which quanbty supplied is greater than quanbty demanded. If a surplus occurs, producers reduce prices to sell their products. This creates a new market equilibrium. A Fall in Supply The exact opposite will occur when supply is decreased. As supply decreases, producers will raise prices and demand will decrease. Shi^s in Demand Excess Demand A shortage is a situabon in which quanbty demanded is greater than quanbty supplied. Search Costs Search costs are the financial and opportunity costs consumers pay when searching for a good or service. A Fall in Demand When demand falls, suppliers respond by cu`ng prices, and a new market equilibrium is found.

10 Analyzing Shi^s in Supply and Demand Graph A: A Change in Supply Graph B: A Change in Demand $800 $60 $600 a b $50 Supply Price $400 Original supply c Price $40 $30 a c b $200 0 New supply Demand $20 $ New demand Original demand Output (in millions) Output (in thousands) Graph A shows how the market finds a new equilibrium when there is an increase in supply. Graph B shows how the market finds a new equilibrium when there is an increase in demand.

11 Chapter 7: Market Structures KEY CONCEPT A market structure is an economic model that helps economists examine the nature and degree of compebbon among businesses in the same industry. WHY THE CONCEPT MATTERS The level of compebbon in a market has a major impact on the prices of products. The more sellers compete for your dollars, the more compebbve prices will be.

12 The CharacterisBcs of Perfect KEY CONCEPTS CompeBBon Economists classify markets based on how compebbve they are Market structure economic model of compebbon within an industry Perfect compebbon ideal model of a market economy economists assess how compebbveness of market by where it falls short

13 The CharacterisBcs of Perfect CompeBBon CharacterisBc 1: Many Buyers and Sellers No one buyer or seller has power to control price in the market Many sellers means buyers can choose a producer with bejer price Many buyers means sellers can all sell product at market price lack of demand will not cause sellers to lower prices CharacterisBc 2: Standardized Product Standardized product one producer s product is idenbcal to another s Perfect subsbtutes include agricultural products, such as wheat, eggs, milk basic commodibes, such as notebook paper, gold Price is only basis for consumer choice CharacterisBc 3: Freedom to Enter and Exit Markets Producers can enter market when profitable and exit when unprofitable RegulaBons do not restrict businesses from entering or exibng CharacterisBc 4: Independent Buyers and Sellers Neither buyers nor sellers join together to influence price Supply and demand set the equilibrium price Independent acbon ensures that market stays compebbve CharacterisBc 5: Well- informed Buyers and Sellers Buyers can compare prices Sellers know what compebtors charge, what buyers willing to pay Price taker seller that accepts market price set by supply and demand

14 CompeBBon in the Real World KEY CONCEPTS No perfectly compebbve markets; none meet all condibons Imperfect compebbon market structures that lack one or more of the condibons Some markets come close, such as some wholesale farm products Example 1: Corn Thousands of growers; decide only how much to produce at market price Many buyers; standardized product; wholesale price easy to determine In reality, several factors can interfere: government subsidies; farmers or buyers somebmes band together Example 2: Beef Many producers; each cut of beef is standard sellers can adjust only their producbon CompeBBon somewhat imperfect because ranchers may join together to influence price producers may say products differ due to factors such as feed

15 CharacterisBcs of a Monopoly KEY CONCEPTS Monopoly market structure with one seller, no subsbtutes for product Cartel organizabon of sellers that agree to set prices, limit output Price maker business without compebtors, can set prices Barrier to entry obstacle to entering market include government regulabons, size, resources, technology

16 CharacterisBcs of a Monopoly CharacterisBc 1: Only One Seller Single business controls supply of product without close subsbtutes De Beers cartel controlled diamond market in 20th century because produced over half of world s diamond supply bought up diamonds from smaller producers to resell CharacterisBc 2: A Restricted, Regulated Market Government regulabons allow single firm to control market De Beers worked with South African government restricted access of other producers controlled supply of diamonds CharacterisBc 3: Control of Prices Monopolists can control prices because there are no close subsbtutes During economic downturns, De Beers created arbficial shortage by withholding diamonds from market, kept prices higher

17 Types of Monopolies KEY CONCEPTS Natural monopoly cost of producbon lowest with only one producer Example 1: Natural Monopoly: A Water Company In some markets, inefficient to have companies compebng Example: public ublibes that require complex systems economies of scale average producbon cost falls as producbon grows Government both supports and regulates Government monopoly government owns and runs or permits only one producer Example 2: Government Monopoly: The Postal Service Government runs some businesses that provide goods and services private firms cannot or do not want to provide because of low profits Example: Postal Service has sole right to deliver first- class mail New services and technologies now compete private delivery companies, fax, e- mail, online bill paying

18 Types of Monopolies KEY CONCEPTS Technological monopoly one firm owns invenbon, technology, method Example 3: Technological Monopoly: Polaroid Patent legal registrabon of invenbon; gives inventor sole rights enables businesses to recover costs of development Monopoly lasts for Bme limit of patent or unbl subsbtute invented Patent let Polaroid keep Kodak out of instant- photography market simpler cameras, digital cameras, quick processing reduced its market Geographic monopoly no other sellers within a region Example 4: Geographic Monopoly: Professional Sports Sports leagues Be teams to cibes, regions; limit number of teams owners can charge high Bcket prices, sell team merchandise Physical isolabon no other supplier in area lets owner control prices Very small market may not support two businesses of same type

19 Profit MaximizaBon by Monopolies KEY CONCEPTS Monopoly cannot set prices too high faces downward- sloping demand curve raises equilibrium price by producing less than compebbve market would Most countries have laws to prevent monopolies EXAMPLE: Drug Manufacturer Drug companies maximize profits during patent period a^erwards, others market cheaper generic versions Schering- Plough strongly marketed non- drowsy anbhistamine ClariBn made up to $3 billion per year worldwide with patent a^er patent ended sales dropped to about $1 billion per year

20 CharacterisBcs of MonopolisBc KEY CONCEPTS CompeBBon Most real markets fall between perfect compebbon and monopoly MonopolisBc compebbon many sellers offer similar products one of most common market structures product differenbabon sellers try to disbnguish their products from similar ones nonprice compebbon use factors other than price to ajract customers

21 CharacterisBcs of MonopolisBc CompeBBon CharacterisBc 1: Many Sellers and Many Buyers Many sellers and many buyers fewer sellers than perfect compebbon but enough for true compebbon Each seller chooses product to make, amount to make, price to charge examples include T- shirts, bajeries, hamburger restaurants CharacterisBc 2: Similar but DifferenBated Products Consumer loyalty gained with unique product or apparent difference Sellers use market research to decide how to differenbate product Chains use sophisbcated techniques learn consumer lifestyles, tastes focus groups moderated discussions with small groups of consumers survey large numbers of consumers CharacterisBc 3: Limited Control of Prices DifferenBaBon gives producers limited control of prices low price disbnguishes some products name brands or bejer quality priced higher Consumers pay extra if they perceive important enough difference will switch to subsbtute if price goes too high CharacterisBc 4: Freedom to Enter or Exit Market No great barriers to entry in monopolisbcally compebbve markets when firms earn profit, other firms enter and increase compebbon compebbon can be difficult for small businesses against large ones Some firms start to take losses signal that it is Bme to exit the market

22 CharacterisBcs of an Oligopoly KEY CONCEPTS Oligopoly market structure with only a few sellers offering similar product Less compebbve than monopolisbc compebbon each firm has large market share percent of total sales in the market Few firms due to high start- up costs expenses of entering market

23 CharacterisBcs of an Oligopoly CharacterisBc 1: Few Sellers and Many Buyers A few firms dominate market industry is oligopoly if four firms control 40 percent of market About half of manufacturing industries in United States are oligopolies include breakfast cereals, so^ drinks, movies, industrial products CharacterisBc 2: Standardized or DifferenBated Products Many industrial products standardized such as flat glass, aluminum firms differenbate by brand name, service, locabon Many consumer goods are differenbated use markebng strategies, such as focus groups, surveys create brand- name products that can be marketed widely CharacterisBc 3: More Control of Prices Each firm s decisions about supply and price affect enbre market If one firm lowers prices, others probably will too no firm gains market share from price drop; all risk losing profits If one raises prices, others may not in order to gain market share AnBcipate compebtors response to price, output, markebng changes CharacterisBc 4: Lijle Freedom to Enter or Exit Market High start- up costs such as factories, warehouses make entry hard new firm may sell on small scale; hard to compete with established ones Established firms have resources, patents, economies of scale High investment by firms in oligopoly make exit difficult operabons too vast, complex to sell and reinvest easily

24 Comparing Market Structures KEY CONCEPTS Each market structure has benefits, problems each creates different balance of power between producers and consumers Consumer has most influence, lijle choice in perfect compebbon Consumer has some influence, most choice in monopolisbc compebbon Consumer has limited influence, some choice in oligopolies Producers have the most control in a monopoly

25 Joan Robinson: Challenging Established Ideas Explaining Real- World CompeBBon In 1933, Robinson published The Economics of Imperfect CompeBBon Described oligopoly, monopsony (market with many sellers, one buyer) Her theory reflected modern market economies in which firms compete through product differenbabon and adverbsing many industries are controlled by oligopolies

26 PromoBng CompeBBon KEY CONCEPTS Government regulabon rules or laws that control business behavior promotes compebbon and protects consumers AnBtrust legislabon define monopolies, allow government to control or break them up Trust group of firms combined to reduce compebbon Merger joining of firms or purchase of one firm by another Origins of AnBtrust LegislaBon Late 1800s, trusts dominated oil, steel, railroad industries 1890 Sherman AnBtrust Act enabled government to control monopolies regulate pracbces that might reduce compebbon Standard Oil Company had 90 percent of industry; set output, prices forced to give up control of 33 companies AnBtrust LegislaBon Today Federal Trade Commission, JusBce Department enforce anbtrust legislabon tend to support mergers that benefit consumers tend to block mergers that concentrate market in hands of few firms To evaluate potenbal merger, look at how market is defined market share before and a^er merger; if compebtors get eliminated

27 Ensuring a Level Playing Field KEY CONCEPTS Government ensures business pracbces do not reduce compebbon with less compebbon, prices go up, supply goes down In United States, laws prohibit most of these pracbces ProhibiBng Unfair Business PracBces Price fixing compebng businesses collaborate to set prices alternabvely, they might agree to restrict output to drive up prices Market allocabon businesses divide up market, control own territory Predatory pricing set prices below cost to drive out small producers used by cartels or large producers

28 ProtecBng Consumers KEY CONCEPTS Cease and desist order requires firm to stop unfair business pracbce issued when business behavior is unfair to compebtors or consumers Public disclosure requires businesses to reveal product informabon enables consumers to make informed buying decisions Consumer ProtecBon Agencies Government protects consumers by regulabng different aspects of business Federal Trade Commission promotes compebbon, prevents unfair pracbces Other agencies regulate specific industries, protect consumers

29 DeregulaBng Industries KEY CONCEPTS 20th century regulabon focused on public service industries DeregulaBon reduces or removes government oversight and control DeregulaBon may lead to fewer consumer protecbons Usually results in lower prices since markets become more compebbve with regulated prices, firms have no incenbve to reduce costs DeregulaBng the Airlines Airline DeregulaBon Act of 1978 removed control of routes and rates Benefits New carriers entered market: greater efficiency, lower prices More people chose plane travel Problems Quality of service declined; airports became crowded MulBple bankruptcies resulted: layoffs, lower wages, lost pensions