Chapter 6:Prices and Decision

Making

Chapter 6:Prices and Decision

Making

6-1: Prices as Signals• Prices help the economy run smoothly

by providing a good way to allocate resources.– Prices are neutral, because they favor

neither the producer or the consumer.– Prices are flexible, absorbing unexpected

shocks from unforeseen events.– Prices are familiar and easy to

understand.– Prices have no costs of administration.

• How would allocations be made without a price system?• In command economies, the government decides.

• Rationing is a system in which the government decides everyone’s “fair” share. People receive ration coupons, a ticket or receipt that allows the holder to obtain a certain amount of a product.

• Problems with rationing:• Almost everyone feels their share is too small.• Administration is expensive.• Coupons can be stolen, sold, or counterfeited.• Has a negative impact on the incentive to work.

• Prices do more than convey information to buyers and sellers in a market. They also allocate resources between markets. This is why economists think of prices as a “system” that links all markets in the economy.

6-2: The Price System at Work

Buyers and sellers have exactly opposite goals.Buyers want to find good buys at low prices.Sellers hope for high prices and large profits.

Because transactions are voluntary in a market economy, the compromise that settles the differences between buyer and seller must benefit both sides.

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Surplus – quantity supplied is greater than quantity demanded

- Will drive the price down. Items will go on “sale”.

Shortage – quantity demanded is greater than quantity supplied - Will drive the price up.

Equilibrium price – price where quantity supplied is equal to the quantity demanded

Surplus

Shortage

Explaining and Predicting Prices

Food PricesChange in Supply

Energy Prices Change in Demand

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6-3: Social Goals and Market Efficiency

VideoPrice Ceilings Rent controls make

housing more affordable.

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Shortage

More renters will be able to afford an apartment in the city, driving quantity demanded up.

Landlords will try to convert some apartments to other uses with higher returns, driving quantity supplied down.

Creates a shortage in the market.

Landlords will try to lower costs by providing the absolute minimum upkeep.

Prices no longer allocate apartments.

Landlords will create long waiting lists and other non-price criteria to discourage applicants such as excluding pets or children.

Price Floor Lowest legal price that

can be paid for a good or a service.Minimum wage is a price floor.

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Surplus

More people are willing to work at the higher wage, driving quantity supplied up.

Employers will be unable to hire as many people at the higher wage, driving demand down.

Increases unemployment.

Creates a labor surplus in the market.

However, it does raise poor people’s incomes and provides a small measure of equity, one of our economic goals.

Tradeoff of full employment vs. economic equity.

Agricultural Price Supports

Government programs help stabilize prices for farmers.

Target Price

Government sets a target price, or price support, for agricultural products.

Farmer sells his product at market price, and the government makes a deficiency payment to the farmer for the difference between the market price and the target price.

Soil Bank Program is a program where the government pays farmers to take land out of production, shifting supply curve to the left.

Benefits:1. Guarantees a minimum return on

farmer’s investment.2. Encourages farmers to keep

production up and prices stable.3. Keeps small farmers in business.4. Small farmers take better care of

the land because it is a major part of their wealth.