Chapter 6: Prices
Lesson 1: Vocabulary
How do prices help determine WHAT, HOW, and for WHOM to produce?
- Was the price of the product clear and easy to identify? Explain your answer.
- Would you have paid more for the product if you had to? If so, how much more?
- If the price of the product was lower, would you have bought more of it?
- Did the price of a competing brand or product affect the decision you made?
- Would you have gone to another store or website if the price of the product was lower there?
Why Prices Are Important
How do prices help us make decisions?
—the monetary value of a product—does much more than simply tell you how much you have to spend when you make a purchase. Collectively, prices act as a system of signals that help us make economic decisions. At the same time, they function as incentives that affect the behavior of individuals, businesses, markets, and even entire industries. In fact, they have a number of advantages, discussed below, that you probably haven’t even thought about.
Prices as Signals
There are many signals in life you are already familiar with. For example, pain is a signal that tells you something is wrong with your body. A traffic light at an intersection signals when to stop or go. Like pain or a traffic light, prices are signals that give information to buyers and sellers. High prices signal buyers to buy less and producers to produce more. Low prices signal buyers to buy more and producers to produce less.
The signals we get from prices also serve as incentives which cause us to take additional actions. If the price of something goes up, you may decide to shop at a different location, or find a suitable substitute. Likewise, a firm may stop producing other items to free up the labor, capital, and machinery needed to increase production of a product that can be sold for a higher price.
Advantages of Prices
Prices help producers and consumers answer the three basic questions of WHAT, HOW, and FOR WHOM to produce. Without prices, the economy would not run as smoothly, and these allocation decisions would have to be made some other way. Prices perform this function well for at least four reasons.
- Neutrality In a competitive market economy, prices are because they favor neither the producer nor the consumer. Since prices are the result of competition between buyers and sellers, they represent compromises that both sides can live with.
- Flexibility Prices in a market economy help provide flexibility. Unforeseen events such as natural disasters and war affect the prices of many items. For example, when hurricane Sandy destroyed much of the northeast United States in October 2012, oyster harvesters in the Chesapeake Bay were unable to work for several days. This caused the price of oysters to temporarily spike in places as far away as Georgia. Buyers and sellers then reacted to the new level of prices and adjusted their consumption and production accordingly, helping the system function smoothly again. The ability of the price system to absorb unexpected “shocks” is one of the strengths of prices in a market economy.
- Familiarity Most people have known about prices all their lives. As a result, prices are familiar and easy to understand. There is no ambiguity over a price—if something costs $1.99, then we know exactly what we have to pay to get it. This allows people to make decisions quickly and efficiently, with a minimum of time and effort.
- Efficiency Finally, prices have no cost of administration. Competitive markets tend to help products find their own prices without outside help or interference. No bureaucrats need to be hired, no committees formed, no laws passed, or other decisions made. Even when prices adjust from one level to another, the changes are usually so gradual that people hardly notice.
What If We Did Not Have Prices?
Are prices the best way to allocate resources?
Have you ever thought about how our economy would function without prices? Without knowing the prices of goods or services, how would we decide WHAT to produce? Without knowing the cost of productive inputs, how would we answer the HOW to produce question? Finally, how would we decide FOR WHOM to produce? Would intelligence, good looks, or even political connections determine the allocation?
Without prices, another system must be used to decide who gets what. One method is—a system under which government decides everyone’s “fair” share. Under such a system, people receive a ration coupon, a ticket or a receipt that entitles the holder to obtain a certain amount of a product. The coupon can be given to people outright, or the government can charge a modest fee.
Rationing was used widely during World War II, but has not had widespread use since then. This is because the problems with rationing are more extensive than most people realize.
Problems with Rationing
- Perceived Fairness The debate over fairness began immediately. People in small towns thought they should have more coupons than people in big cities, because big cities had better mass transit systems. People with older cars thought they should have more coupons, because their cars were less fuel-efficient than newer ones. However, people with newer cars thought that this would penalize them for having bought more expensive, fuel-efficient ones. Couples with several cars thought they should have more coupons because they had more cars, but couples with one car thought that would not be fair to them. Consequently, making a distribution system that everyone thought would be fair seemed almost hopeless.
- Administrative Expense The administrative cost of rationing is another major issue. Someone has to pay for the printing and distribution costs of the coupons, and that includes the salaries of workers. Every community would also need “review boards” so that someone could listen to those who thought they should have more coupons. In 1974, nearly 5 billion gasoline ration coupons were printed just in case the government decided to go ahead with a rationing program. The tentative plans, never carried out, were to ship the coupons to every post office in every city or town in the country so that everyone would have access to them after the “fairness” problem was resolved.
- Distorted Incentives Rationing programs are specifically designed to take the place of supply and demand. The one in 1974 that was designed to keep the cost of gasoline low for consumers would have distorted market incentives in three different ways: Energy companies would have been discouraged from producing more gasoline. Automobile companies would have had less incentive to produce more fuel-efficient vehicles. And, consumers would have had less incentive to reduce unnecessary driving to save gasoline. None of these incentives solved the basic problem of too little supply and too much demand.
- Abuse and Misuse Finally, no matter how much care was taken, some coupons would have been stolen, sold, or counterfeited. The 1974 gasoline coupons had another unique problem. To make them difficult to counterfeit, each carried a high-quality portrait of President Washington like the one on a dollar bill. Unfortunately the likeness was so good that a coupon could also be used in a dollar-changing machine. This gave anyone with a coupon the option to use it for a gallon of gas that cost about sixty cents, or to use it in a coin changer to get four quarters.
As you can imagine, the problems with rationing are extremely difficult to solve. The many problems surrounding the 1974 gasoline rationing coupons were the reason that they were never issued and later destroyed.
Prices as a System
How do prices connect markets in an economy?
Although the price system is not perfect, most economists believe it is the most efficient way to allocate resources. This is because prices do more than help individuals make decisions; they also help allocate resources both within and between markets.
Consider the way in which higher prices rippled through markets today, causing changes both large and small. Because the demand for gas is basically inelastic, high gas prices mean that people have to spend a greater part of their income on gas, leaving them with less money to spend elsewhere. If enough drivers believe that higher gas prices are likely to be permanent, they may buy more fuel-efficient cars, including hybrids that run on both electricity and gasoline. Many others may instead decide to rely more on their city mass-transit systems, or do without automobiles altogether.
Over time, the impact of higher gas prices will spill over to the farm and consumer food sectors. Farmers will benefit if they sell more of their grain to companies that make gasohol, a blend of 90 percent unleaded gasoline and 10 percent grain alcohol. But, whenever more grain is used in fuels, less is available to make flour—which raises the price of bread. Other companies may make major investments in—fuels whose energy is derived from renewable plant and animal materials, vegetable oils, and municipal and industrial wastes—in hopes of developing adequate substitutes for gasoline.
The ultimate impact of higher gas prices is to cause productive resources, like raw materials and workers, to shift out of some industries and into others: out of wheat production for flour and bread and into wheat production for gasohol; out of gas-guzzling automobiles and into fuel-efficient hybrids; out of other industries and into renewable fuels. Although the adjustment process is painful for many individuals and companies, it is a natural and necessary shift of resources for a market economy.
In the end, prices do more than convey information to buyers and sellers in a market: they also help allocate resources between markets. This is why economists think of prices as a “system”—part of an informational network—that links all markets in the economy.
What factors affect prices?
a. $7.99 for a new bicycle
b. $1.00 for a can of corn
c. $44 for a Frisbee
d. $99 for a burrito
e. $35 for a wristwatch
f. $2 for a pair of socks
How Prices Adjust
How does price affect a seller’s decision to produce a product?
Of course you don’t have to argue with sellers over the price of every product you buy. However, prices for almost all goods and services in a market economy represent compromises between buyers and sellers to reach a final price.
Markets and Prices
In a market economy, buyers and sellers have exactly the opposite goals: buyers want to find good deals at low prices, and sellers hope for high prices and large profits. Neither can get exactly what they want, so some adjustment is necessary to reach a compromise. In this way, everyone who participates has a hand in determining prices.
Supply and Demand
As we know from previous chapters, the data in Figure 6.1 show the market demand for and supply of burritos at various prices. Panel A shows this information in the form of a schedule, while Panel B shows both the market demand curve and the supply curve that are in the schedule. However, both curves can be combined into one diagram because the vertical and horizontal axes are identical in Figure 4.3 and Figure 5.3.
Note that the supply and demand curves intersect at a specific point. The price associated with this point is called the,the price at which the number supplied equals the number demanded. The equilibrium price is also called the market clearing price because it is the price at which there is neither a surplus nor a shortage. The is also associated with this price because the quantity supplied is equal to the quantity purchased. This price, $5 in both Panels A and B of Figure 6.1, helps sellers decide how many productive and financial resources must be allocated to the production of that product.
Surpluses—When Prices Are Too High
We start on Day 1 with sellers thinking that the price of burritos will be $9. If you examine the supply schedule in Panel A or the supply curve in Panel B of Figure 6.1, you can see that suppliers will offer 44 burritos for sale at that price. Buyers, however, only want 4 burritos at that price, leaving a surplus of 40 burritos.
A surplus shows up as unsold units of the product. Because suppliers have 40 unsold burritos at the end of the day, the suppliers know that $9 is too high. Suppliers also know that they have to lower the price if they want to attract more buyers.
Therefore, the price tends to go down as a result of the surplus. Of course the model cannot tell us how far the price will go down, but we can reasonably assume that the price will go down only a little if the surplus is small, and much more if the surplus is larger.
Surpluses can occur in all types of markets. For example, the clearance section at a department store is full of surplus products. Another example of a surplus happens when the government tries to help farmers by setting a price for a farm product that is higher than the market-clearing equilibrium price. Naturally, farmers respond by producing more than consumers want to buy at that price, and then the government has to decide how to deal with the surplus.
Shortages—When Prices are Too Low
Burrito sellers are more cautious on Day 2, so they anticipate a much lower price of $3. At that price, the quantity they are willing to supply changes to 12 burritos. However, as Panel B in Figure 6.2 shows, this price turns out to be too low. At a market price of $3, only 12 burritos are supplied and 40 are demanded—leaving a shortage of 28 burritos.
Ais a situation in which the quantity demanded is greater than the quantity supplied at a given price. When a shortage happens, sellers have no more burritos to sell, and they end the day wishing they had charged a higher price.
As a result of the shortage, the price will go up. While our model does not show exactly how much the price will go up, we can assume that the next price will be less than $9, which we already know is too high.
Shortages could happen in any market. Suppose, for example, that hospital administrators decide to decrease the salaries of nurses. At lower salaries, fewer nurses would enter or remain in the profession and the quantity supplied could easily be less than the quantity demanded—leading to a shortage of nurses.
Equilibrium—When the Price Is Just Right
If the new price is $7 on Day 3, the result will be a surplus of 24 burritos. This surplus will cause the price to drop again, but probably not below $3, which already proved to be too low. However, if the price drops to $5, the market will have found its equilibrium price. As we saw earlier, the equilibrium price is the price that “clears the market” by leaving neither a surplus nor a shortage. Also note that Panel B in both Figures 6.1 and 6.2 shows 24 as the equilibrium quantity of output at the equilibrium price of $5.
Although our economic model of the market cannot show exactly how long it will take to reach equilibrium, or if the exact equilibrium price will ever be reached, theof prices due to surpluses and shortages will always be pushing the price in that direction. Whenever the price is too high, the surplus will tend to force the price down. Whenever the price is too low, the shortage will tend to force the price up. As a result, the market tends toward its own equilibrium.
The supply and demand for burritos affects the price you pay for them, but keep in mind that many different markets are connected in an economy. As a result, price adjustments that take place in other markets play a role in the price you pay for the products you buy. For example, a change in the price of black beans affects not only the income of black bean farmers and distributors, but also the income of the burrito vendor who uses black beans in his product. If the price of black beans is too high, the burrito vendor might raise his prices in order to stay profitable, or he might choose to use a different kind of bean in his product, which would in turn affect the income of his suppliers.
Think of how much more difficult it would be to reach an equilibrium price and quantity of output if we did not have markets to help us. Competitive markets have the advantage of giving us prices that are neutral, flexible, understood by everybody, and free of administrative costs. It would be difficult to find another system that works equally well at reaching the equilibrium price of $5 and the equilibrium quantity of 24 units. When competitive markets reach equilibrium prices, and if nothing else changes, prices and quantities will be stable because there are no surpluses or shortages.
Why Prices Change
How do changes in supply and demand affect prices?
Once a market has found its equilibrium price and quantity, things could still change. This is because the market supply curve and the market demand curve are influenced by a variety of factors, any of which could change at any time.
Economists use their market models of supply and demand to explain how prices are determined and why prices change. A change in price can be caused by changes in supply, changes in demand, or changes in both. Elasticity is also important when predicting how prices are likely to change.
Changes in Supply
An excellent example of how supply changes affect price can be seen in agriculture, which often experiences wide swings in prices from one year to the next. A farmer may keep up with all the latest developments and have the best advice experts can offer, but the farmer can never be sure what price to expect for the crop. For example, a corn farmer may plant 500 acres of corn, hoping for a price of $5 a bushel. However, the farmer also knows that the actual price may end up being anywhere from $2 to $10.
Weather is one of the main reasons for variations in agricultural prices. If it rains too much after planting, the seeds may rot or be washed away and the farmer must replant. If it rains too little, the seeds may not sprout. Even if the weather is perfect during the growing season, rain can still interfere with the harvest. The weather, then, often causes a change in supply.
Changes in Demand
A change in demand, like a change in supply, can affect the price of a good or service. All of the factors that affect individual demand—changes in income, tastes, prices of related products, expectations, and the number of consumers—also affect the market demand for goods and services. One example is the demand for gold.
In Panel B of Figure 6.3, a small increase in demand, illustrated by a shift from D to D1, causes a large increase in the price. This is exactly what happened in late 2012 when uncertainty over economic growth and unstable political situations around the world encouraged people to buy gold. The rapid increase in demand drove the price of gold to over $1,800 an ounce, when 10 years earlier it was about $300 an ounce.
Changes in Supply and Demand
In most cases, price is affected by both supply and demand changing at the same time. For example, Hurricanes Katrina and Rita tore through the Gulf of Mexico in 2005, destroying or disabling hundreds of oil-drilling platforms, refineries, and storage facilities. This caused the supply of oil to decrease (or shift to the left), driving the price of gasoline higher.
To make matters worse with respect to gasoline prices, 2006 and 2007 were years of relatively strong economic growth, so the demand for oil and gasoline shifted to the right just after the supply of oil had shifted to the left. The result was a near doubling of oil prices and a sharp increase in gas prices that peaked in 2008.
Prices and Competitive Markets
Economists like to see competitive markets because the price system is more efficient when markets are competitive. A purely competitive market requires a set of ideal conditions and outcomes that are seldom found, but fortunately markets don’t have to be perfect to be useful. As long as prices are allowed to adjust to new levels in response to the pressures exerted by surpluses and shortages, prices will perform their role as signals to both consumers and producers.
Trying to achieve the ideal model of a competitive market is also the basis for considerable government policy. For example, to increase the number of competitors in a market, laws have been passed to prevent companies from becoming too large. Other laws were passed that require firms to disclose information to help consumers decide if they want to buy something. Further laws have been passed to prevent firms from taking unfair advantage of consumers. All of this is done in order to make markets more competitive.
The great advantage of competitive markets is that they allocate resources efficiently. As sellers compete to meet consumer demands, they are forced to lower the prices of their goods. This encourages them to keep their costs down. At the same time, competition among buyers helps prevent prices from falling too far. This means that both consumers and producers have a role in determining the market’s equilibrium price.
What factors affect prices?
Write a paragraph explaining why you think the government should or should not adjust the product’s price.
What are the costs and benefits of economic policies aimed at creating equity and security?
Attempts to fix prices are not new. During World War I and World War II, the federal government locked down the prices of certain foods to ensure that everyone had access to affordable meals. President Nixon tried to combat inflation in the early 1970s by trying to freeze prices for 90 days, but his efforts were largely ineffective. Today the government uses a combination of price ceilings and price floors to fix prices on a number of products.
The consequence of the price ceiling in the figure is clear. With a price ceiling of $10, there are 10 units demanded but only 4 units are supplied—leaving a shortage of 6.
Normally the resulting shortage of 6 would be enough to drive the price toward its equilibrium level of $15, but not in the case of a price ceiling. Instead, the shortage becomes permanent and will persist as long as the price ceiling stays below its equilibrium price. A shift in demand or supply could cause the shortage to increase or decrease, but a shortage will always be there as long as the price ceiling remains below the equilibrium price.
At other times, lawmakers may think that the market clearing price is too low, so they take steps to raise it by legislating a, the minimum legal price that a seller can charge.
The consequence of the price floor is shown in Panel B of Figure 6.4. With a price floor of $25, 2 units are demanded but 11 units are supplied—leaving a surplus of 9.
Normally the resulting surplus of 9 would be enough to drive the price toward its equilibrium level of $15, but not in the case of a price floor. Instead, the surplus becomes permanent and will persist as long as the price floor stays above the market’s equilibrium price. A shift in either demand or supply could cause the surplus to increase or decrease, but a surplus will always be there as long as the price floor remains above the equilibrium price.
Examples of Fixed-Price Policies
Whom do price supports benefit, and whom do they hurt?
Government imposed price controls are not just something that happened in the midst of a major war. There is a surprising amount of it around today. The minimum wage, discussed more fully in Chapter 9, along with farm subsidies and rent controls, are major examples of price controls being used today.
Using Price Floors to Support Sugar Prices
Historically, prices on almost all agricultural products have fluctuated much more widely than prices on other goods and services. This is because farmers often face periods of boom or bust. In years when crops are plentiful, the extra production drives prices down. In years of drought or flooding, the lower crop yields drive agricultural prices up. Because of this, the government has taken steps toagricultural prices to help farmers and processors of farm products with the use of price floors.
The sugar industry provides just one example of how the government can stabilize farm prices with the use of price floors. Beginning in 1981, and reauthorized by the 2008 Farm Act, the government set target prices on sugar derived from sugar cane. Ais a price floor the government thinks is fair for a particular product. To ensure that farmers receive the target price for their products, the government sets up a loan system.
For example, in 2013 the government set a loan rate of 18.75 cents per pound on cane sugar. A processor of sugar cane could take out a loan from the United States Department of Agriculture (USDA) at this rate as long as it pledged its sugar as collateral, or security, for the loan. After the sugar was processed, the processor had two options:
- The sugar could be sold on the open market at a higher price than the target price, and then the proceeds of the sale could be used to repay the USDA loan.
- Or, if the market price of sugar fell below the target price, the processor could keep the proceeds of the loan and let the USDA take possession of the sugar.
Because the loan does not have to be repaid, it is called a—a loan that carries neither a penalty nor further obligation to repay. Either way, the processor is guaranteed to get at least 18.75 cents per pound for the processed sugar, which is why it is a price floor that helps to stabilize farm income.
In addition to stabilizing agricultural incomes, the price supports in sugar have helped domestic sugar producers compete with foreign sugar producers. The price supports have also saved a number of jobs in the sugar production industry.
Unfortunately, the sugar support policies have also raised the price of sugar for the American consumer. Since the first Farm Act that introduced this type of policy in 1981, U.S. sugar prices have been about twice as high as world sugar prices, something that has cost American consumers billions of dollars. The higher cost of domestic sugar has also been a problem for domestic industries that use sugar, like makers of candy, sweets, and beverages. These domestic industries have lost jobs as a result of higher sugar prices.
Agricultural price supports are just one example of a nation trying to achieve one economic goal—economic security—at the expense of another—full employment. As you can see, setting a legal price too high to achieve a socially desirable goal has its consequences.
Using Price Ceilings to Control Rents
Let us assume that without rent controls, the free market would establish rents at $1,500 a month, with an equilibrium quantity of two million apartments at that rate. If the government wants to promote the social goals of equity and security for people who cannot afford these rents, it canestablish a price ceiling at $1,000 a month.
Are people better off? Perhaps not. Clearly, the 800,000 potential renters who could not get apartments are unhappy. Also, landlords are unhappy because they are being forced to accept a lower price for their rental units. Because of this, the landlords want to rent fewer units than they would under free market conditions. More than likely, they would convert some of the nicer apartments to high-priced condos or offices—leaving the less desirable ones to be rented. They would also cut back on basic repairs and upkeep on the units they rent, which allows the buildings to deteriorate.
The only people who are better off are the 1.6 million renters who were able to get the apartments for $1,000 a month. But even they may eventually become unhappy when they discovered that their landlords were neglecting upkeep on their buildings. Meanwhile, there are long lines of people waiting to get the low-cost rental units. All of this results in a situation where prices no longer allocate apartments. Instead, landlords deal with the shortage by using long waiting lists or by resorting to non prime criteria, such as excluding renters with children and pets.
Is the landlord’s behavior unreasonable? After all, what would you do if you owned rental units in a city with rent controls? If you could not increase rents to keep up with repairs and city building taxes, you might do what other landlords do, and that is lower your costs by providing the absolute minimum upkeep. You may even tear some buildings down to make way for more profitable shopping centers, factories, parking garages, or high-rise office buildings. All of this contributes to the gradual movement of productive resources out of the rental market and into other activities. This is just one example of how rent controls distort the economy’s allocation of productive assets.
In the end, government attempts to achieve two of our seven economic goals—economic equity and economic security—will be in conflict with another goal—economic efficiency. Whether or not the tradeoff is worth it depends on the way voters evaluate the costs and benefits of the action, and then express their satisfaction or frustration in the voting booth.
Government and Social Goals
The American free enterprise system has seven broad economic and social goals that most people seem to share: economic freedom, economic efficiency, economic equity, economic security, full employment, price stability, and economic growth. However, we also know that these goals are often in conflict with one another. As a result, legislation to achieve any one goal almost always conflicts with other economic goals—which makes effective government policy-making difficult.
So, how does government decide which of the seven economic goals to promote? And, how does government evaluate the costs and benefits of a specific policy to see if it should be supported rather than another?
So why do we still have price ceilings and floors today when economic conditions are much better than they were during the Great Depression or during either world war? Part of the answer is that once price supports are put in place, they often have enough political support to keep them there. Or, as in the case of sugar support prices, so few people know about them that there is no effective opposition.
When Markets Talk
How do markets “talk”?
- Gold Prices Rise A rising price of gold is usually not a good sign for the economy. This is because gold has historically been thought of as a hedge, or protection, against a possible economic or social crisis. Sharp increases in the price of gold would capture the attention of other investors and perhaps even encourage some of them to buy gold as well, driving the price of gold up even further. Gold prices tend to come down slowly when the economic news is good, so sharp increases in the price of gold captures the most attention.
- Stock Prices Fall Falling stock prices generally reflect a lack of confidence in business conditions or in government policy. Suppose the federal government announced that it would raise taxes on investments to pay off some of the federal debt. If investors thought that this policy would not work, or that other policies might be better, they might sell some of their stocks, causing stock market prices to fall. In a sense, then, we could say that the market has “talked” by voicing its disapproval of a new government policy or some other event whenever stock prices go down. If stock market prices had gone up, however, it would be a sign that investors had a more favorable view of the policy or event.
- Oil Prices Rise Investors closely watch the price of oil. This is because it is a commodity used worldwide, and it has very inelastic supply and demand curves. Because of this, even slight changes in the supply or demand for oil can have a dramatic impact on the price of oil. A sharp increase in the price of oil could indicate that there has been a modest decrease in the quantity supplied, something the market foresees as a possible difficult time ahead for the economy.