Chapter 6 – PriceChapter 6 – Price

Cutler – Economics

BELLRINGERBELLRINGER

• What would happen if the government decided gas prices should be lowered by $2.50 per gallon?

Section 1 – Section 1 – Combining Supply and Combining Supply and

Demand Demand • Balancing the

Market– Defining Equilibrium– Graphing Equilibrium

• Disequilibrium– Excess Demand– Excess Supply

• Government Intervention

• Price Ceilings– The Cost of Price

Ceilings– Ending Rent Control

• Price Floors– Minimum Wage – Price Supports in

Agriculture

Balancing the MarketBalancing the Market

• Market System– Consumers can buy productions they want– Sellers make enough profit to stay in

business– Sellers respond to changing needs of

consumers

• Turning competing interests into a positive outcome for both sides

Balancing the MarketBalancing the Market

• Buyers and sellers come together in the market– Combining Supply and Demand

• Review Demand Schedule– Price of goods compared to how much is

produced

• Review Supply Schedule– Price of goods compared to how much is

consumed

Demand and Supply Demand and Supply ScheduleSchedule

Price of a slice of pizza

Quantity demanded

Quantity supplied

Result

Combined Supply and Demand Schedule

$ .50 300 100

$2.00

$2.50

$3.00

150

100

50

250

300

350

$1.50 200 200

$1.00 250 150

Defining Equilibrium Defining Equilibrium

• Equilibrium: The point at which quantity demanded and quantity supplied are equal

• Balance between price and quantity– Market is then stable

• The amount produced will equal the amount consumed

Graphing Equilibrium Graphing Equilibrium P

ric

e p

er

sli

ce

Equilibrium Point

Finding Equilibrium

Price of a slice

of pizza

Quantity demanded

Quantity supplied

Result

Combined Supply and Demand Schedule

$ .50 300 100

$3.50

$3.00

$2.50

$2.00

$1.50

$1.00

$.50

Slices of pizza per day

050 100 150 200 250 300 350

Supply Demand$2.00

$2.50

$3.00

150

100

50

250

300

350

Surplus from excess supply

$1.50 200 200 Equilibrium

Equilibrium Price

a

Eq

uili

briu

m

Qu

an

tity

$1.00 250 150

Shortage from excess demand

Disequilibrium Disequilibrium

• Disequilibrium: a point when quantity supplied does not equal quantity demanded

• Creates excess demand or excess supply

Excess DemandExcess Demand

Price

Slices of Pizza

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

50 100 150 200 250 300 350

Excess DemandExcess Demand

• At $1.00 per slice – QD = 250 Slices– QS = 150 Slices

• Creates a Shortage

Excess Supply Excess Supply

Price

Slices of Pizza

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

50 100 150 200 250 300 350

Excess SupplyExcess Supply

• At $2.50 per slice – QD = 100 Slices– QS = 300 Slices

• Creates a Surplus

Analyze the Data Analyze the Data

Price of a slice of pizza

Quantity demanded

Quantity supplied

Result

Combined Supply and Demand Schedule

$ .50 300 100

$2.00

$2.50

$3.00

150

100

50

250

300

350

$1.50 200 200

$1.00 250 150

Shortage Occurs because QD > QS

Surplus Occurs because QD < QS

Equilibrium QD = QS

BELLRINGERBELLRINGER

• Can you think of any products you buy that have recently changed in price?

Government InterventionGovernment Intervention

• Markets tend to reach equilibrium

• Price Ceiling: a maximum price that can be legally charged for a good or service

• Price Floor: a minimum price for a good or service

Price CeilingsPrice Ceilings

• Rent Control – Housing is essential but wages might not

keep up with the supply and demand of houses

– Reduces the quantity and quality of housing

Cost of Price CeilingsCost of Price Ceilings

• When price cannot rise to equilibrium, market determines who receives good or service

• By setting price below equilibrium, profits are reduced– Cost cutting occurs – Poor quality homes/apartments

Ending Rent ControlEnding Rent Control

• Landlords gain an incentive to maintain buildings

• What affect does it have on the number of apartments?– Rent Graph

Price FloorsPrice Floors

• Minimum price set by the government to be paid for a good or service

• Minimum Wage– Base level pay for work

Price FloorsPrice Floors

• Minimum wage above equilibrium rate decreases employment

Price FloorPrice Floor

Price

Labor

$4.50

$5.15

2 4 6

Price Supports in Price Supports in AgricultureAgriculture

• Price floors are used for many farm products

• Government would buy excess crops when price fell below floor

Section 2 – Changes in Section 2 – Changes in Market Equilibrium Market Equilibrium

• Changes in Price– Understanding a Shift in Supply– Finding a New Equilibrium – Changing Equilibrium

• A Fall in Supply• Shifts in Demand

– Problem of Excess Demand– Return to Equilibrium – A Fall in Demand

Changes in PriceChanges in Price

• Excess supply will cause firms to cut prices

• Falling prices cause QD to rise• QS will fall until they meet again• These are changes ALONG the supply

or demand curve… not shifts

Changes in PriceChanges in Price

• What shifts the supply curve?– Technology Change– New taxes/Subsidies by GOVT– Input costs change

• Because they want to be at equilibrium, curve shifts will create a new equilibrium price and quantity

Understanding a Understanding a Shift in Supply Shift in Supply

• Falling prices affect on supply– CD players were expensive initially – Now less than $100 and compete with MP3

or digital music

• Fall in production costs shifts supply curve to the right

Shifts in SupplyShifts in Supply

$800

$600

$400

$200

0

Pri

ce

Output (in millions)

Graph A: A Change in Supply

1 2 3 4 5

Original supply

Demand

a

New supply

b

c

Shift in SupplyShift in Supply

• As we saw…• The shift in the supply curve created a

surplus.– The price level didn’t change so now

suppliers are offering more but demand hasn’t caught up!

Finding a New EquilibriumFinding a New Equilibrium

• Excess supply or a surplus will cause producers to lower prices to eliminate the surplus

• Did the price drop change the demand curve?

New Equilibrium

$800

$600

$400

$200

0

Pri

ce

Output (in millions)

Graph A: A Change in Supply

1 2 3 4 5

Original supply

Demand

a

New supply

b

c

Change in Equilibrium

• Curve will keep shifting while new technology is introduced to lower production costs

• Equilibrium changes constantly– Changes in the market– Consumer wants and needs– Production costs

Fall in Supply

• Supply curve can shift to the left with a drop in supply

• A strike that results in higher wages• A tax by the government

Shifts in Demand

• New fads for Christmas • New version of a product

– iPhone 5

Shifts in DemandShifts in Demand

Graph B shows how the market finds a new equilibrium when there is an increase in demand.

Graph B: A Change in Demand

Output (in thousands)

$60

$50

$40

$30

$20

$10

0

900800700600500400300200100

Pri

ce

Supply

Original demand

a

New demand

c

b

Problem of Excess Demand

• Shifting the demand curve to the right creates shortages

Shifts in DemandShifts in Demand

Graph B: A Change in Demand

Output (in thousands)

$60

$50

$40

$30

$20

$10

0

900800700600500400300200100

Pri

ce

Supply

Original demand

a

New demand

c

b

Return to Equilibrium Return to Equilibrium

• Prices will rise by produces as a result of this change in demand

• Fall in demand has the opposite effect

BELLRINGERBELLRINGER

• What is the “Black Market?”

Section 3 – The Role of Prices

• Prices in the Free Market

• The Advantages of Prices– Price as an Incentive– Price as Signals– Flexibility– Price System is “Free”

• A Wide Choices of Goods– Rationing Shortages– The Black Market

• Efficient Resource Allocation

• Prices and the Profit Incentive– The Wealth of Nations– Market Problems

Prices in Free Market

• Prices serve a major role in the free market economy– Helps move the FOP

Advantages of Price

• Very Universal– Act as a standard measure of value– Barter system as alternative

• Price acts as an incentive– Think of the Law of Demand and Law of

Supply

Advantages of Prices

• Prices as Signals – Producers – Higher prices signal to producers to make

more– Also signals new suppliers to enter market– Lower prices signal too much is produced– Signals suppliers to leave the market

Advantages of Prices

• Prices as Signals – Consumers– Low prices signal to buy more– Low prices = low opportunity cost– High price to stop and think about a

purchase

Advantages of Prices

• Flexibility – Prices can easily be increased to solve

shortages (excess demand)– Prices can easily be decreased to solve

surpluses (excess supply)

Advantages of Prices

• Supply Shock: a sudden shortage of a good– Creates excess demand– Gasoline for example

• Rationing – Allocating scare goods and services using

criteria other than price– How easy is it to increase supply?

Supply Shock and Rationing

Price

Gallons

$2.50

$5.15

2 4 6

Price Shock and Rationing

• Raising prices quickest way to solve shortage

• People with higher demand will still consume

• Creating new equilibrium

Advantages of Price

• Price System is “Free”– No cost to administer price– Unlike central planning– Soviet Union employed thousands of people

to organize the economy

• A farmer can decide what to plan based on what he thinks will be most profitable

• Prices help goods flow through the economy

Wide Choice of Goods

• Market Based Economy offers diverse goods and services

• Prices allow a “target” consumer base– Bentley

• Fewer choices in Centrally Planned– Reduce costs to meet quotas

Rationing and Shortages

• Despite being inexpensive, products were often hard to purchase in Soviet Union

• Rationing creates shortages

Rationing in the US

• During WWII Rationing existed– GOVT Intent was to ensure everyone had a

level standard of living during wartime– You needed ration points and money to

purchase products– Guns or Butter

• Resources were allocated to guns • Leaving few for butter

The Black Market

• Black Market: A market in which goods are sold illegally– Allows consumers to buy rationed products

buy paying more money

Efficient Resource Allocation

• Free market ensures resources are allocated efficiently – FOP used for most valuable purpose– Resources adjust to change in demands of

consumers– Resources go to the consumer who values

a good or service the most

Price and Profit Incentive

• What happens with a hot summer and the demand for air conditioners and fans?

• How would producers respond to this demand?

Price and Profit Incentive

Price

Air Conditioners

$100.00

500 1000 1500

$250.00

Wealth of Nations

• Adam Smith – 1776– Not because of charity that a baker or

butcher provide people food– A profit is made by providing food

• Business prospers by finding out what people want– Other systems haven’t worked…

Market Problems

• Imperfect Competition – Not enough suppliers reduces competition – Why lower price to have MR = MC

• Spillover Costs (externalities)– Costs of production that affect people who

have no control over how much of a good is produced

– Pollution

• Imperfect Information – Consumers who lack knowledge of alternatives