Prices and Decision Making

Chapter 6

Prices As Signals

Price – monetary value of a product est. by supply and demand – “Signal”

Prices help producers and consumers decide the 3 basic questions:

1. WHAT to produce2. HOW to produce it3. FOR WHOM to produce

What would life be like without prices?

• Intelligence? good looks? political connections?• Communist countries often answer the 3 basic questions in

economics.• Rationing

• Usually unfairly distributed• Cost of distributing, enforcing, issuing coupons• Negative impact on the incentive to produce

Prices as a system• Non price allocation systems are typically corrupt• The price systems help individuals make decision and serve as

a signal for suppliers• Ex. Ebay; Craigslist

Price System at WorkCh.6 Sec.2

Price of pizza Quantity of pizza demanded (per week)

Quantity of pizza supplied (per week)

$25 100 800

$20 210 700

$15 300 625

$10 500 500

$5 650 300

Market Equilibrium Price

Changes In EquilibriumExample 1: Suppose that the price of Chinese food delivery rises. What happens to the market for pizza? Let's figure this out with a 3 step approach:

Step 1: Will this affect the demand or supply curve? •Chinese food is a substitute for pizza, so the price of chinese food affects the demand curve Step 2: In what direction will the affected curve move? •The price of chinese food, a substitute, INCREASES, so the demand for pizza INCREASES, or the demand curve shifts right. Step 3: What is the resulting impact on the equilibrium price and quantity? •This is easiest to answer with a graph. If you look at the graph below you will see that the new equilibrium has a higher price and larger quantity. An increase in demand results in an increase in price and quantity.

Example 2: Suppose instead that the Chinese food business is incredibly popular and profitable. What happens to the market for pizza? Again, we use the same three step approach:

Step 1: Will this affect the demand or supply curve?• The chinese food business is an alternative to the pizza business, affecting the supply curve Step 2: In what direction will the affected curve move?• The profitability of chinese food means that some pizza places will switch to chinese food places, so the supply of pizza DECREASES, or the supply curve shifts left. Step 3: What is the resulting impact on the equilibrium price and quantity? •This is easiest to answer with a graph. If you look at the graph below you will see that the new equilibrium has a higher price and smaller quantity. An decrease in supply results in an increase in price and a decrease in quantity.

Bad News for Orange Juice Fanatics

Orange Juice Prices Could Skyrocket After Freeze Destroys Most of California Output

City News

Market Equilibrium

Changes In Equilibrium

Price Ceilings & Floors• A price ceiling is a legal maximum that can be charged for a good.

• Results in a shortage of a product• Common examples include apartment rentals and credit cards interest

rates.

Price Ceilings

Price Ceilings are always below Equilibrium Price

Price Floors and Ceilings

Many cities have rent control laws to make sure that poor peoplecan find apartments they can afford. But landlords do not find itprofitable to rent at these prices and sometimes convert theirbuildings to condominium or cooperative ownership. This reducesthe number of apartments available: it creates a shortage.

A shortage occurs when quantity demanded exceeds quantity supplied.A shortage implies the market price is too low.

Example:

A surplus occurs when quantity supplied exceeds quantity demanded. •A surplus implies the market price is too high.

The prices of many agricultural commodities, such as milk forinstance, are subject to government price support. This higherprice encourages farmers to produce too much: this creates surpluses. For instance, in the 1980's, the government has beenforced to make cheese from milk surplus and to distribute thatcheese free to poor people.

Example:

Price Ceiling

A price ceiling is set at $2 resulting in a shortage of 20 units.

Rent Control - NYC

Price Floor

A price floor is set at $4 resulting in a surplus of 20 units.

A price floor is a legal minimum that can be charged for a good.•Results in a surplus of a product•Common examples include soybeans, milk, minimum wage