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©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 1 CHAPTER 4 The Power of Prices.

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Presentation on theme: "©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 1 CHAPTER 4 The Power of Prices."— Presentation transcript:

1 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 1 CHAPTER 4 The Power of Prices

2 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 2 Learning Objectives 1.Interpret how demand represents marginal benefit and supply marginal cost. 2.Explain the concept of social surplus and how it is divided between consumers and producers. 3.Demonstrate how both exports and imports increase efficiency while simultaneously harming either consumers or producers. 4.Identify inefficiencies associated with price ceilings. 1.Interpret how demand represents marginal benefit and supply marginal cost. 2.Explain the concept of social surplus and how it is divided between consumers and producers. 3.Demonstrate how both exports and imports increase efficiency while simultaneously harming either consumers or producers. 4.Identify inefficiencies associated with price ceilings.

3 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 3 Learning Objectives 4.Show why price supports are unnecessary and politically counterproductive. 5.(E&A) Pinpoint the economic flaw in California's deregulation of electricity. 4.Show why price supports are unnecessary and politically counterproductive. 5.(E&A) Pinpoint the economic flaw in California's deregulation of electricity.

4 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e PRICE SIGNALS FOR EFFICIENT CHOICE The marketplace depends upon price signals. The market price sends a message to consumers and producers. For consumers market price signals how much of a good they wish to buy. For producers it signals how much of a good they wish to sell. When market price falls consumers respond by buying more, and producers respond by selling less. The marketplace depends upon price signals. The market price sends a message to consumers and producers. For consumers market price signals how much of a good they wish to buy. For producers it signals how much of a good they wish to sell. When market price falls consumers respond by buying more, and producers respond by selling less.

5 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 5 Consumer Surplus 4 Consumer surplus is how much the good is worth to the consumer, in the abstract, minus what the consumer actually paid for it. Consumer Surplus = Demand - Market Price

6 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 6 Marginal Benefit and Consumer Surplus 123 Demand $ Quantity The demand curve shows the maximum price the consumer would pay for each quantity that might be purchased. The maximum price is the consumers marginal benefit – the incremental value of each additional item consumed.

7 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 7 Consumer Surplus PriceQuantity$201 $152 $103Quantity Marginal Benefit Total Benefit 1$20$20 2$15$35 3$10$45 Dwights demand for blue jeans. Dwights benefits from buying blue jeans.

8 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 8 Consumer Surplus PriceQuantity$201 $152 $103 Total Benefit Total Paid Consumer Surplus $20$20$0 $35$30$5 $45$30$15 Dwights demand for blue jeans. Dwights benefits from buying blue jeans.

9 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 9 Consumer Surplus 123 Demand $ Quantity Price =$10 Consumer surplus in general. The consumer surplus is the area under the demand curve and above the market price. It is what consumers gain from their purchases after deducting the cost.

10 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 10 Consumer Surplus 123 Demand $ Quantity Price =$10 At a price of $10 per pair of jeans, Dwight buys three pair, and receives $15 worth of consumer surplus. His consumer surplus equals the sum of the consumer surplus from the 1st, 2nd, and 3rd pair of jeans. $10 +$5 + $0 =$15. $10 $5 $0

11 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 11 Marginal Cost and Producer Surplus The supply curve depicts the minimum price that the producers of a good would be willing to accept for each quantity offered. That minimum price is the producers marginal cost, which is the incremental cost of producing each additional item offered for sale. The producer surplus is equal to the amount by which total revenue exceeds the total cost. The supply curve depicts the minimum price that the producers of a good would be willing to accept for each quantity offered. That minimum price is the producers marginal cost, which is the incremental cost of producing each additional item offered for sale. The producer surplus is equal to the amount by which total revenue exceeds the total cost.

12 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 12 Marginal Cost Supply $ Quantity 123 Marginal cost increases as quantity produced rises.

13 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 13 Producer Surplus PriceQuantity$51 $7.502 $103Quantity Marginal Cost Total Cost 1$5$5 2$7.50$ $10$22.50 Buddys supply of blue jeans. Buddys cost of producing blue jeans.

14 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 14 Producer Surplus Price Quantity Sold $51 $7.502 $103 Total Cost Total Revenue Producer Surplus $5$5$0 $12.50$15$2.50 $22.50$30$7.50 Buddys supply of blue jeans. Buddys cost of producing blue jeans.

15 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 15 Producer Surplus Supply $ Quantity 123 The producer surplus is the area above the supply curve and under the market price. It is what the producers gain from their sale after deducting their cost. their cost. Price$10 Producer Surplus

16 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 16 Producer Surplus Supply $ Quantity 123 At a price of $10 per pair of jeans, Buddy sells 3 pair of jeans, Buddy sells 3 pair and receives pair and receives $7.50 worth of producer surplus. His producer surplus equals the sum of his producer surplus from the 1 st, 2 nd and 3 rd pairs, which is $5 + $2.50 +$0 equals $7.50 Price$10$5$2.50 $0

17 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 17 Marginal Benefit and Marginal Cost Marginal Benefit (to consumers): The value of each additional unit of the good. Marginal Benefit (to consumers): The value of each additional unit of the good. Marginal Cost (to producers): The cost of resources used to produce each additional unit. Marginal Cost (to producers): The cost of resources used to produce each additional unit. The efficient output occurs when societys marginal benefit equals marginal cost. The efficient output occurs when societys marginal benefit equals marginal cost. Marginal Benefit (to consumers): The value of each additional unit of the good. Marginal Benefit (to consumers): The value of each additional unit of the good. Marginal Cost (to producers): The cost of resources used to produce each additional unit. Marginal Cost (to producers): The cost of resources used to produce each additional unit. The efficient output occurs when societys marginal benefit equals marginal cost. The efficient output occurs when societys marginal benefit equals marginal cost.

18 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 18 Market Efficiency Supply = Marginal Cost Demand = Marginal Benefit $ QuantityEfficient Quantity Equilibrium Price Consumer Surplus ProducerSurplus Social Surplus = consumer surplus + producer surplus

19 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 19 The Market Equilibrium Price The market equilibrium price leads to the efficient quantity. No other quantity would generate a larger total of consumer and producer surplus. If the price is less than the equilibrium price, quantity falls because producers arent willing to sell as much. If the price is greater than the equilibrium price quantity falls because consumers arent willing to buy as much. The market equilibrium price leads to the efficient quantity. No other quantity would generate a larger total of consumer and producer surplus. If the price is less than the equilibrium price, quantity falls because producers arent willing to sell as much. If the price is greater than the equilibrium price quantity falls because consumers arent willing to buy as much.

20 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 20 The Market Equilibrium Price The triangular area of area of forgone social surplus caused by inefficient pricing is called the is called the deadweight loss.

21 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 21 The Paradox of Diamonds and Water S D Quantity of Water Dollars Consumer Surplus Dollars Quantity of Diamonds D S Much smaller Consumer Surplus Low Price High price Water Market Diamond Market

22 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 22 The Efficiency of Imports and Exports Market prices of goods and services only reflect the domestic prices of supply and demand within the country, when a country does not engage in international trade. When a country opens its markets to international trade, market prices change as a world of new consumers and producers are involved. Imports are goods and services bought from other countries. Exports are goods and services sold to other countries. Market prices of goods and services only reflect the domestic prices of supply and demand within the country, when a country does not engage in international trade. When a country opens its markets to international trade, market prices change as a world of new consumers and producers are involved. Imports are goods and services bought from other countries. Exports are goods and services sold to other countries.

23 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 23 The Efficiency of Imports and Exports The result of trade is that the price in the domestic market will come to equal the world market price. If the domestic price rises to meet a higher world price, then the country exports the good. If the lower world price causes the domestic price to drop, then the country imports the good. In either case, there are some people within the country who gain, and others who lose. The gains however, can be expected to exceed the losses. The result of trade is that the price in the domestic market will come to equal the world market price. If the domestic price rises to meet a higher world price, then the country exports the good. If the lower world price causes the domestic price to drop, then the country imports the good. In either case, there are some people within the country who gain, and others who lose. The gains however, can be expected to exceed the losses.

24 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e PRICE CEILINGS AND RENT CONTROLS 4 Price Ceiling: a law that restricts a price from rising above a certain level 4 Price Freezes: prohibiting a wide array of prices from rising 4 Rent Controls: laws that limit rent increases to below what the market would bear

25 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 25 Rent Controls Quantity Price ($s) 0 Demand Supply Q*QSQD P* Ceiling Price Housing Shortage

26 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 26 Rent Controls over Time Quantity Price ($s) 0 Initial Supply P* Ceiling Price Later Supply Initial Demand Later Demand Initial Shortage Later Shortage P**

27 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 27 Price Gouging and Ticket Scalping Price Gouging: The practice of hiking up prices to exploit temporary surges in demand Price Gouging: The practice of hiking up prices to exploit temporary surges in demand Ticket Scalping: The practice of buying tickets at the price set by concert promoters and then reselling at whatever the market will bear Ticket Scalping: The practice of buying tickets at the price set by concert promoters and then reselling at whatever the market will bear Price Gouging: The practice of hiking up prices to exploit temporary surges in demand Price Gouging: The practice of hiking up prices to exploit temporary surges in demand Ticket Scalping: The practice of buying tickets at the price set by concert promoters and then reselling at whatever the market will bear Ticket Scalping: The practice of buying tickets at the price set by concert promoters and then reselling at whatever the market will bear

28 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e PRICE FLOORS/PRICE SUPPORT 4 Price floors and price supports are used by government to artificially prop up prices. They establish a minimum price that producers are guaranteed to receive.

29 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 29 Price Supports and Surpluses Agricultural Commodity Price ($s) 0 Demand Supply Q*QSQD P* Floor Price Surplus

30 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 30 The Minimum Wage 4 Increases the price of relatively unskilled labor. 4 Higher wage means more people willing to work. 4 Higher wage also means fewer jobs offered. 4 Increases the price of relatively unskilled labor. 4 Higher wage means more people willing to work. 4 Higher wage also means fewer jobs offered. Result = Surplus of Labor

31 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 31 Minimum Wage Laws Surplus of labor Q*QSQD Demand Supply Minimum wage Fewer JobsMore Applicants Equilibrium wage Low-Skill Labor $ Tonys required wage Daves required wage

32 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e AROUND THE WORLD – Black Markets a Safety Net oPrice controls are in effect around the world. oThe Black Market exist when people buy and sell goods goods illegally. oThis can be seen as the market forces trying to assert themselves. oBlack Markets can temper destructive policies. oBlack Markets act as a safety net and provide people in countries where they exist with necessities they would otherwise have to do without. oPrice controls are in effect around the world. oThe Black Market exist when people buy and sell goods goods illegally. oThis can be seen as the market forces trying to assert themselves. oBlack Markets can temper destructive policies. oBlack Markets act as a safety net and provide people in countries where they exist with necessities they would otherwise have to do without.

33 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e EXPLORE & APPLY The Price of Power In 2001 California lawmakers deregulated the wholesale electricity market. By increasing supply, the lawmakers felt that customers would eventually realize savings. Unfortunately, crude oil prices doubled, and and caused supply to shift to the left, more than the rightward shift caused by deregulation. The decrease in the supply of wholesale electricity caused the wholesale price of electricity to rise sharply. In 2001 California lawmakers deregulated the wholesale electricity market. By increasing supply, the lawmakers felt that customers would eventually realize savings. Unfortunately, crude oil prices doubled, and and caused supply to shift to the left, more than the rightward shift caused by deregulation. The decrease in the supply of wholesale electricity caused the wholesale price of electricity to rise sharply.

34 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 34 The Price of Power Since lawmakers had promised to keep rates at less than the new equilibrium price, the result was shortages in the retail electricity market. Price ceilings cause shortages!!! Since lawmakers had promised to keep rates at less than the new equilibrium price, the result was shortages in the retail electricity market. Price ceilings cause shortages!!!

35 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 35 Terms along the Way price signals marginal benefit consumer surplus producer surplus social surplus deadweight loss price ceiling price signals marginal benefit consumer surplus producer surplus social surplus deadweight loss price ceiling rent controls transfer payments search cost housing vouchers price gouging price floor (price support) minimum wage black market

36 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 36 Test Yourself 1.If Yvette would be willing to pay up to $10 for one gizmo, up to $8 for a second, and up to $6 for a third, and the price of gizmos is $6 apiece, then Yvettes consumer surplus totals a.$24. b.$18. c.$6. d.$4. 1.If Yvette would be willing to pay up to $10 for one gizmo, up to $8 for a second, and up to $6 for a third, and the price of gizmos is $6 apiece, then Yvettes consumer surplus totals a.$24. b.$18. c.$6. d.$4.

37 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 37 Test Yourself 2.If the government places a price ceiling of $1.20 on a good which has an equilibrium price of $1.00 then a.there will be a surplus of the good. b.there will be a shortage of the good. c.neither a surplus nor a shortage will occur. d.if demand for the good decreases, government will not let the price go below $ If the government places a price ceiling of $1.20 on a good which has an equilibrium price of $1.00 then a.there will be a surplus of the good. b.there will be a shortage of the good. c.neither a surplus nor a shortage will occur. d.if demand for the good decreases, government will not let the price go below $1.00.

38 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 38 Test Yourself 3.Efficiency requires that a.total consumer surplus equal zero. b.market prices be fair. c.marginal social benefit equal marginal social cost. d.people buy low and sell high. 3.Efficiency requires that a.total consumer surplus equal zero. b.market prices be fair. c.marginal social benefit equal marginal social cost. d.people buy low and sell high.

39 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 39 Test Yourself 4.Over time, rent controls that remain in place lead to a.increased renovation of old apartments. b.a greater ability for tenants to move to the best apartment for their needs. c.increasingly severe housing shortages. d.people buy low and sell high. 4.Over time, rent controls that remain in place lead to a.increased renovation of old apartments. b.a greater ability for tenants to move to the best apartment for their needs. c.increasingly severe housing shortages. d.people buy low and sell high.

40 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 40 Test Yourself 5.Compared to a free-market equilibrium, agricultural price supports have the effect of a.increasing both the quantities supplied and demanded. b.decreasing both the quantities supplied and demanded. c.increasing the quantity supplied and decreasing the quantity demanded. d.people buy low and sell high. 5.Compared to a free-market equilibrium, agricultural price supports have the effect of a.increasing both the quantities supplied and demanded. b.decreasing both the quantities supplied and demanded. c.increasing the quantity supplied and decreasing the quantity demanded. d.people buy low and sell high.

41 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 41 The End! Next Chapter 5 Measuring National Output"


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