Chapter 6 – Prices and Decision Making

Section One – Prices as Signals Advantages of Prices i. Prices favor neither the producer or consumer ii. Prices are flexible iii. Can accommodate change iv. No cost of administration II. Allocations Without Prices i. Rationing (w/coupons) – The government decides everyone’s “fair-share” a. The Problem of Fairness i. Everyone will think their fair share is too small b. High Administrative Cost i. Coupons need to be printed and the program needs to be administered c. Diminishing Incentive i. Reduces the incentive to work

Prices as a System i. Price systems are favored by economists ii. Serve as signals to allocate resources in markets - Gas in the 1970’s

Section Two – The Price System at Work The Price Adjustment Process a. An Economic Model

b. Market Equilibrium i. Quantity of goods and services supplied is equal to the quantity demanded c. Surplus i. A situation where the quantity supplied is greater than quantity demanded - forces the prices down d. Shortage i. A situation where the quantity demanded is greater than quantity supplied - forces prices up e. Equilibrium Price i. The price at which there is neither a shortage or surplus

II. Explaining and Predicting Prices a. Changes in Supply i. Increases or decreases in supply can change prices b. Importance of Elasticity i. Price changes tend to be wider if both products are inelastic ii. Prices will be less volatile if both curves are elastic c. Changes in Demand i. Changes in demand also effect prices III. The Competitive Price Theory i. Allocate resources efficiently

Section Three – Social Goals vs. Market Efficiency Distorting Market Outcomes i. Setting prices as “socially desirable levels” ii. Prices are not allowed to reach their equilibrium a. Price Ceilings – A maximum legal price that can be charged for a product i. These ceilings have the opposite intended effect (shortages, minimum upkeep, allocated resources somewhere else, waiting lists)

b. Price Floors – The lowest legal price that can be paid for a good or service i. Minimum wage is a price floor ii. Does it lead to unemployment? iii. Is it efficient? iv. Why would we implement it?

II. Agricultural Price Supports a. Loan Supports i. Loans given to support production at a higher price b. Deficiency Payments i. Checks sent to producers that make up the difference between actual market price and the target price (limited production) c. Reforming Price Supports i. Cash payments rather than loan supports or deficiency payments ii. Economic security or efficiency.

III. When Markets Talk i. Speak collectively for all buyers and sellers ii. Prices move based on these forces - Gold prices often move on economic the economic outlook