Lesson Objectives: By the end of this lesson you will be able to: *Identify the many roles that prices play in a free market. *List the advantages of a price-based system. *Explain how a price-based system leads to a wider choice of goods and more efficient allocation of resources. *Describe the relationship between prices and the profit incentive.

Prices in a Free Market In a free market, prices are a tool for distributing goods and resources throughout the economy. Prices are nearly always the most efficient way to allocate (distribute) resources. Prices help move land, labor, and capital into the hands of producers and finished goods into the hands of buyers. The Advantage of Prices Prices provide a common language for buyers and sellers. Without prices as a standard measure of value, a seller would have to barter (trade) for goods by trading shoes or apples for a sweater. A sweater might be worth two pairs of shoes to one customer, but another customer might be willing to trade three pairs of shoes for the same sweater. The supplier would have no consistent and accurate way to measure demand for a product. Such a system would be inconvenient, impractical, and inefficient.

Prices as Signals Think of prices as a traffic light for producers and consumers. Producers *high price = green light which tells the producers that a product is in demand. *low price = red light which tells producers that a good is being over produced. Consumers *high price = red light which tells consumers to stop and think carefully before buying. *low price = green light which tells consumers that they may have the opportunity to get a good deal on a product.

Flexibility Another important aspect of prices is that they are flexible. Prices can easily be increased to solve a problem of shortage, and they can just as easily be decreased to eliminate a problem of surplus. Example: A supply shock is a sudden shortage of a good, such as gasoline. A supply shock creates a shortage because suppliers can no longer meet consumer demand. The immediate problem is how to divide up the available supply among consumers. Rationing is a system of allocating goods and services using criteria other than price. Raising prices is the quickest way to resolve a shortage. A quick increase in prices can reduce quantity demanded to the same level as quantity supplied.

Choice and Efficiency One benefit of a market-based economy is the diversity of goods and services that consumers can buy. Prices help consumers choose among similar products. Prices provide an easy way for you to narrow your choices to a certain price range. Prices also allow producers to target the audience they want with the products that will sell best to that audience. The Black Market Sometimes, people conduct business without regard for government controls on price or quantity. This is called doing business on the black market. Black markets allow consumers to pay more so they can buy a product when rationing makes it otherwise unavailable. Black market trade is illegal and strongly discouraged by governments.

Prices and the Profit Incentive In a free market, efficient resource allocation goes hand in hand with the profit incentive. Example: If scientists predicted extremely hot weather for the coming summer, consumers would buy up air conditioners and fans to prepare for the heat. Suppliers would recognize the possibility for profit in charging higher prices for these goods.