1. Prices and Decision Making
Chapter 6
Prices and Decision Making
Splash Screen

2. Introduction
Life is full of signals that help us make decisions. 
For example, when we pull up to an intersection, we look to see if the traffic light is green, yellow, or red. 
We look at the other cars to see if any have their blinkers on, and in this way we receive signals from other drivers regarding their intentions to turn.
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Section 1-4

3. Introduction (cont.) Introduction
Doctors even tell us that pain is a signal that something is wrong with our body and may need attention. 
But have you ever thought about the signals that help us make our everyday economic decisions? 
It turns out something as simple as a price–the monetary value of a product as established by supply and demand–is a signal that helps us make our economic decisions.
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Section 1-4

4. Introduction (cont.)
Prices communicate information and provide incentives to buyers and sellers. 
High prices are signals for producers to produce more and for buyers to buy less. Low prices are signals for producers to produce less and for buyers to buy more.
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Section 1-4

5. Advantages of Prices
Prices are neutral because they do not favor the buyer or the consumer. They are the result of competition. 
Prices are flexible, allowing for the “shocks” of unforeseen events and changes in the market. 
Prices have no administration costs. 
Prices are familiar and easily understood.
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Section 1-5

6. Allocations Without Prices
Rationing, or the system where the government decides everyone’s “fair” share, leads to the question of fairness. 
Rationing leads to high administrative costs. 
Rationing leads to fewer incentives to work and produce.
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Section 1-8

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Discussion Question
Imagine that no matter how much you studied, you already knew you were going to get a “B” in Economics. How would this affect your incentive to study?
Students should indicate that in school, the grade is often the incentive; therefore, knowing the grade beforehand could be detrimental to the student.
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Section 1-Assessment 1

8. Prices as a System
Together, prices comprise a system that helps buyers and sellers allocate resources between markets, linking all markets in the economy.
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Section 1-12

9. Introduction
One of the most appealing features of a competitive market economy is that everyone who participates has a hand in determining prices. 
This is why economists consider prices to be neutral and impartial. 
The process of establishing prices is remarkable because buyers and sellers have exactly the opposite hopes and desires.
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Section 2-4

10. Introduction (cont.)
Buyers want to find good buys at low prices. Sellers hope for high prices and large profits. 
Neither can get exactly what they want, so some adjustment is necessary to reach a compromise.
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Section 2-4

11. The Price Adjustment Process
Together, demand and supply make a complete picture of the market. 
Price adjustments help a competitive market reach market equilibrium, with fairly equal supply and demand. 
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Section 2-6

12. The Price Adjustment Process (cont.)
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Section 2-8

13. The Price Adjustment Process (cont.)
Surpluses occur when supply exceeds demand.
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Section 2-11

14. The Price Adjustment Process (cont.)
Shortages occur when demand exceeds supply. 
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Section 2-13

15. The Price Adjustment Process (cont.)
The equilibrium price is the price at which supply meets demand.
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Section 2-15

16. The Price Adjustment Process (cont.)
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Section 2-16

17. Explaining and Predicting Prices
A change in price is normally the result of a change in supply, a change in demand, or both.
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Section 2-20

18. Explaining and Predicting Prices (cont.)
Even small changes in an inelastic supply can create big changes in price. 
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Section 2-22

19. Explaining and Predicting Prices (cont.)
Elastic supply and demand help keep prices from changing dramatically.
Section 2-25

20. The Competitive Price Theory
The theory of competitive pricing represents a set of ideal conditions and outcomes; it serves as a model to measure market performance. 
In theory, a competitive market allocates resources efficiently. 
To be competitive, sellers are forced to lower prices, which makes them find ways to keep their costs down. 
Competition among buyers keeps prices from falling too far.
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Section 2-30

21. Introduction
Chapter 2 examined seven broad economic and social goals that most people seem to share. 
We also observed that these goals, while commendable, were sometimes in conflict with one another. 
These goals were also partially responsible for the increased role that government plays in our economy. 
The goals most compatible with a market economy are freedom, efficiency, full employment, price stability, and economic growth.
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Section 3-4

22. Introduction (cont.)
Attempts to achieve the other two goals—equity and security—usually require policies that distort market outcomes. 
In other words, we may have to give up a little efficiency and freedom in order to achieve equity and security. 
Whether this is good or bad often depends on a person’s perspective.
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Section 3-4

23. Introduction (cont.) Introduction
After all, the person who receives a subsidy is more likely to support it however, it is usually wise to evaluate each situation on its own merits, as the benefits of a program may well exceed the costs. 
What is common to all of these situations, however, is that the outcomes can be achieved only at the cost of interfering with the market.
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Section 3-4

24. Introduction (cont.)
After all, the person who receives a subsidy is more likely to support it than is the taxpayer who pays for it. 
In general, it is usually wise to evaluate each situation on its own merits, as the benefits of a program may well exceed the costs. 
What is common to all of these situations, however, is that the outcomes can be achieved only at the cost of interfering with the market.
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Section 3-5

25. Distorting Market Outcomes
Achieving equity and security (two of the seven broad economic and social goals) usually requires policies that distort market outcomes. 
One way to achieve these goals is to set “socially desirable” prices, which interferes with the pricing system. 
Setting price ceilings affects the allocation of resources. 
The minimum wage is an example of a price floor.
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Section 3-6

26. Distorting Market Outcomes (cont.)
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Section 3-7

27. Distorting Market Outcomes (cont.)
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Section 3-12

28. Agricultural Price Supports
Government loan support was offered in the 1930s through Commodity Credit Corporation to help stabilize agricultural prices. The CCC loan program led to food surpluses. 
The CCC switched to deficiency payments, which prevented the government from holding surplus food and had farmers sell their crops on the open market.
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Section 3-15

29. Agricultural Price Supports (cont.)
In 1996, Congress passed FAIR—Federal Agricultural Improvement and Reform Act. Cash payments replaced price supports and deficiency payments. The payments ended up costing as much. In 2002, farmers will no longer receive any kind of payments.
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Section 3-15

30. When Markets Talk
Markets “talk” when prices move up or down dramatically. 
Buyers and sellers respond to changes in the market through their decisions.
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Section 3-21

31. Section 1: Prices as Signals
Prices serve as signals to both producers and consumers. In doing so, they help decide the three basic WHAT, HOW, and FOR WHOM questions that all societies face. 
High prices are signals for businesses to produce more and for consumers to buy less. Low prices are signals for businesses to produce less and for consumers to buy more. 
Prices have the advantages of neutrality, flexibility, efficiency, and clarity.
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Chapter Summary 1

32. Section 1: Prices as Signals (cont.)
Other nonprice allocation methods such as rationing can be used. Under such a system, people receive ration coupons, which are similar to tickets or receipts that entitle the holder to purchase a certain amount of a product. 
Nonprice allocation systems suffer from problems regarding fairness, high administrative costs, and diminished incentives to work and produce. 
A market economy is made up of many different markets, and different prices prevail in each. A change in price in one market affects more than the allocation of resources in that market. It also affects the allocation of resources between markets.
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Chapter Summary 2

33. Section 2: The Price System at Work
Economists often use an economic model to help analyze behavior and predict outcomes. Models of economic markets are often represented with supply and demand curves in order to examine the concept of market equilibrium, a situation in which prices are relatively stable, and the quantity of output supplied is equal to the quantity demanded. 
In a competitive market, prices are established by the forces of supply and demand. If the price is too high, a temporary surplus appears until the price goes down. If the price is too low, a temporary shortage appears until the price rises. Eventually the market reaches the equilibrium price where there is neither a shortage nor a surplus.
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Chapter Summary 3

34. Section 2: The Price System at Work (cont.)
A change in price can be caused by a change in supply or a change in demand. The size of the price change is affected by the elasticity of both curves. The more elastic the curves, the smaller the price change; the less elastic the curves, the larger the price change. 
The theory of competitive pricing represents a set of ideal conditions and outcomes. The theory serves as a model by which to measure the performance of other, less competitive markets. Because of this, absolutely pure competition is not needed for the theory of competitive pricing to be practical.
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Chapter Summary 4

35. Section 3: Social Goals vs. Market Efficiency
Governments sometimes fix prices at levels above or below the equilibrium price to achieve the social goals of equity and security. 
If the fixed price is a price ceiling, as in the case of rent controls, a shortage usually appears for as long as the price remains fixed below the equilibrium price. 
Agricultural price supports were introduced during the 1930s to support farm incomes. Nonrecourse loan support programs allowed farmers to borrow against crops, and then keep the loan and forfeit the crop if market prices were low.
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Chapter Summary 5

36. Section 3: Social Goals vs. Market Efficiency (cont.)
Later, deficiency payments were used, supplying the farmer with a check that made up the difference between the target price and the actual price received for the product.
Chapter Summary 6