Transcript Price Determination
Demand and Supply
Price Determination
In a market economy, the economic questions, “What to produce, how to produce, and for whom to produce”, are answered by the price system.
“What to produce?”: Goods and services are produced because a person can earn a profit, and price is a factor in profit.
“How to produce?”: Costs are the chief determinant in production decisions, so the price of resources influences this question.
“For whom to produce?”: In a market economy, the person who buys the good, receives the good. Prices determine who buys it and who doesn’t.
Prices can be: Prices for goods and services Example: gas, tuition, movie tickets, stock, etc.
Wages: the price of labor Interest rates: the price to use money Rent: the price for using land Prices for ingredients (crude oil, iron ore)
How are prices determined?
In a market economy, prices are determined through the interaction of demand and supply!
A market is a real or artificial meeting place where buyers and sellers come together and decide the price of the good or service.
Examples are: a grocery store, an art auction, EBAY, the stock exchange, applying for a bank loan, a job interview, or buying goods at a mall.
Demand
Demand: The desire, willingness, and ability to want a good or service at different price levels.
The Law of Demand: As prices increase, the quantity demanded decreases.
If P ↑ Q D As prices decrease, the quantity demanded increases.
If P Q D Demand is an inverse relationship because of 2 effects.
Income Effect : increase in Price, you feel less wealthy Substitution Effect: substitute increase in Price, you buy other goods in
Demand can be shown 2 ways: A Demand Schedule and a Demand Curve A table of buyers’ intentions is a Demand Schedule Example: Price of DVDs $6.00
$8.00
$10.00
$12.00
$14.00
$16.00
$18.00
$20.00
$22.00
Quantity Demanded of DVDs 10 million 9 million 8 million 7 million 6 million 5 million 4 million 3 million 2 million
Supply
Supply: The willingness and ability to provide goods and services at different price levels.
Law of Supply: As prices increase, the quantity supplied increases.
If P Q S As prices decrease, the quantity supplied decreases.
If P Q S Direct relationship because when prices increase there is more profit potential, but when prices decrease, a seller cannot cover costs.
There are 2 methods of showing supply: Supply Schedule and a Supply Curve
Supply Schedule: A table of sellers intentions.
Example: Price of DVDs $6.00
$8.00
$10.00
$12.00
$14.00
$16.00
$18.00
$20.00
$22.00
Quantity Supplied of DVDs 2 million 3 million 4 million 5 million 6 million 7 million 8 million 9 million 10 million
Equilibrium
When the demand curve and supply curve intersect, this is called equilibrium.
Equilibrium is defined as a place where the exact quantity demanded at a price is equal to the exact quantity supplied at a price.
In other words Q d = Q s , not D = S
Equilibrium
There is a natural tendency for a market to be in equilibrium. This is called the “Invisible Hand” by Adam Smith (father of Economics). Markets are self-correcting If the price charged is higher than the equilibrium price, then Q d < Q s and a surplus will occur.
If the price charged is less than the equilibrium price, then Q d > Q s and a shortage occurs.
Price of DVDs Quantity Demanded of Quantity Supplied of DVDs DVDs $6.00
$8.00
10 million 9 million $10.00 8 million $12.00 7 million 2 million 3 million 4 million 5 million $14.00 6 million 6 million $16.00 5 million 7 million $18.00 4 million 8 million $20.00 3 million 9 million $22.00 2 million 10 million
Self- Correcting Mechanism
Surplus is eliminated by lowering the price.
As prices decrease, the Q d increases (Law of Demand).
As prices decrease, the Q s Supply).
decreases (Law of Shortage is eliminated by increasing the price.
As price increases, the Q d decreases (Law of Demand).
As price increases, Q s increases (Law of Supply).
What causes prices to change?
The entire demand and/or supply curve must shift.
A shift in a demand or supply curve means that there is an increase or decrease in the Q every price d or Q s at Example of an D: Price $2 $4 Q d1 10 8 Q d2 12 10 $6 6 8
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2.
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Increases in Demand
Caused by the following: Tastes & Preferences Income Price of a substitute good Price of a complementary good Population in Expectation of future prices
Changes in Price Caused by Changes in Supply
Example of S Price Q S1 Q S2 $2 6 8 $4 8 10 $6 10 12
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Increases in Supply
Caused by: in Costs of production Taxes Government Rules Technology Price of resource ingredients Supply Shocks (unexpected events) Number of Sellers Expectations of future prices sellers face
What if the price is too high?
Government can establish a price ceiling Price Ceiling is the legal maximum price a seller may charge for a good or service Sometimes referred to as price caps or price freezes Price ceilings always create a
shortage
of the good or service in question
Price Ceilings continued
Ceilings usually promote the economic goals of stable prices and economic equity, but hurt the goals of economic freedom, and economic growth.
Examples of price ceilings are salary caps in sports, rent controls in large cities, price freezes on prescription medicines, and tuition caps on university costs, and revenue caps on school districts.
What if the price is too low?
Government can establish a price floor Price Floor is the legal minimum price a seller may receive for a good or service. (Sometimes referred to as price supports) Price floor is always placed
above
what the equilibrium price is. Price floors always create a
surplus
of the good or service in question
Price Floors continued
Floors usually promote the economic goals of economic equity and equitable distribution of income, but hurt the goals of economic freedom, and economic growth Examples of price floors are milk, rice, wheat, and sugar supports, and the minimum wage.
Advantages of a price system
compared to rationing
Prices are neutral
: Prices do not favor a consumer or producer.
Prices are flexible
: Prices can absorb unexpected shocks to the economy.
Prices allow for freedom
shopping. of choice when
Prices have no administration cost.
Prices are efficient
: Easy way to change consumer and producer behavior. Without a price system, we would rely on rationing which has a problem with fairness, high costs, and reduced incentives.