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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.