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Objectives: 1. Explain the role of the price system 2. Describe the benefits and identify the limitations of the price system 3. Explain the term market equilibrium 4. Identify how the price system handles product surpluses and shortages 5. Describe how shifts in demand and supply affect market equilibrium 6. Analyze why governments set prices, price floors, and price ceilings and engage in rationing Adam Smith 12.1: Students understand common economic terms and concepts and economic reasoning 12.2: Students analyze the elements of America’s market economy in a global setting 12.3: Students analyze the influence of the federal government on the American economy What is the role of the price system? The price system guides producers and consumers to balance the forces of supply and demand by reaching compromises on production levels. Benefits of the price system The price system provides information, incentives, choice, efficiency, and flexibility General Washington used the price system to keep track of the price of water to run his mill and the price of burlap sacks to put cornmeal into. That knowledge helped him set profitable prices for his cornmeal. Benefits of the price system The price system provides information, incentives, choice, efficiency, and flexibility There is a surplus of shoes— prices are down. I’m a happy girl. I have incentive to go shopping! I ‘d like to buy some USB drive memory sticks but there is a shortage and prices are sky high. There is little incentive to buy. Benefits of the price system The price system provides information, incentives, choice, efficiency, and flexibility There are literally thousands of pairs of shoes in my size at the mall. What a choice I have! Because of consumers like me, manufacturers produce incredible numbers of shoes. I’m such a happy girl! Benefits of the price system The price system provides information, incentives, choice, efficiency, and flexibility It also encourages efficiency by quickly delivering information to producers and consumers. The price system helps manufacturers efficiently use resources and tells us what consumers want to buy. Benefits of the price system The price system provides information, incentives, choice, efficiency, and flexibility (one of the price system’s greatest strengths) Limitations of the price system (market failures) Externalities—the price system may not take into account all of the costs and benefits of production Negative externality exists when someone who does not make or consume a certain product nonetheless bears part of the cost of its production Limitations of the price system (market failures) Externalities—the price system may not take into account all of the costs and benefits of production A positive externality exists when someone who does not sell or buy a certain product nonetheless benefits from its production Limitations of the price system (market failures) Public goods—any goods or services that are consumed by all members of a group, even though not all members pay for or want them Limitations of the price system (market failures) Instability—prices can swing quickly between extremes based on severe weather, natural disasters, worker protests, etc. What is market equilibrium? A situation that occurs when the quantity supplied and the quantity demanded for a product are equal at the same price. At this equilibrium point, the needs of both producers and consumers are satisfied, and the forces of supply and demand are in balance. What is market equilibrium? Price per pair of shoes Quantity Demanded Quantity Supplied $15 180,000 0 $30 150,000 30,000 $45 120,000 60,000 $60 90,000 90,000 $75 60,000 120,000 $90 30,000 150,000 $105 0 180,000 Price per Pair of Tennis Shoes Equilibrium Price Demand and Supply Schedule $105 S-1 $ 90 $ 75 Equilibrium $ 60 $ 45 $ 30 D-1 $ 15 0 30 60 90 120 150 180 Quantity demanded (in thousands) What is market equilibrium? Equilibrium Price Demand and Supply Schedule Quantity Demanded Quantity Supplied Price per Price per pair of shoes Quantity demanded When Surplus Exists When the quantity supplied exceeds the quantity demanded at the prices offered; The surplus tells producers that they are charging too much for their item—they can lower the price and still make a profit. The lower price increases the quantity demanded and decreases the quantity supplied, eliminating the surplus and steering the market toward equilibrium. When Shortage Exists When the quantity demanded exceeds the quantity supplied at the price offered; The shortage tells producers that they are charging too little for items and they decide to raise the price. The higher price decreases the quantity demanded and increases the quantity supplied, eliminating the shortage and steering the market toward equilibrium When Shortage Exists National Gasoline Shortage 1973-1974 Price per Pair of Tennis Shoes Surplus & Shortage $105 A Surplus B $ 90 S-1 $ 75 E $ 60 $ 45 D-1 $ 30 C Shortage C $ 15 0 30 60 90 120 150 180 Quantity demanded (in thousands) Shifts in Equilibrium Changes in consumer tastes and preferences, Market size, Income, Prices of related goods Consumer expectations Equilibrium, Demand, and Supply Shifts Shift in Demand Shift in Supply 105 $105 S-1 $90 S-1 $90 $75 $75 E-2 D-2 E-1 $60 S-2 E-1 $60 $45 $45 $30 $30 E-2 D-1 $15 $15 0 0 30 60 90 120 150 180 Quantity demanded (in thousands) D-1 30 60 90 120 150 180 Quantity demanded (in thousands) Increase in Demand Decrease in Demand Why do Price ceilings governments and floors sometimes set prices? I’ll answer that one. I’m Price ceilings—set a U. S. Secretary of a maximum price for Agriculture, Tom Vilsack. particular good (rent If my staff and I believe a controls). Price commodity’s price floors will, for (more common)—a some reason, swing too government regulation dramatically, we may set to protect that prices establishes a producers minimum leveland for prices consumers. (crop prices). Price ceilings and floors Rationing Unfair Expensive Creates black markets Black market gasoline in Iraq Water rationing in California. Was it fair? Northern California Southern California Objectives: 1. Define perfect competition 2. Define monopolistic competition 3. Explain how sellers differentiate their products under monopolistic competition 4. Describe the structure of an oligopoly 5. Define a monopoly 6. Describe the factors that affect price in oligopolies and monopolies 7. Describe the history of antitrust legislation in U. S. history Adam Smith 12.1: Students understand common economic terms and concepts and economic reasoning 12.2: Students analyze the elements of America’s market economy in a global setting 12.3: Students analyze the influence of the federal government on the American economy Characteristics Perfect Competition Monopolistic Competition Oligopoly Pure Monopoly Number of firms in each industry Many Many Few (3-4) One Market Concentration Low Low High Absolute Type of Product Similar or identical Similar or identical Similar or differentiated Unique (no substitutes) Availability of Information Much (Product advertising) Much (Product advertising) Much (Product advertising) Some (Product and Institutional Ad) Entry into Industry Very Easy Fairly Easy Difficult Prohibitive Control over Prices None Little Some Complete Example Industries Agriculture Long-distance telephone service •Automobiles •Breakfast cereals Electric Power Perfect Competition An ideal market structure in which buyers, or consumers, and sellers, or producers, each compete directly and fully under the laws of supply and demand. This means that no one buyer or seller controls demand, supply or prices and nothing prevents competition among both buyers and sellers Conditions for Perfect Competition Many buyers and sellers act independently Sellers offer identical products Buyers are well informed about products Sellers can enter or exit the market easily Perfect Competition An ideal market structure in which buyers, or consumers, and sellers, or producers, each compete directly and fully under the laws of supply and demand. This means that no one buyer or seller controls demand, supply or prices and nothing prevents competition among both buyers and sellers Monopolistic Competition vs. Perfect Competition Differs in one key respect—sellers offer different, rather than identical, products—each firm seeks to have monopoly-like power by selling a unique product Monopolistic Competition vs. Perfect Competition Similarities: First, both buyers and sellers in monopolistic competition operate under the laws of supply and demand Both systems also feature many buyers and sellers acting independently Monopolistic Competition vs. Perfect Competition Product differentiation—pointing out differences and using brand names Non-price competition—most common is advertising Monopolistic Competition Businesses involved in monopolistic competition try to create profits by setting its product apart from the competition and convincing buyers to base their decision on non-price factors, a seller can raise the price of its product above the competitive level and make more profit. The seller does this by increasing demand for its product, thereby shifting market price upward. Shift in Demand and Equilibrium Price $70 S-1 Price per Pair of Jeans $60 B $50 D-2 $40 A $30 $20 $10 D-1 0 20 40 60 80 100 120 Quantity demanded (in thousands) Oligopoly A market structure in which a few large sellers control most of the production of a good or service Three conditions that must be present for an oligopoly to exist: Only a few large sellers Sellers offer identical or similar products Other sellers cannot enter the market easily Kellogg’s, General Mills and Post: 80% of sales Price war Sellers aggressively undercut each other’s prices in an attempt to gain market share. Price wars can initially benefit consumers by lowering prices. If this level of competition lasts a long time, a seller may lose so much money that it is forced out of business. When a price war ends, prices tend to rise again as oligopolistic sellers return to price leadership and non-price competition. If one or more sellers have gone out of business, prices may rise even higher than before the price war because of reduced competition. Price war Example: John D. Rockefeller Standard Oil Company of Ohio Sold oil at a price lower than cost of producing it to drive competitors out of business After gaining market control, increased prices far above original level Cartels A group of sellers openly organize a system of price setting and market sharing. Cartels are illegal in the U.S. because they fix prices. What conditions for a monopoly to exist? There is a single seller No close substitute goods are available Other sellers cannot enter the market easily Natural Monopolies A single large seller produces a good or service most efficiently. Economies of scale: the seller’s large scale, or size, allows it to use its human, capital, and other resources more efficiently and economically than if those resources were divided among several smaller producers. Geographic Monopolies Technological Government Monopolies Monopolies Limits on Seller’s Control Over Prices Consumercompetition Government Potential Demand Regulation Antitrust Legislation Interstate Commerce Act of 1887 Attempt to regulate the railroads Clear: only Federal Government could regulate railroads Banned discrimination in rates between long and short hauls RRs required to publish rate schedules and file them with the government All interstate rail rates had to be reasonable and just Created the Interstate Commerce Commission Antitrust Legislation Sherman Anti-Trust Act of 1890 Proposed by John Sherman, Senator from Ohio Outlawed trusts as interfering with free trade Almost impossible to enforce— Law was too vague and Supreme Court did not support Clayton Antitrust Act 1914 Strengthened Sherman Antitrust Act of 1896 Declared certain business practices illegal: Corporations could no longer acquire stock of another corporation if so doing would create a monopoly Clayton Antitrust Act Officers of companies who violated the law could be prosecuted Labor unions and farm organizations could exist and would no longer be subject to antitrust laws Strikes, peaceful picketing, boycotts, & collecting strike benefits became legal. Federal Trade Act of 1914 Set up a 5-member “watchdog” agency called the Federal Trade Commission (FTC) with the power to investigate possible violations of laws regulating business and to put a stop to unfair business competition and business practices. Robinson-Patman Act of 1936 AKA Antiprice Discrimination Act) protects businesses by prohibiting wholesalers from charging small retailers higher prices than they charge large retailers and by prohibiting large retailers from setting artificially low prices. Celler-Kefauver Act of 1950 Amended the Clayton Act to prohibit corporate acquisitions when they substantially decrease competition Antitrust Procedures and Penalties Act of 1975 Increased penalties for violating antitrust laws Parens Patriae Act of 1976 Gives states the right to sue companies on behalf of citizens harmed by the company’s antitrust violations; requires large companies to notify the government of planned mergers; strengthened the federal government’s power to investigate antitrust violations. Is Microsoft a monopoly? If Microsoft is a monopoly, what remedy would you propose? What contributions has Bill Gates made in his role as entrepreneur?