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ECON NO#8 Market Equilibrium & The Price System
Mr. Lua Economics Y-6
Directions--Take out a sheet of paper and do the following:

Choose 5 underlined words and define or describe them using the info on this page. Doing this is worth approximately 3 points. THEN:

Create 8 "Checkpoint Questions" about the information below and answer your own questions. This is worth 7 points.

For Extra Credit, take out a separate sheet of paper and copy everything below verbatim
I. The Role Of Prices In A Free Enterprise System
A) What is Price?
1.
Price = the monetary value of a product
2.
It is established after the forces of supply & demand are measured.
B) Prices set up a Price System in the United States
1.
The price system determines answers to the three basic economic questions:

What goods/services will be produced? How will goods/services be produced? Who will get the goods/services produced?
C) What are some advantages of an economy that incorporates a price system?
1.
Advantage #1: Prices Send signals

Low prices send signals to PRODUCERS:

That certain goods/services are being overproduced

That they should consider shifting their resources to make a different product

That it is not a great time for new producers to enter the market.

Low prices send signals to CONSUMERS:

To take advantage of low prices by purchasing more goods/services. Why? Because each low-price purchase has a small opportunity cost.
2.
Advantage #2: Prices Are Neutral

They don’t favor producers or consumers

They are the result of competition between buyers & sellers

Remember: buyers always seek the lowest price, sellers always seek the highest.

After a purchase is made, it is assumed that both sides were satisfied with the price
3.
Advantage #3: Prices Are Flexible

They can be easily increased or decreased.

Increasing prices can easily fix the problem of EXCESS DEMAND

Lowering prices can easily fix the problem of EXCESS SUPPLY

The ability to be flexible can help the economy deal with Supply Shocks

Supply Shock = a sudden shortage of a good/service caused by some event

They always lead to excess demand (because for some reason suppliers are not able to meet the needs of consumers)

Example of a supply shock: if a snow blizzard suddenly froze all lemon trees, this would have the effect of limiting supply of all goods/services related to
lemons since lemon producers would have fewer options in terms of making goods/services.
4.
Advantage #4: Prices have no “cost of administration”

Competitive markets (such as the “Free Enterprise System” in the U.S.) tend to find their own prices.

Expensive government bureaucrats, committees, and laws are NOT NEEDED to determine price (as is the case in centrally planned economies)
5.
Advantage #5 Prices are familiar and easy to understand

This allows people to make decisions quickly and efficiently, with minimum time & effort.
II. Rationing: The Main Alternative To A Price System
A) Rationing = a system in which the government decides what everyone’s “fair share” will be.
1.
Historically, such systems have used tickets that allow the holder to obtain certain amounts of goods/services.
B) What Are problems that are typically experienced under economies that use rationing?
1.
Problem #1: The problem of fairness

Everyone tends to feel that his/her share is too small

It is difficult for the central government to determine needs.
2.
Problem #2: The problem of high administrative costs.

Large numbers of government workers (bureaucrats, etc) need to be hired to manage rationing systems at a large public cost.

Statisticians are needed to calculate amounts; distributors are needed to pass out supplies
3.
Problem #3: The problem of diminishing incentives

Such systems have a negative impact on the desire of people to work hard because the “profit motive” (found in free enterprise economies) is lacking.
4.
Problem #4: Rationing systems often give rise to “Black Markets”

Black Market = a market in which goods/services are sold illegally.

Black markets allow consumers to pay more so they can buy a good/service when rationing makes it otherwise unavailable.

On the flip side, black markets allow suppliers additional opportunities for production.

Black markets are always discouraged by governments because they are illegal (illegal drugs, for example).
III. The Price Adjustment Process and Equilibrium
A) The U.S. economy contains an invisible Price Adjustment Process.
1.
Price Adjustment Process = the notion that changes in demand or supply will cause prices to change.
2.
In market economies, producers & consumers have exactly opposite hopes and desires.

Buyers demand goods/services at low prices; but sellers seek to supply goods/services at high prices and large profits.

Because neither can get exactly what they want, adjustments are necessary to reach a compromise.
3.
When the forces of supply & demand have reached a compromise a point of "equilibrium" is always achieved (read below).
B) The concept of "Equilibrium"
1.
Equilibrium is the PRICE at which QUANTITY DEMANDED of a good/service is equal to QUANTITY SUPPLIED.

In other words, all goods/services have a price at which all things made by suppliers will be purchased by consumers.

In Graph “A” below, the equilibrium price is $1.50 since all quantities of pizza supplied will be sold to consumers.
2.
When a market is in equilibrium:

there are no shortages or surplus extras of goods/services

people will find ample supplies of goods/services on store shelves.

suppliers that are willing to sell at the equilibrium price will find enough buyers for their goods/services.
3.
Therefore, the "equilibrium price" should be considered as a "point of balance" between the forces of supply & demand.
IV. The Concept of Disequilibrium
A) The concept of Disequilibrium
1.
Disequilibrium = all prices at which the QUANTITY SUPPLIED of a good/service is NOT EQUAL to the QUANTITY DEMANDED

Therefore, on Graph “A,” all prices that are not $1.50 would qualify as leading to a situation of disequilibrium.
2.
When a market is in "DISEQUILIBRIUM," then the economy must be experiencing one of the following: "Excess Demand" or "Excess Supply"
B) What is Excess Demand?
1.
Excess Demand = when quantity demanded of a good/service IS MORE than quantity supplied

It always occurs when the price of a good/service is BELOW the “could be” equilibrium price.

Graph “B” below illustrates Excess Demand. At a price of $1 pizza makers are willing to produce 150 slices, yet 250 people have a demand for a slice of pizza. At .50
cents, excess demand becomes greater because pizza makers are only willing to make 100 slices (but only 300 are demanded)

During times of "excess demand," customers might be seen standing in lines or being placed on "waiting lists"
2.
How do producers normally react to excess demand?

Producers normally raise the price of the good/service in question since it is in high demand.
C) What is Excess Supply?
1.
Excess Supply = when quantity demanded of a good/service IS LESS than quantity supplied

It always occurs when the price of a good/service is ABOVE the “could be” equilibrium price.

Graph “C” below illustrates Excess Supply. At a price of $2 pizza makers are willing to produce 250 slices, but only 150 people have a demand for a slice of pizza. At
.$2.50, excess supply becomes greater because pizza makers are willing to make 300 slices (but only 100 are demanded)

During times of Excess Supply, you might see many unsold products sitting on store shelves.
2.
How do producers/consumers react to "excess supply?

Producers normally lower the price of the good/service until equilibrium is reached.

Consumers might buy fewer amounts, might refuse to buy the product, or might switch to a substitute until the price lowers.
V. How Can The Government Attempt To Control Prices?
A) At times, the U.S. government attempts to influence prices through one of two means: price floors or price ceilings.
B) Price Floor = a law that sets a MINIMUM PRICE that a supplier can charged for a good/service.
1. "Price floors" are always GREATER than the "would be" equilibrium price, and can be represented with Graph “C” below.

Any supplier that attempts to sell a good or service BELOW the "price floor" is breaking the law.

Price floors tend to affect the consumer since he/she must artificially pay above the equilibrium price for goods/services.
2. Two examples of Price Floors

Minimum wage laws: force consumers (businesses needing labor) to pay suppliers (the laborer) at or above a certain price.
 Graph “D” shows the effect of a minimum wage law. The government is forcing consumers (in this case the business) to pay a
minimum wage of $5.15 to all suppliers (in this case the worker/laborer). If the minimum waged did not exist, consumers would be
allowed to hire workers at the equilibrium price of $4.50.

Gas Rationing laws: a government that is attempting to limit consumption of gas might force gas stations to charge customers a high price per
gallon.

Possible negative effects of Price floors: it might lead to less Quantity Demanded
 For example, companies might hire fewer employees because the price of hiring them per hour at the minimum wage price is too high.
C) Price Ceilings = a law that sets a MAXIMUM PRICE on what sellers can charge for a good or service.
1. Price Ceilings are always LESS THAN the "would be" equilibrium price and can be represented with Graph “D” below

Any supplier that attempts to sell a good or service ABOVE the "price ceiling" is breaking the law

Price ceilings are meant to protect consumers from conditions that might make access to certain goods/services unattainable.
2. Example Of a “Price Ceiling” is Rent Control:

Rent Control = setting a maximum price that landlords (the supplier) can charge for rent.
 Goal is to allow low-income people to be able to afford high rent neighborhoods.
 Graph “E” shows that the government is forcing apartment owners to charge rent that is $600 or less. Therefore the apartment owner
(supplier) is losing the opportunity to make $300 (which he would be getting if allowed to charge the equilibrium price of $900).

Possible negative effects of rent control: Suppliers might drop out (apartment owner might sell off his building or convert it to a factory)
 Sellers might attempt to lower costs in order to maximize their profits (they might delay repairs or use lower quality ingredients, etc)
People who have enough money and value the good most highly willl pay the most for the good.
A) Prices provide a common language for buyers and sellers
Prices serve as a measure of value
Prices provide an accurate way for producers to measure demand.
B) Prices help determine which producers will have access to the factors of production (land, labor, capital, etc)
Prices help determine which consumers will get goods & services made by producers.
B) Prices have proven to be the most
for distributing a society's resources.
Efficiency means that all economic resources will be used for their most valuable purpose.
C) Prices are a signal that tell a consumer or producer how to adjust.
Prices communicate to both buyers and sellers whether goods are in short supply or readily available.
Rising prices cause Existing firms to produce more goods/services
rising prices attract new firms to enter hte market.
Lower prices tell producers that perhaps the should use resources to produec different products.
Prices ensure that resource use will adjust to the changing demands of consumers.
A) The
Price = monetary value of a product as established by forces of supply and demand
Price is:
the monetary value of a product as established by supply & demand
a signal that helps us make our ecnomic decisions
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.
ADVANTAGES OF PRICES
#1
Prices help decided the three basic questions that all societies must answer:
What should we make? How should it be made? For Whom should it be made?
Prices are the result of competiton between buyers and sellers.
Prices represent compromises that both sides can live with.
The more competitive the market, the more efficient the prices adjustment process.
#2
Prices in market economy are flexible
Prices can easily be increased to solve the problem of "excess demand"
Prices can easily be DEcreased to eliminate hte problem of "excess supply"
#3
Third, prices have no cost of administration: competitive markets tend to find their own prices without outside help or interference.
Buerocrats aren't needed to be hired, no committees needed to be formed, no laws pased, or no other decisions made.
#4
Prices are familiar and easy to understand. No complex bartering or trading is required.
Prices are precise, which allows people to make decisions quickly and efficietnly (with minimum time and effort).
WHAT WOULD LIFE BE LIKE WITHOUT A PRICE SYSTEM?
Allocation of resources would be based on something other than price:
wouldl take place based on good looks, intelligence, political connections, etc.
One method is Rationing (system underwhich an agency such as government decides everone's "fair share)
Under ration systems, people received a ration couple (ticket or receipt) that entitles the holder to obtain a certain amount of product.
Rationing is used in many societies today, and it has been widely used during wartime.
Rationing has its problems:
What is considered a person's "fair share" always causes problems.
If gas is rationed (for example), it would be tough to determine who should be allotted more of a supply:
Should it be distributed equally, or according to need?
Rationing Has High Administrative Costs
People need to be hired to manage rationing systems
Statisticians are needed to calculate amounts
Distributors are needed to pass out supplies
Rationing Diminishes The Incentive To Increase Productivity
Rationing has a negative impact on people’s incentive to work hard, produce, and increase productivity.
Why? Working harder does not lead to increased payouts under rationing systems.
Key Point: Whenever the market is in DISEQUILIBRIUM, market forces sill eventually push it back to Equilibrium.
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