The Price System

We have products that we purchase every day, and we pay a specific price for those products. Price is the monetary value of a product as established by supply and demand. Prices are signals that help us make economic decisions, and they give information to both buyers and sellers. High prices signal buyers to buy less and producers to produce more. Low prices signal buyers to buy more and producers to produce less, which both fall in line with the law of supply.

Prices help producers and consumers to answer the three basic questions previously discussed of WHAT, HOW, and FOR WHOM to produce. Without prices, the economy would not run as smoothly, and allocation decisions would have to be made some other way. Prices help us make everyday economic decisions and allocate scarce resources. With that, there are then four main advantages of price within a market economy:

1. Prices offer neutral incentives - they favor neither the producer or the consumer. Prices are a result of competition between buyers and sellers, and represent compromises that both sides can live with.
2. Prices are flexible - they can be affected by unforeseen events such as war or natural disasters. Buyers and sellers then react to the new level of prices and adjust their consumption and production accordingly, and the system then returns to running smoothly.
3. Prices are familiar (signals) - people have known about them all of their lives, therefore they are easy to understand. There is no confusion over price, which allows people to make decisions quickly and efficiently with minimal time and effort.
4. No cost of administration (free)- there does not need to be outside help or interference for prices to be set. There is no need for bureaucracy or laws because the change in price is so gradual that people hardly notice.

There are other ways to determine the allocation of scarce resources that do not involve a price system. In many countries that have a command economy, they use a rationing system where a government agency decides everyone's "fair" share. People then receive a ration coupon, which is a ticket or receipt that entitles the holder to obtain a certain amount of a product.

The process of establishing a price can be complicated because buyers and sellers have opposite hopes and desires. Sellers want high prices and large profits, where as buyers want to find good buys at low prices. Because transactions in a market economy are voluntary, the compromise that settles the differences between buys and sellers must be to the benefit of both, or the compromise would not occur. Within the price adjustment process, economists use an economic model to analyze behavior and predict outcomes. These models show both the demand for and supply of a product at various prices. For example, below is the model for CD's:

As you can see above, the quantity demanded and quantity supplied are equal at six units and the price of $15. This is called the equilibrium price - the price where quantity supplied equals quantity demanded, or the number of units produced equals the number of units sold. How does the market reach this equilibrium price? In many cases, you will need to go through a process of trial and error to find how this price was settled upon.

Looking at the $25 price, producers will provide 11 units at this price. However, buyers will only purchase one unit at this price, therefore you have a surplus. This is when quantity supplied is greater than the quantity demanded at a given price. These products then sit on the producers shelves as unsold products, and it communicates to them that their price is too high. In order to eliminate the surplus, they need to lower their prices to attract more buyers.

Moving to the $10 price, suppliers are only producing 3 units at this price, however there are 10 units demanded. The variance here results in a shortage: a situation in which the quantity demanded is greater than the quantity supplied at a given price. Whenever a shortage takes place, producers have no more CD's to sell, and they end the day wishing they had charged a higher price for their products. A producer will then go back and forth on their quantity supplied at each price until they find their equilibrium price. Once established, the equilibrium price will most likely stay the same, Situations could cause a disturbance in the equilibrium price, but the process will continue until that equilibrium price is reached again.

Price Floors and Ceilings (mjmfoodie Episode 15)

Student Activity

Articles that accompany the questions in the notes:

Sources

• http://www.npr.org/sections/thesalt/2016/08/26/491362623/americas-real-mountain-of-cheese-is-on-our-plates
• Price Ceilings and Price Floors