Chapter 2 The Price System

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Chapter 2The Price System
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The Basic Competitive Model

• Assumptions about the behavior of consumers and
  firms and how they interact in markets
• Households decide
• which goods to buy
• how much to save
• what careers to follow
• how much to work
• Firms decide
• what to produce
• how much labor and capital to hire
• They meet in markets where they exchange goods
  and services.

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Rational Consumers and Profit-Maximizing Firms (a)

• Scarcity forces us to make choices.
• Economists assume individuals and firms make
  choices rationally
• Pursue what they see as their own self-interest
• Weigh costs and benefits as they see them
• If benefits costs, take the action
• Different people have different interests.
• Economists do not judge people's preferences.

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Rational Consumers and Profit-Maximizing Firms (b)

• For firms, rationality means maximizing profits.
• Profit revenue - costs
• Revenue PQ
• Profit PQ - costs

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Information Costs

• Individuals and firms often make decisions with
  little or no information.
• Is the car a lemon?
• Will the worker be productive?
• Will the investment be profitable?
• Rationality can also be applied to the
  acquisition of information.
• If the benefit of more information the cost of
  acquiring that information, the information is
  acquired.

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Choice by Consumers and Firms

• Both consumers and firms make constrained
  choices.
• That is, they make the best choice available to
  them given all the aspects of the economic
  environment.
• The constraints that consumers and firms face are
  different.

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Opportunity Sets and Scarcity

• Opportunity sets are combinations of goods.
• Due to scarcity of money or time not all
  combinations of goods are attainable.
• The opportunity set facing a consumer is called
  the budget constraint.

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Budget Constraint (a)

• Alice has 160 to spend on CDs and books. The
  price of a CD is 16 and the price of a book is
  20.
• She can buy either 10 CDs and no books, or 8
  books and no CDs, or some combination in between.

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Time Constraint

• Bob has 6 hours of free time every day after we
  subtract
• Working
• Getting ready for work
• Commuting
• Sleeping
• It takes Bob 1 hour to listen to a CD and 2 hours
  to watch a video.

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Time Constraint (continued)

• Bob can listen to 6 CDs and watch no videos, or
  watch 3 videos and listen to no CDs, or some
  combination in between.

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The Production Possibilities Curve (PPC)

• This represents the constraint on firms or
  producers.
• With a given quantity of inputs, a firm can only
  produce certain quantities of goods.
• Guns versus butter
• The boundary is the production possibilities
  curve.

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The Production Possibilities Curve (PPC)
(continued)

• The PPC is curved, bowed out from the origin.
• Guns and butter have different inputs.
• Steel makes great artillery shells but not
  butter.
• Cow's udders do not make good weapons.

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Optimal Production on the PPC

• Inside the PPC a firm can produce more of both
  goods by moving out to the curve.
• Points interior to the curve are inefficient.
• Economists want to know the source of these
  inefficiencies, and which resources are
  unemployed.
• The best production choice is always on the curve.

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Costs (a)

• Opportunity cost the value of the next best
  alternative when one makes a choice
• Opportunity costs are represented on
• Budget constraints
• Time constraints
• Production possibilities curves

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Costs (b)

• The cost of an education is
• Tuition
• Room and board
• Books
• Travel expenses
• Opportunity cost lost earnings from not working
  for four years
• Opportunity cost is often used by the government
  when it considers the costs and benefits of a
  program.

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Sunk and Marginal Costs

• Sunk costs Nonrecoverable expenditures
• Sunk costs play no role in deciding whether to
  continue an activity.
• Setup costs, like the installation charge turn on
  the electricity, are sunk costs.
• Marginal Costs The extra costs of small changes
  in production or consumption
• The additional cost of producing or consuming one
  additional unit
• Monthly electric bills are marginal costs.

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Competitive Markets

• Many firms selling identical products to many
  consumers
• Firms and consumers are price takers.
• Firms provide as much output as consumers will
  buy.
• Each firm can sell as much as it wants but is
  small compared to the market.
• If a firm charges a price higher than the market
  price, it loses all its customers.
• All firms in the industry charge the same price.

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The Basic Competitive Model

• Combines self-interested consumers,
  profit-maximizing firms, and competition
• Will test the model by comparing its predictions
  with actual markets
• Economists believe this model can provide answers
  to four important questions
• What is produced, and in what quantities?
• How are goods produced?
• For whom are those goods produced?
• Who decides the answers to the first three
  questions, and how?
• Government is not needed to answer these
  questions in the basic competitive model.

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Efficiency of the Basic Competitive Model

• The basic competitive model is efficient.
• Scarce resources are not wasted.
• It is not possible to produce more of one good
  without producing less of another good.
• On the production possibilities curve
• It is not possible to make one person better off
  without making someone else worse off.
• This property is known as Pareto efficiency.

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Income as an Incentive

• Income is an incentive for consumers, workers,
  investors, and firms.
• Firm income is revenue which goes to pay costs,
  any residual is profit.
• Consumer or household income is known as personal
  income.

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Property Rights

• The right of the owner to use and sell their
  property.
• Well-defined property rights access to the
  property is excludable, rivalrous, and
  transferable
• A combination of freedom and responsibility is
  crucial to markets.
• Freedom Must be creative and free to try new
  techniques
• Responsibility Individuals must reap the reward
  if successful or suffer the loss if not

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Incentives versus Equality

• Well-defined property rights permit incentives to
  provide rewards and costs.
• If rewards are tied to performance, then a
  problem arises when many people help to produce a
  good or service.
• Who contributed what?
• Who are the most productive employees is the hot
  salesperson good or just lucky?

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Performance-Based Compensation

• Even if pay can be tied to performance, how does
  one measure performance?
• If compensation is tied to performance, this
  leads to inequality.
• Since different people perform differently
• If this inequality is from luck, would another
  criterion of compensation do "better"?
• Some economists hold that equality is a value in
  its own right.
• Trade-off between efficiency and equality.

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When Property Rights Fail

• In many cases property rights are not clearly
  defined.
• This causes problems with the efficient
  allocation of resources.
• In the early days of radio broadcasting many
  broadcasters used the same frequency and jammed
  each other's broadcasts.
• Property rights were ill-defined anyone could
  infringe on others' uses of airwaves.
• The government instituted a licensing system that
  established well-defined property rights.
• Each broadcaster was the sole owner of a
  frequency and could sue to protect its property.

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Nontransferable Property Rights

• Sometimes the ability to dispose of property is
  restricted by law it is not transferable.
• Water rights cannot, in general, be sold.
• If water rights were sellable, ranchers could
  sell water to thirsty cities.
• Both benefit
• Ranchers earn extra income.
• Cities pay less for water.

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Consensus on Incentives

• Providing appropriate incentives is a fundamental
  economic problem.
• Profits provide incentives for firms to produce
  the goods individuals want.
• Wages provide incentives for individuals to work.
• Property rights provide people with incentives to
  invest and save and to put their assets to the
  best possible use, because they receive the
  benefits of their actions.

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Rationing

• In a market, those individuals who are willing to
  pay the most receive the good.
• In a market system the allocation of goods is
  based on the price system.
• Rationing is the primary alternative to price
  allocation.

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Types of Rationing

• Queues Price set below market price ? customers
  wait in line to buy
• The wasted time is a waste of resources.
• Example long lines for food in countries with
  prices controls
• Lottery Customers are picked at random.
• Coupons One must pay both the market price and a
  coupon to buy a good.
• Coupon rationing is favored during wartime.
• Often goods and coupons may be traded in a black
  market.

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Inefficiency of Rationing

• Those who are most willing to pay for the
  rationed good or service do not necessarily get
  the good or service.

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The Efficiency of Competitive Markets

• Competitive markets coordinate the actions of
  millions of households and firms to satisfy
  consumer needs at low cost.
• The presence of competitors keeps prices close to
  costs.
• Competitive markets get the right goods to the
  right peoplethose who are most willing to pay.
• The free exchange of goods is voluntary, so trade
  is mutually beneficial.
• Economists call this outcome Pareto efficiency
• No one can by made better off without someone
  else's being made worse off.

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Imperfect Competition

• Imperfectly competitive firms have the power to
  influence the price.
• They typically control a substantial proportion
  of the total market supply, so the price is too
  far above costs.
• Monopoly single seller of a product.
• Controls the total market supply and sets a price
  above the competitive price
• Not everyone who would be willing to pay the
  competitive price gets the product.
• In monopolistic competition many firms sell the
  same basic product.
• These firms use product differentiation through
  advertising to make their brand appear different
  from their rivals brands.
• Consumers pay for this advertising

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Imperfect Information (a)

• Households do not have perfect information about
  all prices for all goods at all stores all the
  time, so consumers may make poor choices.
• Firms do not have perfect information about the
  abilities and motivation of workers, so they may
  not hire the best workers.
• Owners of firms do not know whether the managers
  they have hired are maximizing profits.

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Imperfect Information (b)

• Managers may take fewer risks than the owners
  want since their livelihood is more closely tied
  to the firm they are managing than stockholders'.
• Because stockholders may have diversified
  holdings
• So firms may not take enough risks
• Banks do not have perfect information about
  whether their loans will be repaid.
• Raising interest rates may increase the
  proportion not repaid.
• This leads to credit rationing.
• Worthy projects may not be financed.

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Technological Change

• Patent system allows inventors to collect the
  rewards of their inventions and to cover the
  costs of RD.
• Patents grant monopoly power to inventors this
  has costs.

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Implications for MacroeconomicsThe Individual
Demand Curve (a)

• Demand The quantity of a good or service
  purchased at a given price
• Demand curve The quantity of the good demanded
  by the market at each price
• Individual demand curve The quantity demanded by
  one consumer at each price

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Demand and Demand Curves (b)

• Demand curves are downward sloping.
• As price falls, consumers buy more of the good.
• An individual's demand also depends on
• Income
• Social trends
• Prices of related goods
• The availability of credit
• Expectations about the future
• These influence the position of the individual's
  demand curve not the slope.

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The Market Demand Curve

• The horizontal sum of the demand curves of all
  the individuals

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Movement Along and Shifts in Demand Curves

• A change in price is represented by a movement
  along the demand curve.
• All other changes that affect demand will shift
  the demand curve.

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Sources of Shifts in Demand Curves (a)

• Tastes
• Prices of related goods
• Income
• Demographics
• Information
• Availability of credit
• Expectations

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Sources of Shifts in Demand Curves (b)

• Tastes If one day everyone in the United States
  wakes up and dislikes Britney Spears CDs, the
  demand curve for Britney Spears CDs shifts to the
  left.

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Sources of Shifts in Demand Curves (c)

• Prices of related goods
• Complementary goods peanut butter and jelly
• The price of peanut butter rises (a movement
  along the demand curve for peanut butter).
• The demand for jelly falls, so its demand curve
  shifts to the left.

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Sources of Shifts in Demand Curves (d)

• Prices of related goods
• Substitute goods coffee and tea
• The price of coffee rises (a movement along the
  demand curve for coffee).
• The demand for tea increases, so its demand curve
  shifts to the right.

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Sources of Shifts in Demand Curves (e)

• Income
• An increase in income increases the demand for
  most goods.
• The demand curves shift to the right.

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Sources of Shifts in Demand Curves (f)

• Availability of credit
• If banks reduce the number of automobile loans
  they approve, the demand for cars decreases and
  the demand curve for cars shifts to the left.
• Expectations
• If consumers believe the price of a good will
  increase in the future, demand increases today
  (when the good is cheaper) and the demand curve
  for the good shifts to the right.
• Changes in expectations of the future affect
  current variables.
• Changes in expectations may be self-fulfilling.

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Market Supply

• The market supply curve Formed by adding up
  (horizontally) the supply curves of all the
  suppliers.
• As individual supply curves have a positive
  slope, so do market supply curves.
• A change in price is represented by a movement
  along the supply curve.

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Sources of Shifts in Supply Curves (a)

• Price of inputs
• Technology
• Environment
• Availability of credit
• Expectations

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Sources of Shifts in Supply Curves (b)

• A rise in the price of flour increases the costs
  of making bread.
• The supply of bread decreases, and the supply
  curve for bread shifts left or upward.

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Sources of Shifts in Supply Curves (c)

• A new technology improves cornflake production.
• This lowers the costs of producing cornflakes.
• Increases suppliers desire to sell at each
  price.
• Supply increases and the supply curve shifts
  right.

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Using Demand and Supply Curves (a)

• Equilibrium a situation in which there are no
  forces or reasons for change
• A marble in a bowl is in a stable equilibrium.
• It remains at the bottom if there are no external
  changes to the system.
• In a market equilibrium, neither consumers nor
  suppliers have an incentive to change their
  actions.

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Using Demand and Supply Curves (b)

• Equilibrium price The market-clearing price
  equates quantity demanded and quantity supplied
• Where the demand curve intersects the supply
  curve
• Qd Qs

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Excess Supply

• The law of supply and demand predicts prices will
  move to equilibrium values.
• Excess supply causes prices to fall.
• Suppliers cannot sell all they wish, so they cut
  the price.
• Quantity demanded increases along the demand
  curve to point E0.
• Quantity supplied decreases along the supply
  curve to point E0.

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Excess Demand

• Excess demand causes prices to rise.
• Consumers cannot buy as much of the item as they
  want.
• They bid up the price.
• As the price rises, the quantity supplied
  increases along the supply curve.
• As the price rises, the quantity demanded
  decreases along the demand curve.

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Using Demand and Supply Curves to Predict Price
Changes (a)
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Using Demand and Supply Curves to Predict Price
Changes (b)
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Shortages and Surpluses (a)

• When Qd Qs , the market clears.
• Instances when the market does not clear are
  shortages or surpluses.
• Shortage buyers who are willing to pay the
  going price for a good cannot find the good
• Surplus goods go unsold at the going price

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Shortages and Surpluses (b)

• In panel A, the horizontal gap between Qd and Qs
  is the size of the shortage. Consumers compete to
  get a bargain.
• In panel B, the horizontal gap between Qd and Qs
  is the size of the surplus.
• Now sellers compete to move the merchandise.
• The rate of adjustment depends on the kind of
  market as well as the size of the surplus.

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Government Involvement

• Governments often interfere with the outcomes of
  the law of supply and demand because they are
  politically unacceptable.
• If rents on apartments are seen as too expensive,
  there will be pressure on city hall to regulate
  the market for apartments.
• If wages are seen as being too low, then there
  will be pressure on the government to regulate
  the labor market.
• An obvious way to try to circumvent the law of
  supply and demand is to legislate the price of an
  object.
• Usually, such legislation involves either price
  ceilings or price floors.

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Price Ceilings

• Price ceilings are popular government controls on
  basic goods such as food, shelter, and oil.
• An example of a price ceiling is rent control.
• In the long run, supply is more price elastic, so
  the effect on quantity is more pronounced.

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Price Floors

• Price supports given to farmers are one of the
  most expensive price floors in the U.S. economy.
• Farmers participating in the federal commodity
  programs receive a target price for their crops.
• If the market price for their crops falls below
  this price floor, the U.S. Department of
  Agriculture pays them the difference.
• The Congressional Budget Office (CBO) has
  estimated the savings which would occur to the
  federal government if the price floor was reduced
  3 a year starting in 1996.
• The estimated savings were 501 million in 1996,
  1.38 billion in 1997, 2.38 billion in 1998,
  3.34 billion in 1999, and over 4.1 billion in
  2000.
• The CBO also pointed out that many farmers might
  opt out of the price support framework.
• When they do, they become free to plant as much
  or little of a crop as they desire. This newfound
  flexibility would lower their lost revenue.

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Alternative Solutions

• Attempts to get around the law of supply and
  demand generally do not work.
• Examples
• If government wants higher wages for unskilled
  labor, it can attempt to increase the demand for
  such labor.
• If it wants affordable housing, it can subsidize
  housing.
• Such methods often generate some problems of
  their own but are usually more effective than
  disregarding the law of supply and demand.