Chapter 6: Prices and Decision Making
In this chapter we look at how prices are established and
how prices function as a system to allocate resources between
markets. Price is the monetary value of a product, which is
normally established by supply and demand and is an important
1 describes prices as signals to both producers and consumers.
High prices are signals for businesses to produce more and
for consumers to buy less. Low prices signal the reverse.
Prices have the advantage of being neutral and flexible. In
addition, they permit freedom of choice, have no administrative
costs, are highly efficient, and are easily understood by
everyone. Nonprice allocations systems such as rationing exist,
but they suffer from a number of problems, including the issue
of allocating ration coupons in a fair and equitable manner.
Section 2 explains how economists develop economic models
of markets with supply and demand curves. In a competitive
market, the forces of supply and demand establish prices.
A temporary surplus drives prices down; a temporary shortage
forces prices up. Eventually the market reaches the equilibrium
price where there are neither shortages nor surpluses. Changes
in supply or demand can disturb the market, but the market
will tend to find its new equilibrium with the help of temporary
shortages and/or surpluses. Competitive markets represent
the ideal, but the lessons learned from them apply to other
markets as well.
3 shows how prices work as a system to allocate resources
between markets. However, if prices are fixed in one market,
temporary shortages and surpluses tend to become permanent.
A price ceiling such as rent controls is one form of fixed
price; a price floor such as the minimum wage is another example.
If prices are free to adjust, they change when either the
demand or supply curves change. The size of the price change
is affected by elasticitythe more elastic the curves, the
smaller the price change; the less elastic the curves, the
larger the price change. Agriculture is especially hard-hit
by price changes because demand and supply tend to be inelastic,
while weather often causes the supply curve to change.