6-2: Prices as Signals and Incentives

6-2: Prices as Signals and Incentives

How the Price System Works • More producers in a market increases supply which leads to increased competition and a lower equilibrium price • Competitive pricing occurs when producers sell goods and services at lower prices to lure customers away from rival producers while still making a profit

Example: Competitive Pricing • Elm Street Hardware prices its snow shovels at $20 • Uptown Hardware prices its snow shovels at $13 • Uptown would then have a lower profit margin per shovel but ideally it would sell more shovels at the lower price of $13

Characteristics of the Price System • In a market economy, the price system has 4 characteristics: • 1. It is neutral: the interaction between producers and consumers determines the equilibrium price in the market.

Characteristics of the Price System (continued) 2. It is market driven: market forces determine price of goods/services

Characteristics of the Price System (continued) • 3. It is flexible: when market conditions change, prices change too. Surpluses and shortages motivate producers to changes prices to reach equilibrium.

Characteristics of the Price System (continued) • 4. It is efficient: prices will adjust until the maximum number of goods and services are sold.

Prices Motivate Producers and Consumers • The laws of demand and supply show that consumers and producers have different attitudes toward price • Consumers want to buy at low prices • Producers want to sell at high prices

Prices and Producers • The price system has 2 great advantages: it provides information and motivation

Prices and Producers (continued) • Prices provide information by acting as signals to producers about whether or not it is a good time to enter/leave a market • Rising prices and the expectation of profits motivate producers to enter a market • Falling prices and the possibility of losses motivate them to leave a market

Prices and Producers (continued) • A shortage is a market signal that consumer demand is not being met by existing suppliers • Producers see that as an opportunity to raise prices • Higher prices are an incentive for producers to enter a market

Prices and Producers (continued) • When more producers are motivated by higher prices to enter a market, quantity supplied increases • When prices are too high relative to consumer demand, a surplus occurs

Prices and Producers (continued) • Producers respond to a surplus by reducing prices or reducing production • Falling prices are a signal that it is a good time for producers to leave the market

Prices and Producers (continued) • While prices are signals that are visible in the market, it is the expectation of profits or the possibility of losses that motivated producers to enter or leave a market

Prices and Consumers • Prices also act as signals and incentives for consumers • Surpluses that lead to lower prices tell consumers that it is a good time to buy a particular good/service

Prices and Consumers (continued) • Producers send signals to consumers in the form of advertising and store displays

Prices and Consumers (continued) • High prices discourage consumers from buying a particular product • Often high prices are a signal that it is time for a consumer to switch to a substitute good with a lower price

Prices and Consumers (continued) • A high price may signal that a good is in short supply or has a higher status • Think name brand goods

6-3: Intervention in the Price System

Price Ceilings • Definition: the legal maximum price that sellers may charge for a good/service • This is a price below the equilibrium price and results in a shortage

Example: Rent Control as a Price Ceiling • Rent control means that despite what is going on in the market, rent prices cannot exceed a certain level • This leads to a shortage of rental properties • Often these rental properties are not well-maintained due to the fact that the rent cannot go above a certain point

Price Floors • Definition: legal minimum price that buyers must pay for a good/service

Example: Minimum Wage as a Price Floor • Minimum wages are set below the equilibrium price to prevent the wage from becoming unprofitable

Rationing Resources and Products • The market uses prices to allocate goods and services • Rationing is an example in which the government allocates goods/services using a factor other than price

Rationing Resources and Products (continued) • Generally a rationing system uses coupons that allow each person only a certain amount of a specific good • The black market, the illegal buying and/or selling of a good, can be used to avoid rationing

Questions • 1. A local supermarket decides to sell a premium brand of meats and cheeses in its deli department. This brand is priced $2 more per pound than the store brand. About 80% of the space in the deli display cases is devoted to the premium brand and 20% to the store brand. • A. How did price serve as an incentive to the supermarket? • B. What kind of signals is the supermarket sending to its customers with this pricing strategy?

2. The percentage of workers who were paid the minimum wage or less decreased from 6.5% in 1988 to 3% in 2002 to 2.7% in 2004. What does this trend tell you about the relationship of the minimum wage to the equilibrium wage for those kinds of work?

6-2: Prices as Signals and Incentives