CHAPTER 4 The Power of Prices

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CHAPTER 4The Power of Prices
MACROECONOMICS EXPLORE APPLYby Ayers and
Collinge
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Learning Objectives

• Interpret how demand represents marginal benefit
  and supply marginal cost.
• Explain the concept of social surplus and how it
  is divided between consumers and producers.
• Demonstrate how both exports and imports increase
  efficiency while simultaneously harming either
  consumers or producers.
• Identify inefficiencies associated with price
  ceilings.

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Learning Objectives

• Show why price supports are unnecessary and
  politically counterproductive.
• (EA) Pinpoint the economic flaw in California's
  deregulation of electricity.

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4.1PRICE SIGNALS FOR EFFICIENT CHOICE

• The marketplace depends upon price signals. The
  market price sends a message to consumers and
  producers.
• For consumers market price signals how much of a
  good they wish to buy.
• For producers it signals how much of a good they
  wish to sell.
• When market price falls consumers respond by
  buying more, and producers respond by selling
  less.

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Consumer Surplus

• Consumer surplus is how much the good is worth
  to the consumer, in the abstract, minus what the
  consumer actually paid for it.

Consumer Surplus Demand - Market Price
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Marginal Benefit and Consumer Surplus

The demand curve shows the maximum price
the consumer would pay for each quantity
that might be purchased.
The maximum price is the consumers marginal
benefit the incremental value of each
additional item consumed.
Demand
1
2
3
Quantity
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Consumer Surplus
Dwights demand for blue jeans.
Dwights benefits from buying blue jeans.
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Consumer Surplus
Dwights demand for blue jeans.
Dwights benefits from buying blue jeans.
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Consumer Surplus
The consumer surplus is the area under the
demand curve and above the market price. It is
what consumers gain from their purchases after
deducting the cost.

Price 10
Demand
Quantity
1
2
3
10
Consumer Surplus
At a price of 10 per pair of jeans, Dwight buys
three pair, and receives 15 worth of consumer
surplus. His consumer surplus equals the sum of
the consumer surplus from the 1st, 2nd, and 3rd
pair of jeans. 10 5 0 15.

Price 10
Demand
Quantity
1
2
3
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Marginal Cost and Producer Surplus

• The supply curve depicts the minimum price that
  the producers of a good would be willing to
  accept for each quantity offered.
• That minimum price is the producers marginal
  cost, which is the incremental cost of producing
  each additional item offered for sale.
• The producer surplus is equal to the amount by
  which total revenue exceeds the total cost.

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Marginal Cost

Marginal cost increases as quantity
produced rises.
Supply
Quantity
1
2
3
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Producer Surplus
Buddys supply of blue jeans.
Buddys cost of producing blue jeans.
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Producer Surplus
Buddys supply of blue jeans.
Buddys cost of producing blue jeans.
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Producer Surplus

The producer surplus is the area above
the supply curve and under the market price. It
is what the producers gain from their sale after
deducting their cost.
Supply
Price 10
Quantity
1
2
3
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Producer Surplus

At a price of 10 per pair of jeans, Buddy
sells 3 pair and receives 7.50 worth of
producer surplus. His producer surplus equals
the sum of his producer surplus from the 1st, 2nd
and 3rd pairs, which is 5 2.50 0 equals
7.50
Supply
Price 10
Quantity
1
2
3
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Marginal Benefit and Marginal Cost

• Marginal Benefit (to consumers) The value of
  each additional unit of the good.
• Marginal Cost (to producers) The cost of
  resources used to produce each additional unit.
• The efficient output occurs when societys
  marginal benefit equals marginal cost.

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Market Efficiency

Supply Marginal Cost
Consumer Surplus
Equilibrium Price
Producer Surplus
Demand Marginal Benefit
Quantity
Efficient Quantity
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The Market Equilibrium Price

• The market equilibrium price leads to the
  efficient quantity.
• No other quantity would generate a larger total
  of consumer and producer surplus.
• If the price is less than the equilibrium price,
  quantity falls because producers arent willing
  to sell as much.
• If the price is greater than the equilibrium
  price quantity falls because consumers arent
  willing to buy as much.

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The Market Equilibrium Price
The triangular area of forgone social surplus
caused by inefficient pricing is called the
deadweight loss.
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The Paradox of Diamonds and Water
Dollars
Dollars
Much smaller Consumer Surplus
S
Consumer Surplus
High price
S
Low Price
D
D
Quantity of Water
Quantity of Diamonds
Water Market
Diamond Market
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The Efficiency of Imports and Exports

• Market prices of goods and services only reflect
  the domestic prices of supply and demand within
  the country, when a country does not engage in
  international trade.
• When a country opens its markets to international
  trade, market prices change as a world of new
  consumers and producers are involved.
• Imports are goods and services bought from other
  countries.
• Exports are goods and services sold to other
  countries.

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The Efficiency of Imports and Exports

• The result of trade is that the price in the
  domestic market will come to equal the world
  market price.
• If the domestic price rises to meet a higher
  world price, then the country exports the good.
• If the lower world price causes the domestic
  price to drop, then the country imports the good.
• In either case, there are some people within the
  country who gain, and others who lose.
• The gains however, can be expected to exceed the
  losses.

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4.2 PRICE CEILINGS AND RENT CONTROLS

• Price Ceiling a law that restricts a price
  from rising above a certain level
• Price Freezes prohibiting a wide array of
  prices from rising
• Rent Controls laws that limit rent increases
  to below what the market would bear

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Rent Controls
Supply
Price (s)
P
Ceiling Price
Demand
0
Quantity
Q
QS
QD
Housing
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Rent Controls over Time
Later Supply
Initial Supply
P
Price (s)
P
Ceiling Price
Later Demand
Initial Demand
0
Quantity
Initial Shortage
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Price Gouging and Ticket Scalping

• Price Gouging The practice of hiking up prices
  to exploit temporary surges in demand
• Ticket Scalping The practice of buying tickets
  at the price set by concert promoters and then
  reselling at whatever the market will bear

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4.3 PRICE FLOORS/PRICE SUPPORT

• Price floors and price supports are used by
  government to artificially prop up prices. They
  establish a minimum price that producers are
  guaranteed to receive.

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Price Supports and Surpluses
Supply
Floor Price
Price (s)
P
Demand
0
Agricultural Commodity
Q
QS
QD
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The Minimum Wage

• Increases the price of relatively unskilled
  labor.
• Higher wage means more people willing to work.
• Higher wage also means fewer jobs offered.

Result Surplus of Labor
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Minimum Wage Laws

Supply
Surplus of labor
Minimum wage
Equilibrium wage
Demand
Q
QS
QD
Low-Skill Labor
Fewer Jobs
More Applicants
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4.4AROUND THE WORLD Black Markets a Safety Net

• Price controls are in effect around the world.
• The Black Market exist when people buy and sell
  goods goods illegally.
• This can be seen as the market forces trying to
  assert themselves.
• Black Markets can temper destructive policies.
• Black Markets act as a safety net and provide
  people in countries where they exist with
  necessities they would otherwise have to do
  without.

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4.5 EXPLORE APPLYThe Price of Power

• In 2001 California lawmakers deregulated the
  wholesale electricity market.
• By increasing supply, the lawmakers felt that
  customers would eventually realize savings.
• Unfortunately, crude oil prices doubled, and and
  caused supply to shift to the left, more than the
  rightward shift caused by deregulation.
• The decrease in the supply of wholesale
  electricity caused the wholesale price of
  electricity to rise sharply.

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The Price of Power

• Since lawmakers had promised to keep rates at
  less than the new equilibrium price, the result
  was shortages in the retail electricity market.
• Price ceilings cause shortages!!!

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Terms along the Way

• price signals
• marginal benefit
• consumer surplus
• producer surplus
• social surplus
• deadweight loss
• price ceiling

• rent controls
• transfer payments
• search cost
• housing vouchers
• price gouging
• price floor (price support)
• minimum wage
• black market

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Test Yourself

• If Yvette would be willing to pay up to 10 for
  one gizmo, up to 8 for a second, and up to 6
  for a third, and the price of gizmos is 6
  apiece, then Yvettes consumer surplus totals
• 24.
• 18.
• 6.
• 4.

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Test Yourself

• 2. If the government places a price ceiling of
  1.20 on a good which has an equilibrium price of
  1.00 then
• there will be a surplus of the good.
• there will be a shortage of the good.
• neither a surplus nor a shortage will occur.
• if demand for the good decreases, government will
  not let the price go below 1.00.

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Test Yourself

• 3. Efficiency requires that
• total consumer surplus equal zero.
• market prices be fair.
• marginal social benefit equal marginal social
  cost.
• people buy low and sell high.

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Test Yourself

• 4. Over time, rent controls that remain in place
  lead to
• increased renovation of old apartments.
• a greater ability for tenants to move to the best
  apartment for their needs.
• increasingly severe housing shortages.
• people buy low and sell high.

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Test Yourself

• 5. Compared to a free-market equilibrium,
  agricultural price supports have the effect of
• increasing both the quantities supplied and
  demanded.
• decreasing both the quantities supplied and
  demanded.
• increasing the quantity supplied and decreasing
  the quantity demanded.
• people buy low and sell high.

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The End! Next Chapter 5 Measuring National
Output"