prices - frank schneemann ch-6.pdfmarkets and prices how many slices are sold at $2.50 a slice? how...

Prices

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AAnyone who has everhaggled over the price

of a used car, a stereo, oreven an old lamp at agarage sale knows aboutthe opposing interests ofbuyers and sellers. Buyers alwayswant to pay the lowest possibleprice, while sellers hope to sell atthe highest possible price. Withbuyers and sellers at odds, howcan a market system satisfy bothgroups?

In a free market system, supplyand demand work together. Theresult is a price that both sidescan agree on.

Economics JournalEconomics Journal

Write down how much you feel youshould be paid for an hour of doingeach of the following tasks: washingdishes, sweeping floors, baby-sittinga neighbor’s child, and bagginggroceries at the supermarket.

ECON_07NA_se_CH06_CO 8/3/05 11:08 AM 24

equilibrium the point at which quantitydemanded and quantitysupplied are equal

Combining Supply and Demand

ObjectivesAfter studying this section you will be able to:1. Explain how supply and demand create

balance in the marketplace.2. Compare a market in equilibrium with a

market in disequilibrium.3. Identify how the government sometimes

intervenes in markets to control prices.4. Analyze the effects of price ceilings and

price floors.

PreviewSection FocusIn an uncontrolled market, the priceof a good and quantity sold will settleat a point where the quantity suppliedequals the quantity demanded. Thegovernment can set a maximum orminimum price, but that can lead toan imbalance between supply anddemand.

Key Termsequilibriumdisequilibriumexcess demandexcess supplyprice ceilingprice floorrent controlminimum wage

TT he market system makes certain thatconsumers can buy the products they

want, that sellers make enough profit tostay in business, and that sellers respond tochanging needs and tastes of consumers.Other economic systems have been tried—most notably, central planning—and havebeen judged by most observers to be lesssuccessful than the market system.

In this section we will combine our toolsfor studying demand and supply to learnhow markets operate and how markets canturn competing interests into a positiveoutcome for both sides. In the process wewill discover that free markets usuallyproduce some of their best outcomes whenthey are left alone, without governmentintervention.

Balancing the MarketJust as buyers and sellers come together in amarket, the study of demand and supplywill come together in this section. We beginby looking at the supply and demand sched-ules. As you will recall, a demand scheduleshows how much consumers are willing tobuy at various prices. A supply scheduleshows how much sellers are willing to sellat various prices. Comparing these sched-ules should allow us to find commonground for the two sides of the market.

The combined supply and demandschedule in Figure 6.1 combines the marketdemand and supply schedules for pizzaslices that you saw in Chapters 4 and 5. Foreach price, this schedule lists both thenumber of slices that consumers are willingto buy and the number of slices that pizze-rias are willing to supply.

Defining EquilibriumThe point where demand and supply cometogether at the same number of slices iscalled the equilibrium. Equilibrium is thepoint of balance between price andquantity. At equilibrium, the market for agood is stable.

Chapter 6 ■ Section 1 125

� In the marketequilibrium, pricesadjust to make thequantity suppliedequal to the quantitydemanded.

ECON_07NA_se_CH06_S1 8/3/05 11:10 AM Page 125

To find the equilibrium price and equi-librium quantity, simply look for the priceat which the quantity supplied equals thequantity demanded. Do you see that inFigure 6.1 this occurs at a price of $1.50per slice? At that price, and only at thatprice, the quantity demanded and thequantity supplied are equal, at 200 slicesper day. This is the market equilibrium.

In the market for pizza, as in anymarket, quantities supplied and demandedwill be equal at only one price and onequantity. At this equilibrium price, buyerswill purchase exactly as much of theproduct as firms are willing to sell. Buyerswho are willing to purchase the goods atthe equilibrium price will find amplesupplies on store shelves. Firms that arewilling to sell at the equilibrium price willfind enough buyers for their goods.

Graphing EquilibriumWe can also illustrate equilibrium with asupply and demand graph. In Figure 6.1,we have plotted on the same graph themarket supply curve and the marketdemand curve for slices of pizza. The equi-librium price and quantity can be foundwhere quantity supplied equals quantity

demanded, or the point where the supplycurve crosses the demand curve. On thegraph, this is point a.

Disequilibrium If the market price or quantity supplied isanywhere but at the equilibrium, themarket is in a state that economists calldisequilibrium. Disequilibrium occurs whenquantity supplied is not equal to quantitydemanded in a market. In the aboveexample, disequilibrium will occur withany price other than $1.50 per slice orany quantity other than 200 slices.Disequilibrium can produce one of twooutcomes, excess demand or excess supply.

Excess Demand The problem of excess demand occurs whenquantity demanded is more than quantitysupplied. When the actual price in amarket is below the equilibrium price, youhave excess demand, because a low priceencourages buyers and discourages sellers.

For example, in Figure 6.1, a price of$1.00 per slice of pizza will lead to aquantity demanded of 250 slices per dayand a quantity supplied of only 150 slices

Pric

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50 100 150 200 250 300 350Slices of pizza per day

$1.00

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$3.50

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Combined Supply and Demand Schedule

Figure 6.1 Finding EquilibriumFigure 6.1 Finding Equilibrium

126 Prices

disequilibriumdescribes any price orquantity not atequilibrium; whenquantity supplied is notequal to quantitydemanded in a market

excess demand whenquantity demanded ismore than quantitysupplied

Market equilibrium will be found at the price at which the quantity demanded is equal tothe quantity supplied. Markets and Prices How many slices are sold at $2.50 a slice?How many slices are sold at equilibrium?



per day. At this price, there is excessdemand of 100 slices per day.

When customers want to buy 100 moreslices of pizza than restaurants areprepared to sell, these customers will haveto wait in long lines for their pizza, andsome will have to do without. In Figure6.2, below, we have illustrated the excessdemand at $1.00 per slice by drawing adotted line across the graph at that price.As you can see, at $1.00 a slice, thequantity demanded is 250 slices, and thequantity supplied is 150 slices.

If you were running the pizzeria, andyou noticed long lines of customerswaiting to buy your pizza at $1.00 perslice, what would you do? Assuming thatyou like to earn profits, you wouldprobably raise the price. As you increasedthe price of pizza, you would be willing towork harder and bake more, because youwould know you could earn more moneyfor each slice you sell.

Of course, as the price rises,customers will buy less pizza,since it is becoming relativelymore expensive. When theprice reaches $1.50 per slice,you will find that you areearning more profits and cankeep up with demand, but thelines are much shorter. Somedays you may throw out a fewleftover slices, and other daysyou have to throw an extrapizza or two in the oven tokeep up with customers, buton the whole, you are meetingthe needs of your customers.In other words, the market isnow at equilibrium.

As long as there is excess demand, andthe quantity demanded exceeds the quantitysupplied, suppliers will keep raising theprice. When the price has risen enough toclose the gap, suppliers will have found the

50 100 150 200 250 300 350Quantity

demandedQuantitysupplied

$1.00

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$2.00

$3.00

Pri

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er s

lice

Slices of pizza per daySlices of pizza per day

Excesssupply

Excess SupplyExcess Demand

Figure 6.2 Excess Demand and Excess Supply

50 100 150 200 250 300 350Quantitysupplied

Quantitydemanded

LightSupply

LightDemand

HeavyDemand

HeavySupply

$1.00

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$3.50

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$3.00

Pric

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Supply

Demand

Supply

Demand

Excessdemand

Figure 6.2 Excess Demand and Excess Supply

O O

Excess supply was a major problem for the tourism industry in the last months of 1999. Hotels, restaurants, and cruise lines assumed that people would be willing to pay a very high price to celebrate the start of the year 2000, and doubled or tripled their usual rates for special “millennium” travel packages. Unfortunately, many people decided not to travel around January 1, 2000, and many who did travel refused to pay thousands of dollars for dinner or one night in a hotel. High prices and the large number of choices led to a problem of excess supply.

FAST FACT

Excess demand and excess supply both lead to a market with fewer sales than at equilibrium.Supply and Demand Why are sales lower at $1.00 a slice than at $2.00 a slice?


128 Prices

highest price that the market will bear.They will continue to sell at that price untilone of the factors described in Chapter 4 or5 changes the demand or supply curve andcreates new pressures to raise or lowerprices, and eventually, a new equilibrium.

Excess SupplyIf the price is too high, then the marketwill face a problem of excess supply.Excess supply occurs when quantitysupplied exceeds quantity demanded. Forexample, at a price of $2.00 per slice ofpizza, the quantity supplied of 250 slicesper day is much greater than the quantitydemanded of 150 slices per day. Thismeans that pizzeria owners will be making100 more slices of pizza each day thanthey can sell at that price. The relativelyhigh price encourages pizzeria owners towork hard and bake lots of pizza, but itdiscourages customers from buying pizza,since it is relatively more expensive than

other menu items. Some customers willbuy one slice instead of two, while otherswill eat elsewhere. The problem is showngraphically in Figure 6.2. At the end of theday, it is likely that 100 slices will have tobe thrown out.

After a short time, pizzeria owners willget tired of throwing out unsold pizza atclosing time and will cut their prices. As theprice falls, the quantity demanded will rise,and more customers will buy more pizza.At the same time, pizzeria owners willprepare fewer pizzas. As the price of pizzafalls, the quantity demanded rises and thequantity supplied falls. This process willcontinue until the price reaches $1.50 perslice. At that price, the amount of pizzathat pizzeria owners are willing to sell isexactly equal to the amount that theircustomers are willing to buy.

Whenever the market is in disequilibriumand prices are flexible, market forces willpush the market toward the equilibrium.Sellers do not like to waste their resources onexcess supply, particularly when the goodscannot be stored for long, like pizza. Andwhen there is excess demand, profit-seekingsellers realize that they can raise prices toearn more profits. In this way, market pricesmove toward the equilibrium level.

Government Intervention Markets tend toward equilibrium, but insome cases the government steps in tocontrol prices. The government canimpose a price ceiling, or a maximum pricethat can be legally charged for a good. Inother cases, the government can create aprice floor, or a minimum price for a goodor service.

Price CeilingsA price ceiling is a maximum price, set bylaw, that sellers can charge for a good orservice. The government places price ceilingson some goods that are considered “essen-tial” and might become too expensive forsome consumers. For example, some localgovernments, notably New York City, have

excess supply whenquantity supplied ismore than quantitydemanded

price ceiling amaximum price thatcan be legally chargedfor a good or service

price floor a minimumprice for a good orservice

� How much wouldyou be willing to payto live in one of theseapartments?



experimented with ceilings on apartmentrents, called rent control. Rent control wasintroduced to prevent inflation during ahousing crisis in the early 1940s andcontinued after World War II. More recently,other cities imposed rent control, often moti-vated by a desire to help poor households bycutting their housing costs and permittingthem to live in neighborhoods they couldotherwise not afford. As we’ll see, rentcontrol reduces the quantity and quality ofhousing, so it helps some households butharms others, including many poor house-holds. If the ceiling is established below theequilibrium price, the result will look likegraph A in Figure 6.3 below.

In this market, the supply and demandcurves for two-bedroom apartments meetat the equilibrium shown at point c ingraph B. At this point, rents are $900 amonth. Consumers will demand 30,000apartments and suppliers will offer 30,000apartments for rent.

Suppose that the city government passesa law that limits the rent on two-bedroomapartments to $600 per month. At thatprice, the quantity of apartments demandedis 40,000 (point b), and the quantitysupplied is 20,000 (point a). At such a lowprice, apartments seem inexpensive, andmany people will try to rent apartmentsinstead of living with their families orinvesting in their own houses.

However, some landlords will have diffi-culty earning profits or breaking even atthese low rents. Fewer new apartmentbuildings will be built, and older onesmight be converted into offices, stores, orcondominiums.

As you can see in graph A of Figure 6.3,the result is excess demand of 20,000apartments. The price ceiling increases thequantity demanded but decreases thequantity supplied. Since rents are notallowed to rise, this excess demand will lastas long as the price ceiling holds.

The Cost of Price CeilingsWhen the price cannot rise to the equilib-rium level, the market must determinewhich 20,000 of the 40,000 householdswill get an apartment, and which 20,000will do without. Although governmentsusually pass rent control laws to helprenters with the greatest need, few of theserenters benefit from rent control. Methodsbesides prices, including long waiting lists,discrimination by landlords, and evenbribery, are used to allocate the scarcesupply of apartments among the manypeople who want them. Luck becomes animportant factor, and sometimes the onlyway to get a rent-controlled apartment is toinherit it from a parent or grandparent.

New York City revised its laws in the1990s to exclude the wealthiest renters

rent control a priceceiling placed on rent

Figure 6.3 The Effects of Rent ControlFigure 6.3 The Effects of Rent Control

Number of apartments(in thousands)

Number of apartments(in thousands)

Pric

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(ren

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Quantity supplied rises

10 20 30 40 50 60 10 20 30 40 50 60Quantitysupplied

Quantitydemanded

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A. With Rent Control B. Without Rent Control

Rent control helpssome people, but italso creates a housingmarket with fewer,less-desirable homes. Supply and DemandAt what price doesthe market for apart-ments reach equilib-rium without rentcontrol?


130 Prices

from rent control protection after newspa-pers discovered that some very wealthypeople rented spacious apartments at pricesmuch less than market value.

Additionally, since the rent controls limitlandlords’ profits, landlords may try toincrease their income by cutting costs. Whyshould a landlord give a building a freshcoat of paint and a new garden if he or shecan’t earn the money back through higherrent? Besides, if there’s a waiting list to getan apartment, the landlord has no incentiveto work hard and attract renters. As a result,many rent-controlled apartment buildingsbecome run-down, and renters may have towait months to have routine problems fixed.

Ending Rent ControlIf rents were allowed to rise to the marketequilibrium level, which is $900 permonth, the quantity of apartments in themarket would actually rise to 30,000apartments. The market would be in equi-librium, and people who could afford $900a month would have an easier time findingvacant apartments. Instead of spendingtime and money searching for apartments,and then having to accept an apartment ina poorly maintained building, many renterswould be able to find a wider selection ofapartments. Landlords would also have a

greater incentive to properly maintain theirbuildings and invest in new construction.

On the other hand, people lucky enoughto live in a rent-controlled apartment mayno longer be able to afford to stay thereonce rent control is ended and the landlordcan legally raise the rent. As soon as theneighborhood improves, these renters maybe priced out of their own apartments, tobe replaced by people willing to pay theequilibrium price. Remember that endingrent control increases the number of apart-ments on the market by 10,000.

Certainly, the end of rent control benefitssome people and hurts others. Economistsagree that the benefits of ending rentcontrol exceed the costs, and suggest thatthere are better ways to help poor house-holds find affordable housing.

Price FloorsA price floor is a minimum price, set by thegovernment, that must be paid for a goodor service. Price floors are often imposedwhen government wants sellers to receivesome minimum reward for their efforts.

The Minimum WageOne well-known price floor is the minimumwage, which sets a minimum price that anemployer can pay a worker for an hour oflabor. The federal government sets a baselevel for the minimum wage, and statescan set their own minimum wages evenhigher. A full-time worker being paid thefederal minimum wage will earn less thanthe federal government says is necessary tosupport a couple with one child. However,it does provide some lower limit forworkers’ earnings. The important question,as you will read in Debating Current Issueson pages 238–239, is whether the benefitsto minimum wage workers outweigh theloss of some jobs.

If the minimum wage is set above themarket equilibrium wage rate, the result isa decrease in employment, as demon-strated in Figure 6.4. This figure illustratesthe supply curve of labor, which shows thenumber of worker-hours offered at various

� The minimumwage has a strongimpact on teens inthe work force.

minimum wage aminimum price that anemployer can pay aworker for an hour oflabor.



wage rates, and a demand curve for labor,which shows the number of workersemployers will hire at various wages.

If the market equilibrium wage for low-skilled labor is $4.50 per hour, and theminimum wage is set at $5.15, the resultis an excess supply of labor. There are now4 million more people looking for workthan employers are willing to hire.(Remember that in this example, theworker is the supplier because he or shesupplies labor that is bought by anemployer.) Firms will employ 2 millionfewer workers than they would at theequilibrium wage rate because the pricefloor on labor keeps the wage rate artifi-cially high. If the minimum wage is belowthe equilibrium rate, it will have no effectbecause employers would have to pay atleast the equilibrium rate anyway to findworkers in a free market.

Price Supports in AgriculturePrice floors are used for many farmproducts around the world. Until 1996,the United States set minimum prices forseveral commodities, although these price

floors were not legal limits. Instead,whenever the price fell below the pricefloor, the government created demand bybuying excess crops.

Congress abolished these programs in1996 because they conflicted with freeenterprise. Today, the federal governmentresponds to low commodity prices byproviding emergency financial aid to farmers.

Section 1 Assessment

Key Terms and Main Ideas1. What is unique about an equilibrium price?2. What situation can lead to excess demand?3. How is a price floor different from a price ceiling?4. How does rent control work?

Applying Economic Concepts5. Using the Databank Turn to the graph of median weekly

earnings on page 536 in the Databank. Suppose that thefederal government has raised the minimum wage to $600per week. (a) Which category of jobs would be leastaffected by the change? (b) Which two categories wouldbe most affected by the new minimum wage? (c) Whatare the likely consequences for workers in these twofields?

6. Critical Thinking What are the benefits and drawbacksof a price ceiling?

7. Math Practice The graph below shows supply anddemand curves in the notebook market. Use what you

have learned in this section to identify the followingelements of the graph: price floor, supply curve, equilibrium point, disequilibrium point, demand curve,price ceiling.

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D

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2O

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Supply of labor

Demand for workers

Figure 6.4 Effects of Minimum WageFigure 6.4 Effects of Minimum Wage

A minimum wage lawcan set the price oflabor above the equi-librium price, leadingto a labor surplus.Supply and DemandAccording to thisgraph, how big is thesurplus of workerswhen the minimumwage is $5.15 perhour?

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132

1. Identify the two parts of a cause-effectrelationship. A cause is an event or anaction that brings about an effect.Words such as because, due to, and

on account of signal causes. Wordssuch as so, thus, therefore, and as aresult signal effects. Read statementsA through F at the left and answerthe following: (a) Which statementsare cause-effect statements? (b) Identify the cause and the effectin each cause-effect statement. (c) Which word or words signal thecause-effect relationship?

2. Remember that an event can have morethan one cause and more than oneeffect. Read statement E at the leftand answer the following questions.(a) What are the causes presented inthe statement? (b) What are theeffects of those causes?

3. An event can be both a cause and aneffect. Causes and effects can form a chain of events. Read statement Fat the left and use arrows to draw adiagram of the causes and effectsthat show the chain of relatedevents.

Determining Cause and Effect

Recognizing cause and effect means examining how one event or actionbrings about others. Because an economy is a complex web of choices

and events, one challenge economists face is finding and defining the rela-tionships between events. Use the following steps to learn how to deter-mine causes and effects.

STATEMENTS LIST

A. Because of floods in South America, lastyear’s coffee crop was poor.

B. Coffee is grown in Brazil, Colombia, andseveral countries in West Africa.

C. Because of the poor harvest, there wasnot enough good coffee available forAmerican distributors to buy. As a result,prices went up, and many stores chose tostop selling the most expensive blends.

D. Many Americans drink coffee in the morn-ing to wake up, while others drink coffeein the afternoon or after dinner.

E. The poor state of this year’s crop led cof-fee shops to raise prices even as the qual-ity of their coffee declined. When a heatwave hit the Northeast in July and August,sales dropped by 30 percent, manyservers lost their jobs, and a major chaindecided to delay opening new stores inPhiladelphia and Washington, D.C.

F. When high quality coffee became expen-sive and difficult to find, many consumersswitched to tea and soft drinks instead.Importers bought more tea in SoutheastAsia to meet the new demand, and teaplantations planted more crops for the fol-lowing year. While farmers in SouthAmerica struggled to rebuild, farmers inIndia and Indonesia made more moneyand were able to invest in new machinery.

Based on what you have learned inthis chapter, construct a chain ofevents to show the impact of a newtax on the coffee market.

Additional Practice

LIFESkills for

132

ECON_05_se_SK_CH06 6/20/05 8:23 AM Page 132

EEconomists say that a market will tendtoward equilibrium, which means that

the price and quantity will gradually movetoward their equilibrium levels. Why doesthis happen? Remember that excessdemand will lead firms to raise prices.Higher prices induce the quantity suppliedto rise and the quantity demanded to falluntil the two values are equal.

On the other hand, excess supply willforce firms to cut prices. Falling prices willcause quantity demanded to rise andquantity supplied to fall until, once again,they are equal. Through these relation-ships, the market price and quantity soldof a good will move toward their equilib-rium values.

Remember from Chapters 4 and 5 thatall of the changes in demand and supplydescribed above are changes along ademand or supply curve. Assuming that amarket starts at equilibrium, there are twofactors that can push it into disequilib-rium: a shift in the entire demand curveand a shift in the entire supply curve.

Changes in PriceIn Chapter 5, you read about the differentfactors that shift a supply curve to the leftor to the right. These factors includeadvances in technology, new governmenttaxes and subsidies, and changes in theprices of the raw materials and labor usedto produce the good.

Since market equilibrium occurs at theintersection of a demand curve and asupply curve, a shift of the entire supplycurve will change the equilibrium price andquantity. A shift in the supply curve to theleft or the right creates a new equilibrium.Since markets tend toward equilibrium, achange in supply will set market forces intomotion that lead the market to this newequilibrium price and quantity sold.

Changes in Market Equilibrium


Section FocusWhen a supply or demand curveshifts, a new equilibrium occurs. Themarket price and quantity sold movetoward the new equilibrium.

Key Termssurplusshortagesearch costs

ObjectivesAfter studying this section you will be able to:1. Identify the determinants that create

changes in price.2. Explain how a market reacts to a fall in

supply by moving to a new equilibrium.3. Explain how a market reacts to shifts in

demand by moving to a new equilibrium.

Preview

� A functioningmarket will carefullybalance supply anddemand.


134 Prices

Understanding a Shift in SupplyWhen compact disc players were firstintroduced in the early 1980s, a basic,single-disc machine cost around $1,000.The early compact disc players were muchmore expensive and less sophisticated thanthe compact disc players people use today.Gradually, as firms developed better tech-nology for producing compact disc players,their prices fell. In 1990, a consumer couldpurchase a fancy single-disc player for$300; just five years later, in 1995, a similarplayer could be purchased for about $200.Today, consumers can buy a compact discplayer for less than $100.

Not only have the prices of compactdisc players fallen, but the machines onsale today have many more features andoptions than the original $1,000 machine.Technology has lowered the cost of manu-facturing compact disc players and hasalso reduced the costs of some of theinputs, like computer chips. Theseadvances in production have allowedmanufacturers to produce compact discplayers at lower costs. Producers havepassed on these lower costs to consumersin the form of lower market prices.

We can use the tools developed inChapter 5 to graph the effect of thesechanges on the CD market’s supply curve.Figure 6.5 shows how the supply curveshifted outward, or to the right, as manu-facturers offered more and more CD

players at lower prices. In the early 1980s,no compact disc players were offered for$300. They were simply too expensive todevelop and manufacture. Today, manu-facturers can offer millions of CD playersat this price.

Finding a New EquilibriumPicture the point in time when compactdisc players were evolving from an expen-sive luxury good to a mid-priced good. Anew generation of computer chips has justreduced the cost of production. Theselower costs have shifted the supply curveto the right where at each price, producersare willing to supply a larger quantity.

This shift, shown in Figure 6.6 usingfictional quantities, has thrown the marketinto disequilibrium. At the old equilibriumprice, suppliers are now willing to offer4,000,000 compact disc players, up from2,000,000.

In Figure 6.6, the increase in quantitysupplied at the old equilibrium price isshown as the change from point a topoint b. However, the quantity demandedat this price has not changed, andconsumers will only buy 2,000,000compact disc players. At this market price,unsold compact disc players will begin topile up in the warehouse. When quantitysupplied exceeds quantity demanded at agiven price, economists call this a surplus.The surplus compact disc players are

surplus situation inwhich quantity suppliedis greater than quantitydemanded; also knownas excess supply

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a

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pact

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c pl

ayer

$1,000

$800

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1995 20001990

$200

$0

Falling Prices*

Figure 6.5 Falling Prices and the Supply CurveFigure 6.5 Falling Prices and the Supply Curve

$1,000

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Shifting Supply Curve*

1985 15 20 25 30105Today

1985 1990 1995 Today

* Fictional data Quantity of compact disc players (in millions)

As CD playersbecome cheaper toproduce, the supplyincreases at all butthe lowest prices.Supply and DemandWhy do the 1985 and1990 supply curvesbegin so high up onthe graph?


excess supply, so something will have tochange to bring the market to equilibrium.

As you read in Section 1, suppliers willrespond to excess supply by reducingprices. As the price falls from $600 to$400, more consumers decide to buycompact disc players, and the quantitydemanded rises. The combined movementof falling prices and increasing quantitydemanded can be seen in Figure 6.6 as achange from point a to point c. Notice thatthis change is a movement along thedemand curve, not a shift of the entiredemand curve.

Eventually, the price falls to a pointwhere quantity supplied and quantitydemanded are equal, and excess supply isno longer a problem. This new equilib-rium point, shown at point c in Figure 6.6,marks a lower equilibrium price and ahigher equilibrium quantity sold thanbefore the supply curve shifted. This ishow equilibrium changes when supplyincreases, and the entire supply curveshifts to the right.

Changing EquilibriumAs the price of compact disc players fell dueto better technology, more and morepeople bought them. The equilibrium inthis market, then, started moving graduallydownward and to the right. This is wherethe quantities demanded and supplied arehigher, and the prices are lower.

The supply curve for compact discplayers has been moving to the right eversince the first $1,000 compact disc playerswere sold. The curve continues to shifttoday as new technology continues todrive down the production cost andmarket price of the most basic machines.

Equilibrium is usually not an un-changing, single point on a graph. Theequilibrium in the compact disc playermarket has always been in motion. Themarket equilibrium follows the intersectionof the demand curve and the supply curveas that point moves downward along thedemand curve.

Equilibrium is a “moving target” thatchanges as market conditions change.

Manufacturers and retail sellers of compactdisc players are constantly searching for anew equilibrium as technology and methodsof production change. Consumers recognizethis “searching” by the frequent pricechanges, sales, and rebates on compact discplayers. Each of these tactics is designed tokeep the machines moving out of stores asfast as new machines come in.

A Fall in SupplyJust as new technology or lower costs canshift the supply curve to the right, so otherfactors that reduce supply can shift thesupply curve to the left. Consider themarket for cars. If the price of steel rises,automobile manufacturers will producefewer cars at all price levels,and the supply curve willshift to the left. If autoworkers strike for higherwages, and the companymust pay more for labor tobuild the same number ofcars, supply will decrease. Ifthe government imposes anew tax on car manufac-turers, supply will decrease.In all of these cases, thesupply curve will move tothe left, because the quantitysupplied is lower at all pricelevels.


Pric

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Output (in millions)

Figure 6.6 A Change in SupplyFigure 6.6 A Change in Supply

Originalsupply

Newsupply Demand

c

a b

1 2 3 4 5

$400

$200

$600

$800

O

When supplyincreases, prices fall, and quantitydemanded increasesto reach a new equilibrium.Supply and DemandHow would youcompare the point ofthe new equilibriumto the old equilibrium?

In the News Read more about supply in“Ups and Downs,” an article in The Wall Street Journal Classroom Edition.

The Wall Street JournalClassroom Edition

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136 Prices

When the supply curve shifts to the left,the equilibrium price and quantity soldwill change as well. This process is theexact opposite of the change that resultsfrom an increase in supply. As the supplycurve shifts to the left, suppliers raise theirprices and the quantity demanded falls.The new equilibrium point will be at a spotalong the demand curve above and to theleft of the original equilibrium point. The

market price is higher than before, and thequantity sold is lower.

Shifts in DemandAlmost every year, around November, anew doll or toy emerges as a nationwidefad. People across the country race tostores at opening time and stand in longlines to buy that year’s version of TickleMe Elmo or Pokémon.

As you read in Chapter 4, these fadsreflect the impact of consumer tastes andadvertising on consumer behavior. Fadslike these, in which demand rises quickly,are real-life examples of a rapid, right-ward shift in a market demand curve.Figure 6.7 shows how a rapid, unexpectedincrease in market demand will affect theequilibrium in a market for a hypothet-ical, trendy toy.

The Problem of Excess DemandIn Figure 6.7, the fad causes a suddenincrease in market demand, and thedemand curve shifts to the right. This shiftleads to excess demand at the originalprice of $24 (point b). Before the fadbegan, quantity demanded and quantitysupplied were equal at 300,000 dolls,shown at point a. On the graph, excessdemand appears as a gap between thequantity supplied of 300,000 dolls and thenew quantity demanded of 500,000 at$24, shown at point b. This is an increaseof 200,000 in the quantity demanded.Economists would also describe this as ashortage of 200,000 dolls.

In the stores that carry the dolls, excessdemand appears as bare shelves and longlines. Excess demand also appears in theform of search costs—the financial andopportunity costs consumers pay insearching for a good or service. Driving todifferent stores and calling different townsto find an available doll are both examplesof search costs.

In the meantime, the available dolls mustbe rationed, or distributed, in some othermanner. In this case, long lines, limits onthe quantities each customer may buy, and

� Almost every fall, a trendy toy emerges as one that everychild “must have.” Demand for these toys increases.

Figure 6.7 A Change in DemandFigure 6.7 A Change in Demand

100 200 300 400 500 600 700 800 900

$20

$30

$10

$40

$60

$50

Pric

e

Output (in thousands)

c

a b

Originaldemand

Newdemand

Supply

O

When demand shifts, price and quantity supplied change tocreate a new equilibrium. Prices and Markets What happens to prices when thedemand curve shifts to the right?

shortage situation inwhich quantitydemanded is greaterthan quantity supplied;also known as excessdemand

search costs thefinancial andopportunity costsconsumers pay whensearching for a good orservice

ECON_07NA_se_CH06_S2 8/3/05 11:15 AM 6


“first come, first serve” policies are used todistribute the dolls among customers.

Return to EquilibriumAs time passes, firms will react to thesigns of excess demand and raise theirprices. In fact, customers may actuallypush prices up on their own if there is“bidding” in the market, as there is forreal estate, antiques, fine art, and hard-to-find items.

If a parent cannot find the doll he wantsat the store, he might offer the store keeperan extra $5 to guarantee him a doll fromthe next shipment. Through these methods,the market price will rise until the quantitysupplied equals the quantity demanded at300,000 dolls. All of these dolls are sold atthe new equilibrium price of $30, shown atpoint c in Figure 6.7.

When demand increases, both the equi-librium price and the equilibrium quantity

also increase. The demand curve hasshifted, and the equilibrium point hasmoved, setting in motion market forcesthat push the price and quantity towardtheir new equilibrium values.

A Fall in DemandWhen a fad passes its peak, demand canfall as quickly as it rose. Excess demandturns into excess supply for the once-popular toy as parents look for a new, moretrendy gift for their children. Overflowingstore shelves and silent cash registers, thesymptoms of excess supply, replace longlines and bidding wars.

When demand falls, the demand curveshifts to the left. Suppliers respond bycutting prices on their inventory. Price andquantity sold slide down along the supplycurve to a new equilibrium point at point ain Figure 6.7. The end of the fad restoresthe original price and quantity supplied.


Key Terms and Main Ideas1. What conditions lead to a surplus?2. What is an example of a search cost?

Applying Economic Concepts3. Decision Making Explain how the equilibrium price

and quantity sold of eggs will change in the followingcases. Remember that they need not move in the samedirection. (a) An outbreak of food poisoning is traced toeggs. (b) Scientists breed a new chicken that lays twiceas many eggs each week. (c) A popular talk show hostconvinces her viewers to eat an egg a day.

4. Critical Thinking What will happen to suppliers in amarket if there is a surplus of the good they sell, but nosupplier can afford to lower prices?

5. Math Practice The graph at the right shows the effectsof a demand shift on a particular market. (a) Has demandincreased or decreased? Explain. (b) What are theoriginal equilibrium price and quantity sold? (c) What arethe new equilibrium price and quantity sold? (d) A newtax raises the cost of production. How does the supplycurve react? (e) Give a market price and quantity soldthat might be a new equilibrium point after this costincrease.

Pri

ce

Output

$20.00

$25.00

150 180

Supply

Originaldemand

Newdemand

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ECONOMIC

138

Michael DellMichael Dell (b. 1965)(b. 1965)

In 1984, Michael Dell took $1,000 and an idea, and began to build acomputer business. Defying the odds against the success of a newbusiness, Dell built what is now the largest direct-sale computermanufacturer in the world. In the process, he made millionaires outof investors who had faith in a young person and his ideas.

From Out of a Dorm Room“I often wonder what new developmentwill come along and totally change the faceof our industry,” says computer magnateMichael Dell. This visionary Texan has notonly adapted well to change, he hasrevolutionized the way products aremarketed and sold. Dell has been called theHenry Ford of the computer industry.

As a teenager in the early 1980s, Dellsaw a future in personal computers (PCs).During his freshman year at the Universityof Texas, he sold PCs from his dorm room.Business was so good that the next year hequit school and, with $1,000 in capital,started a company. Fifteen years later, DellComputer Corporation was a $19.9 billionbusiness, with more than $18 million a dayin sales on its Internet site alone.

Direct From DellWhen Dell started his company in 1984,PC manufacturers were all selling standardmodels through retail stores. Dell’s visionwas to sell his computers directly toconsumers. This approach allowed him tocustomize each computer to the customer’sneeds. It also enabled Dell to sell PCs forless than his competitors did because therewere no retailers marking up his prices tomake a profit for their stores.

Dell’s direct-marketing model had costadvantages as well. By custom-buildingeach computer, he did not have to maintainwarehouses full of unsold goods. Thecompany took each order by phone or faxand shipped the finished computer withintwo weeks. The low inventory costs werealso reflected in Dell’s pricing. Not only didDell’s customers receive exactly what theyneeded, they got it at a lower price thanthat of his competitors’ standard PCs.

Dell in CyberspaceAs the Internet grew in the early 1990s,Dell saw new opportunities. Most people atthe time viewed the Internet as a source ofinformation. “Commerce . . . was prettymuch restricted to ordering T-shirts,” Dellsays. “But it . . . struck me that if you couldorder a T-shirt online, you could orderanything—including a computer.” In 1996,Dell became one of the first manufacturersto offer products via the Internet. The DellWeb site allows visitors to create acomputer system, calculate its price, placean order, pay, and even arrange financingonline.

The success of this “Dell direct”approach to the sale of computers hasshaped how other business sectors, such asbanking and the auto industry, market andsell their products.

1. Source Reading Summarize thefactors that allowed Dell ComputerCorporation to sell personal computersat lower prices than its competitorscould.

2. Critical Thinking What would belikely to happen to its prices if DellComputer Corporation opened storesacross the country? Explain why.

3. Learn More How has DellComputer Corporation strived to main-tain its success against competitorswho have imitated the Dell direct salesapproach?

CHECK FOR UNDERSTANDING

Economist

Entrepreneur

ECON_05_se_PR_CH06 6/20/05 8:18 AM Page 138

II n Section 1, you read how supply anddemand interact to determine the equilib-

rium price and quantity sold in a market.You also read about how those priceschange over time. Prices are a key elementof equilibrium. Price changes can movemarkets toward equilibrium and solveproblems of excess supply and excessdemand. In this section we will discuss theimportance of prices and the role they play.

In a free market, prices are a tool fordistributing goods and resourcesthroughout the economy. Prices are nearlyalways the most efficient way to allocate,or distribute, resources. The alternativemethod for distributing goods andresources, namely a centrally plannedeconomy, is not nearly as efficient as amarket system based on prices.

Prices in the FreeMarketPrices serve a vital role in a freemarket economy. Prices helpmove land, labor, and capitalinto the hands of producers, andfinished goods into the hands ofbuyers. The following exampleshows the benefits of a system based onfree market prices.

Kevin decides to buy a sweater for hissister for her birthday next month. He goesto a nearby shopping center and comparesthe prices of several different sweaters.Kevin finds that a department store offerscotton cable-knit sweaters for $30 to $50and soft cashmere sweaters for $110. Hevisits other stores and finds that he canspend as little as $20 for an acrylic sweateror as much as $350 for a designer cashmeresweater. Kevin considers his sister’s tastesand his own income and buys his sister oneof the less expensive cotton sweaters.

Later, Kevin uses his computer to browsecatalogs of mail-order stores. He’s surprisedto find a sweater very similar to the one hebought, but it’s on sale for $5 less, shipping

The Role of Prices


Section FocusGoods and services can be dividedup among buyers and sellers by acentral plan or a price-based marketsystem. Prices allow an efficient,flexible exchange of goods.

Key Termssupply shockrationingblack marketspillover costs

ObjectivesAfter studying this section you will be able to:1. Analyze the role of prices in a free market.2. List the advantages of a price-based

system.3. Explain how a price-based system leads to

a wider choice of goods and more efficientallocation of resources.

4. Describe the relationship between pricesand the profit incentive.

Preview

� Sweaters sell fordifferent prices,depending on quality,style, and type of yarn.


140 Prices

included. Kevin decides to buy the sweateron-line with his credit card and return thesweater he bought at the mall.

Kevin’s story, familiar to anyone whohas shopped for a gift, demonstrates theimportance of prices to the free marketsystem. The simple process of buying a giftfor a friend or relative would be muchmore complicated and inefficient withoutthe price system.

The Advantages of PricesPrices provide a language for buyers andsellers. Could you conceive of a market-place without prices? Without prices as astandard measure of value, a seller wouldhave to barter for goods by bidding shoesor apples to purchase a sweater. A sweatermight be worth two pairs of shoes to onecustomer, but another customer might bewilling to trade three pairs of shoes for thesame sweater. The supplier would have noconsistent and accurate way to measuredemand for a product.

Price as an IncentiveBuyers and sellers alike look at prices tofind information on a good’s demand andsupply. The law of supply and the law of

demand describe how people and firmsrespond to a change in prices. In thesecases, prices are a signal that tell aconsumer or producer how to adjust. Pricescommunicate to both buyers and sellerswhether goods are in short supply orreadily available.

In the example of the popular dolldiscussed in Section 2, the increaseddemand for the doll told suppliers thatpeople wanted more dolls, and soon!However, the signal that producers respondto is not simply the demand, but the highprice consumers are willing to pay for thedoll, well above the usual retail price. Thishigher price tells firms that people wantmore dolls, but also that the firms can earnmore profit by producing more dolls,because they are in demand. Therefore,rising prices in a market will cause existingfirms to produce more goods and willattract new firms to enter a market.

Prices as SignalsThink of prices as a traffic light. A rela-tively high price is a green light that tellsproducers that a specific good is in demandand that they should use their resources toproduce more. New suppliers will also jointhe market. A low price, however, is a redlight to producers that a good is beingoverproduced. In this case, low prices tell asupplier that he or she might earn higherprofits by using existing resources toproduce a different product.

For consumers, a low price is a greenlight to buy more of a good. A low priceindicates that the good carries a low oppor-tunity cost for the consumer, and offers agood buying opportunity. By the sametoken, a high price is a red light to stop andthink carefully before buying.

FlexibilityAnother important aspect of prices is thatthey are flexible. When a supply shift or ademand shift changes the equilibrium in amarket, price and quantity supplied need tochange to solve problems of too much ortoo little demand. In many markets, pricesare much more flexible than output levels.

� Drought, floods, or frost can killcrops and cause asupply shock.



Prices can be easily increased to solve aproblem of excess demand, and they canbe just as easily decreased to eliminate aproblem of excess supply.

For example, a supply shock is a suddenshortage of a good, such as gasoline orwheat. A supply shock creates a problem ofexcess demand because suppliers can nolonger meet the needs of consumers. Theimmediate problem is how to divide up theavailable supply among consumers.

What are the options? Increasing supplycan be a time-consuming and difficultprocess. For example, wheat takes time toplant, grow, and harvest. Rationing, ordividing up goods and services usingcriteria other than price, is expensive andcan take a long time to organize. Rationingis the basis of central planning, which youread about in Chapter 2.

Raising prices is the quickest way toresolve excess demand. A quick rise in priceswill reduce quantity demanded to the samelevel as quantity supplied and avoid theproblem of distribution. The people whohave enough money and value the goodmost highly will pay the most for the good.These consumers will be the only consumersstill in the market at the higher price, andthe market will settle at a new equilibrium.

Price System Is “Free” Unlike central planning, a distributionsystem based on prices costs nothing toadminister. Central planning requirescentral planners who collect informationon production and decide how resourcesare to be distributed. In the former SovietUnion, the government employed thou-sands of bureaucrats in an enormousagency called GOSPLAN to organize theeconomy. During World War II, the UnitedStates government set up the Office of PriceAdministration to prevent inflation andcoordinate rationing of important goods.

On the other hand, free market pricingdistributes goods through millions of deci-sions made daily by consumers andsuppliers. Kevin, from the beginning of thesection, looks at the prices of sweaters anddecides which one to buy for his sister and

which supplier to buy it from. A farmerreads the reports from the commodityexchanges and decides whether to growcorn instead of soybeans next year.Everyone is familiar with how prices workand knows how to use them. In short,prices help goods flow through theeconomy without a central plan.

A Wide Choice of GoodsOne of the benefits of a market-basedeconomy is the diversity of goods andservices consumers can buy. Price givessuppliers a way to allow consumers tochoose among similar products. Kevincould buy his sister an acrylic sweater for$20, a cotton sweater for $40, or acashmere sweater for much more. Based onhis income and his sister’s tastes, Kevindecided on a cotton sweater at the lowerend of the price range. The prices providedan easy way for Kevin to narrow hischoices to a certain price range. Prices alsoallow producers to target the audience theywant with the products that will sell best tothat audience.

In a command economy, however, oneorganization decides what goods areproduced and how much stores will chargefor these goods. To limit their costs,

supply shock a suddenshortage of a good

rationing a system ofallocating scarce goodsand services usingcriteria other than price

� During the WorldWar II era, civilianscould only buy acertain amount ofmeat and other goodseach month. Peopleneeded both cash andration points to buy.


142 Prices

central planners restrict production to afew varieties of each product. As a result,consumers in the former Communist statesof Eastern Europe and the Soviet Unionhad far fewer choices of goods thanconsumers in Western Europe and theUnited States. You may ask whyCommunist governments used a commandeconomic system. The answer is, in part,that they hoped to distribute wealth evenlythroughout their society. As a result, thegovernment of the Soviet Union built wholeneighborhoods of identical apartmentblocks and supermarkets with names suchas “Supermarket No. 3.”

Rationing and ShortagesAlthough goods in the Soviet Union wereinexpensive, consumers could not alwaysfind them. When they did, they often hadto wait hours for eggs or soap, years forapartments or telephones. The UnitedStates experienced similar problems,although far less severe, when the govern-ment instituted temporary price controlsduring World War II.

Although rationing in the United Stateswas only a short-term hardship, likerationing in the Soviet Union it was expen-sive and left many consumers unhappy. Theneeds of the U.S. armed forces for food,metal, and rubber during World War IIcreated tremendous shortages at home,

and the government controlledthe distribution of food andconsumer goods. Choices werelimited, and consumers felt,rightly or wrongly, that somepeople fared better than others.However, rationing was chosenbecause a price-based systemmight have put food andhousing out of the reach of someAmericans, and the governmentwanted to guarantee everycivilian a minimum standard ofliving in wartime.

The Black MarketDespite the ration system, the

federal government was unable to controlthe supply of all goods passing through theeconomy. A butcher could sell a steakwithout asking for ration points, or alandlord might be willing to rent an apart-ment at the rate fixed by the governmentonly if the renter threw in a cash “bonus”or an extra two months’ rent as a“deposit.”

When people conduct business withoutregard for government controls on price orquantity, they are said to do business onthe black market. Black markets allowconsumers to pay more so they can buy agood when rationing makes it otherwiseunavailable. Although black markets are anearly inevitable consequence of rationing,such trade is illegal and strongly discour-aged by governments.

Efficient Resource AllocationAll of the advantages of a free marketallow prices to allocate resources effi-ciently. Efficient resource allocation meansthat economic resources—land, labor, andcapital—will be used for their mostvaluable purposes. A market system, withits freely changing prices, ensures thatresources go to the uses that consumersvalue most highly. A price-based systemalso ensures that resource use will adjustto the changing demands of consumers.

black market a marketin which goods are soldillegally

� North Korea’sCommunistgovernment has builtidentical apartmentblocks for itscitizens, who do notget to choose whereto live.



These changes take place without anycentral control, because the people whoown resources—landowners, workers whosell their labor, and people who providecapital to firms—seek the largest possiblereturns. How do people earn the largestreturns? By selling their resources to thehighest bidder. The highest bidder will bethat firm that produces goods that are inthe highest demand. Therefore, theresources will flow to the uses that are mosthighly valued by consumers. This flow isthe most efficient way to use our society’sscarce resources.

Prices and the ProfitIncentiveSuppose that scientists predicted extremelyhot weather for the coming summer. Inmost parts of the country, consumerswould buy up air conditioners and fans, toprepare for the heat. Power companieswould buy reserves of oil and natural gasto supply these appliances with enoughpower. Since demand would exceed supply,consumers would bid up the price of fans,and power plants would bid upthe price of fuel. Supplierswould recognize the possibilityfor profit in the higher pricescharged for these goods, andthey would produce more fansand air conditioners. Oil andnatural gas fields would hireworkers to pump more fuel forpower plants. Eventually, morefans, air conditioners, and fuelwould move into the market.The potential heat wave wouldhave created a need for certaingoods, and the rise in priceswould have given producers anincentive to meet this need.

As we previously noted, effi-cient resource allocation occursnaturally in a market systemas long as the system worksreasonably well. Landownerstend to use their scarce property

in the most profitable manner. Workersusually move toward high-paying jobs, andcapital will be invested in the firms that paythe highest returns.

The Wealth of NationsAdam Smith made this point in his famousbook The Wealth of Nations, published in1776. Smith explained that it was notbecause of charity that the baker and thebutcher provided people with their food.Rather, they provide people with breadand meat because prices are such that they

� The People’sRepublic of China ismoving away from acommand economyand rationing to amore market-basedeconomy.

Rationing and Prices Cuba has two different systems for distrib-uting goods. Some goods are rationed, while many others are sold in stores atdifferent prices. The difference between the two systems is that the price-based system uses not Cuba’s currency, the peso, but the United States dollar.Many Cubans earn dollars by working in tourism or as gifts from familymembers outside the country. Cubans with dollars can buy a variety of foodand clothing at stores and restaurants that only accept dollars. Cubans whoare paid in pesos must get their food through the state’s rationing system.Prices are very low, but food is rationed, and the government provides eachperson with a limited amount of grain, coffee, salt, and other basic foods.

Global Connections


144 Prices

will profit from doing so. In other words,businesses prosper by finding out whatpeople want, and then providing it. Thishas proved to be a more efficient systemthan any other that has been tried in themodern era.

Market ProblemsThere are some exceptions to the generalidea that markets lead to an efficient alloca-tion of resources. The first problem, imper-fect competition, can affect prices, andhigher prices can affect consumer decisions.

If only a few firms are selling a product,there might not be enough competitionamong sellers to lower the market pricedown to the cost of production. When onlyone producer sells a good, this producerwill usually charge a higher price than wewould see in a market with several compet-itive businesses. In the following chapter,you will read more about how marketsbehave under conditions of imperfectcompetition.

A second problem can involve spillovercosts, also known as externalities, thatinclude costs of production, such as airand water pollution, that “spill over” ontopeople who have no control over howmuch of a good is produced. Sinceproducers do not have to pay spillovercosts, their total costs seem artificially low,and they will produce more than the equi-librium quantity of the good. The extracosts will be paid by consumers.

Imperfect information is a third problemthat can prevent a market from operatingsmoothly. If buyers and sellers do not haveenough information to make informedchoices about a product, they may notmake the choice that is best for them.


Key Terms and Main Ideas1. How does a supply shock affect equilibrium price and

quantity?2. How is rationing different from a price-based market

system?

Applying Economic Concepts3. Decision Making List three reasons why a price-based

system works more efficiently than central planning. 4. Critical Thinking Give two examples of situations in

which prices gave you an incentive to purchase or notpurchase a good or service.

5. Try This Distribute $50 in play money to each student inyour class. Then, ask students to bid for items from thefollowing basket of goods and services: 10 pairs of movie

tickets, 20 fine restaurant dinners, 40 bagels, 5 pairs ofrunning shoes, and 30 hours of dog walking. (a) Whatprices were bid for these goods? (b) Why do you thinksome goods received higher bids than others? (c) Whatdo you think would happen to the bids if the number ofitems for sale doubled?

6. Critical Thinking What do you think Adam Smith wouldthink of rationing? Explain.

� The price ofwater affects howefficiently it is used.When water isprovided to farmersat a higher price,they have anincentive to irrigatemore efficiently.

spillover costs costs ofproduction that affectpeople who have nocontrol over how muchof a good is produced

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Government and the Market for MilkThe California dairy industry employs more than 250,000 full-time workers and pro-

duces over $35 billion in wages and revenues each year. The success of theCalifornia dairy industry, like that of most other American agricultural industries, islinked to government subsidies.

The Need for Subsidies California’s dairy farmsenjoy a good climate, up-to-date agricultural tech-nology, and a ready market for their goods. And yetthey all rely on government support to some degree.

The government provides subsidies for manyreasons. Many people believe that agriculturalbusinesses would not easily survive in a freelycompetitive international market. If manyAmerican farms were to go out of business, theUnited States would need to depend on othercountries for its food supply. Others argue thatwithout government intervention, basic food prod-ucts like milk could change price rapidly andbecome too expensive for some families.

Price Supports and Trade Barriers Government sup-port of agriculture takes different forms. The fed-eral government uses price supports to set a feder-al minimum price for some dairy products.Whenever the market price falls too low, the Department of Agriculture buys butter,cheese, and dry milk directly from the dairy producers to guarantee that they receivethe minimum price. California has a similar state program for fluid milk. Californiaalso gives farmers special access to state water supplies, which provides inexpensivewater for cows and supports the corn and alfalfa growers who provide cattle feed.

Another way that the federal government intervenes in the dairy market is by plac-ing tariffs or other taxes on dairy imports. Tariffs raise the price of imported goodsand give an advantage to locally produced milk and cheese.

The Future The federal government has reduced assistance given to dairy farmers, andmany leaders would like to end the subsidy programs entirely. The United States isalso entering into more and more free-trade agreements that require the United Statesto reduce financial support of farms and lower trade barriers. The future of dairysubsidies looks less and less certain every year.

Applying Economic Ideas1. Why do governments consider it necessary to treat agriculture differently from

other manufacturing or production industries?

2. What might happen if the government stopped all intervention in the market fordairy products?

� Federal and state governments influencethe cost of many groceries.

145

Supply and Demand

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146

Chapter SummaryChapter Summary

AA summary of major ideas in Chapter 6 appearsbelow. See also the Guide to the Essentials

of Economics, which provides additional review andtest practice of key concepts in Chapter 6.

Section 1 Combining Supply and Demand (pp. 125–131)In an uncontrolled market, the price and quantitysold of a good will move to an equilibrium pointwhere the quantity supplied equals the quantitydemanded. The government can set a maximumprice in a market with a price ceiling, or a minimumprice with a price floor. Although some consumers orproducers benefit, these moves distort the marketand lead to excess demand or excess supply.

Section 2 Changes in Market Equilibrium (pp. 133–137)A market moves to a new equilibrium when there isa shift in either supply or demand. In the short term,a shortage will occur if quantity demanded exceedsquantity supplied, or a surplus will occur if quantitysupplied exceeds quantity demanded. Market priceand quantity sold adjust, and buyers and sellerschange their behavior over time.

Section 3 The Role of Prices (pp. 139–144)In a free market, prices provide a common languagethat enables land, labor, and capital to flow into thehands of those who value them most. Prices tell con-sumers and suppliers which goods are in short sup-ply and which are plentiful. Individual decisions leadto an efficient market with a wide choice of goods.The alternative to a price-based market, rationing, isinefficient and difficult to carry out successfully.

Key TKey TermsermsMatch the following definitions with the termslisted below. You will not use all the terms.

1. The point at which quantity demanded andquantity supplied are equal

2. The financial and opportunity costs con-sumers pay in searching for a good or service

3. A system of allocating scarce goods andservices by criteria other than price

4. A sudden drop in the supply of a good5. Any situation in which quantity supplied

exceeds quantity demanded6. Any situation in which quantity demanded

exceeds quantity supplied7. A government-mandated minimum price

that must be paid for a good or service

Using Graphic OrganizersUsing Graphic Organizers8. On a separate sheet of paper, copy the tree

map below. Then complete it with exam-ples of how government actions can affectprices. Include whether prices are in equi-librium or disequilibrium before and afterthe government’s actions.

price ceilingexcess supplysupply shockequilibrium

shortageprice floorsearch costsrationing

Government Actions Affecting Prices

Rent Control

ECON_07NA_se_CH06_CA 8/3/05 11:22 AM Page 146

147

Reviewing Main IdeasReviewing Main Ideas9. What factors can lead to disequilibrium?

Describe these factors in your own words.10. What role does the government play in deter-

mining some prices?11. What problem can a price floor cause?12. How do prices act as a “language” in the free

market?13. Turn to Figure 6.1 on page 126. Explain how to

interpret the supply and demand graph (left),using the supply and demand schedule (right).

Critical ThinkingCritical Thinking14. Recognizing Cause and Effect Why have some

cities and towns passed rent control laws? Howdo these laws affect price equilibrium? Whathappens when these laws are repealed?

15. Drawing Inferences How do computers lowersearch costs for producers and consumers? Whateffect does this have on price equilibrium?

16. Synthesizing Information How do prices in thefree market lead to efficient resource allocation?Describe an example from your experience.

Problem-Solving ActivityProblem-Solving Activity17. Suppose that a recent snowstorm has caused a

supply shock in the market for sugar in theUnited States. How would you attempt to solvethe problems that follow the storm? Whatactions are available to both consumers and producers?

Skills for LifeSkills for LifeDetermining Cause and Effect Review the stepsshown on page 132; then answer the following ques-tions using the statements below.18. Which of the statements describe cause-effect

relationships?19. Identify three phrases used to identify the cause

of a cause-effect relationship in these statements.20. Identify three terms used to identify the effect of

a cause-effect relationship in these statements.21. Which statement includes more than one cause-

effect relationship? 22. Read statement (f). Create a flowchart describing

the cause-effect relationships shown.

STATEMENTSa) Oranges are grown mainly in the South and

West, especially Florida and California.b) The price of oranges in the United States rose

this year because of a small harvest.c) Some people enjoy orange juice with breakfast,

while others like to drink it after exercise.d) Due to the early frost in much of the South, this

year’s orange crop was poor.e) Overall orange juice production was down this

year, and several national brands lost money.However, the American dairy industry saw anincrease in milk sales. Americans did not drink asmuch orange juice as they had in recent years.

f) This year’s disastrous orange crop caused manybrands to raise their prices. Because of the highprices, many consumers switched to other juices.Several national brands reduced orange juiceproduction and researched new products thatwould meet this alternative demand.

Essay Writing Compare your list of minimumwages for chores with the lists of other students.How do they compare? Use your classroom datato create four supply curves, one for each task. How might the minimum wage affect the supplyof labor for these chores? Draw a line representingthe current minimum wage in your city or state asa price floor.

Economics Journal

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The supply of a good (or service) and the demand for it inter-act in the market. If the quantity supplied or demanded goesup or down, the price of that good or service will also be

affected. Similarly, changes in supply or demand influence the quan-tity produced. At a certain point, the quantity that people want isequal to the quantity available, and theprice stabilizes. This situation is calledmarket equilibrium.

Materials20 slips of paper(one color)20 slips of paper(contrasting color)2 small boxes notebook paper

Preparing the SimulationHow does the market reach a state ofequilibrium? In this simulation, you andyour peers will act as apple producers andconsumers. You will meet in the market toagree on an exchange of apples at a cer-tain price. You’ll see how both producersand consumers change their requirementsin order to reach an agreement.

Step 1: Your class will be divided into twoequal groups, Producers and Consumers.

Step 2: The Consumers group will prepare 20 slips of colored paper thatrepresent the prices a Consumer is willingto pay for a bushel of apples. Consumerswill number the first 10 slips from $4 to $40by fours ($4, $8, and so on), and repeat forthe second 10 slips. Meanwhile, theProducers group will prepare 20 slips ofpaper in a contrasting color that representthe cost of producing a bushel of apples.Producers will number the first 10 slipsfrom $5 to $50 by fives ($5, $10, and so on),and repeat for the second 10 slips.

Step 3: Put the Consumer slips into a box.Each person in the Consumer group shoulddraw a slip. If you are a Consumer, theamount on the slip is the maximum priceyou are willing to pay for a bushel of apples.

Step 4: Put the Producer slips into a box.Each person in the Producer group should

draw a slip from the box. If you are aProducer, the amount on the slip is yourcost of producing a bushel of apples.

Conducting the Simulation There will be three trading periods. Yourgoal is to make the best deal you can—to buy below your maximum price if you are a Consumer, and to sell for more thanyour cost if you are a Producer.

If you are a Consumer, your score will bethe difference between the price you arewilling to pay for apples and the price youactually pay. For example, if the price on yourslip is $50, and you buy apples for $30, yourscore is $20. If you are an apple Producer,your score is your profit—the difference

� The profit from the sale of these apples is thedifference between the sale price and thecost to produce the apples.

EconomicsSimulation Market EquilibriumMarket Equilibrium

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On a sheet of notebook paper, create atransaction chart like the one on this page.As a class, complete the transaction chartusing information that you reported to yourteacher. Then discuss the following ques-tions as a group.

1. In Trading Periods 1 and 2, when was it a good idea for a Consumer not to buyapples?

2. When might a Producer choose not tosell his or her apples?

3. What was the effect of increasing thetotal number of Consumers in TradingPeriod 3? What would happen to theapple market if the number of Producersincreased instead?

4. Predicting Consequences What wouldhappen in this market if all the Producersgot together and agreed on one price forapples?

Trading Period 2 Trading Period 3Trading Period 1

Producers and Consumers willmeet in a trading area and try tomake deals. Each person canbuy or sell one bushel of applesin each period. When you reachan agreement, report the priceand your own score to theteacher. The trading period willend when no more pairs ofProducers and Consumers canmake a deal.

Negotiate as in Trading Period 1.You have another chance tosave money (Consumers) orincrease your profits(Producers). Again, report yourdeals to your teacher.

Before this trading periodbegins, one third of theProducers will move into theConsumer group. (The costs ontheir slips of paper now becomethe maximum prices they arewilling to pay.) Then maketrades as in the first two peri-ods. This trading period will endwhen no more pairs of Prod-ucers and Consumers can makea deal. Take note of any pricedifferences produced by anincrease in the number ofConsumers and a decrease inthe number of Producers.Record your transaction withyour teacher.

Trading Trading Trading

Period 1 Period 2 Period 3

Number of

deals made

Number of

Consumers

unable to buy

Number of

Producers

unable to sell

Average price

for a bushel

of apples

Lowest price

Highest price

Transaction ChartSimulation AnalysisSimulation Analysis

between your cost of producing the apples and theprice at which you can sell them.

You do not have to buy or sell apples in any tradingperiod. If you do not, however, your score for thatround will be $0. Your teacher will keep a record of allthe transactions made. You should also keep a recordof your own scores. The final score is the sum of allyour savings (Consumers) or profits (Producers).

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