Montana Council on

Economic Education

Randy RuckerProfessor

June 19, 2013

PRICES:

• What Are They?• Which Prices Matter? • What Role Does Currency Play?• What Roles Do Prices Play?• How Are Prices Determined?

PRICES•What Is a Price? • A price is the amount paid by a buyer

to purchase a good or service.

• Alternatively, a price is the amount received by a seller for a good or service.

• What units?

PRICES• Examples:

- Navel oranges: 69 cents per pound. - Avocados: $1.19 each.- Green onions: 79 cents per bunch- Bread: $1.99 per loaf.- Milk: $3.29 for a gallon.- Dreyers Spumoni ice cream: 2 containers (1.5

quarts each) for $6- What happens if you just buy one?

PRICES• Note that all of these prices are

expressed on a per unit basis—although the units are not all the same (pounds, by the each, gallons, loaves, etc.).

and

• The transactions are relatively simple—you give the clerk your money and then you leave with the apples, bread, or ice cream.

PRICES

• Sometimes, however, the transaction is not quite so simple. For example,- Awhile back, a new Toyota Rav 4 cost $24,081 at Ressler

- If you paid cash.- If you paid $10,000 up front and then borrowed the balance

from the bank on a six year loan at 4.9%, your monthly payments would have been $226.

- If you signed a three year lease and paid $10,000 up front, you only had to pay $67 per month. But then you didn’t get to keep it at the end of three years unless you paid an additional $15,345.

• How much would you have paid for the car?

PRICES

• Suppose I own a furniture store and am trying to hire a salesperson.

• What price do I pay?- Maybe hourly ($20 per hour)- Maybe commission (7% of sales value)- Maybe a straight salary ($3,200 per month)- Maybe a salary with a bonus- Maybe hourly/commission combination

• How much do I pay for this worker?

PRICES• Which Prices Matter?

- Suppose you wake up one morning in a strange land. You feel something in your pocket and upon reaching into it, you find a bunch of funny-looking coins with numbers on them.- You start walking and come to a food stand with a sign indicating:

- Hot Dogs: *2- Mountain Dew: *1- Slice of Meat Lover’s Pizza: *3

- You ask the owner of the stand about the coins in your pocket and he tells you that the numbers on them correspond to the prices (in terms of asterisks) on his sign.

PRICES

• What have you learned?• You now know that you have enough coins in your

pocket to feed yourself.• You also know that,

- 1 Hot Dog costs you 2 Mountain Dews, or 2/3 of a slice of Pizza

- 1 slice of Pizza costs you 3 Mountain Dews or 1.5 Hot Dogs

- 1 Mountain Dew costs you ½ of a Hot Dog or 1/3 of a slice of Pizza

PRICES• Prices thought of in this way help you

to understand the trade-offs that you are able to make between the goods available at the food stand.

• Next, you might want to walk to another food stand and see how competitive the first stand is, and also whether the available trade-offs are the same.

PRICES• Day 2: You wake up and are still in the

strange world. You get up and walk to the first food stand and see that the sign has changed to the following:- Hot Dogs: *4- Mountain Dew: *2- Meat Lover’s Pizza: *6

• You are a dismayed to see that all the prices have doubled.

• But then, you reach into your pocket and count your coins and realize that you have exactly twice as many as you had yesterday.

PRICES• Are you better or worse off?

- 1 Hot Dog still costs you 2 Mountain Dews- 1 Slice of Pizza still costs you 1.5 Hot Dogs- etc.

and- You can afford to purchase exactly the same amounts as yesterday.

Thus, you are relieved to realize you are exactly as well off today as yesterday.

PRICES• Day 3: You wake up, count your coins (same as

Day 1), walk to the food stand and see that Hot Dogs now cost *8 (Mountain Dew and Pizza prices are the same as Day 1).

• Are you better or worse off?• Price of Hot Dogs has increased relative to

other goods and also relative to your “income.”

• Thus, you eat fewer Hot Dogs and are worse off.

PRICES• So, what prices matter?

Relative prices matter!!

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What is the Role of Currency?• Note that currency comes in lots of forms:

- Dollars, Euros, Funny looking * Coins,Bitcoins, Cigarettes, Seashells, etc.

• Currencies reduce the costs of exchange.• Imagine a grocery store with no currency-

based prices . . .

PRICES• A sign might be posted by each item offered

- Package of pork chops will be exchanged for:- 12 pounds of potatoes- Two 1.5 quart containers of Dreyer’s Spumoni ice cream (frozen)- Three 16 oz. boxes of Raisin Bran

Cereal- One 12-pack of Diet Pepsi (or 9 MGD’s)

- To get the pork chops, you have to provide the store owner with one of these.

- How costly would that be?

PRICES• What Roles Do They Play?

1. They provide information about relative values (e.g., 1 Hot Dog costs 2 Mtn Dews).

2. Prices denominated in currency reduce the costs of transactions.

PRICES• What Roles Do They Play? (continued)

3. They provide signals (and incentives) to producers and consumers.- Suppose the price of corn increases (i.e., corn becomes more scarce)

- Producers have the incentive to produce more.

- Buyers have the incentive to consume less. Consumers and feedlot owners switch to substitutes.

PRICES• What Roles Do They Play? (continued)

4. They act as a rationing device. - Suppose the government decides

that you own all the water in the state. - Way more water than you can

use, so you decide to re-distribute most of the water to others.

PRICES• How will you ration the water among

competing users?– You could give it to your friends. How many

friends will you have?– First come-first served. How long with the lines

be?– Establish a price and lease or sell it to those who

place the highest value on the water. How to set the price?

PRICES• How Are Prices Determined?

- In a free market, prices will be determined by the interaction between supply and demand.

Quantity

Price ($/Q)

Q0

P0

The Market for Hot Dogs

D0

S0

PRICES• Sometimes, however, authorities intervene and over-

ride the market process. - For example,

- Price Supports & Price Ceilings - Production Quotas- Taxes & Subsidies- And so forth . . .

Such policies prevent the price system from working and compromise the information conveyed by prices.

Each of these, however, is a story for another day . . .

Overview of our discussion:

PRICES

• What Are Prices?• Which Prices Matter? • What Role Does Currency Play?• What Roles Do Prices Play?• How Are Prices Determined?

• QUESTIONS?

PRICES

PRICES• Sometimes, however, authorities intervene

and over-ride the market process. - For example,

- Price supports (price can’t fall below PS)

Quantity

Price ($/Q)

Q0

P0

The Market for Hot DogsWith a Price Support

D0

S0

PS

Surplus

• Price ceilings (price can’t rise above PC)

PRICES

Quantity (Q)

Price ($/Q)

Q0

P0

The Market for Hot Dogs with a Price Ceiling

D0

S0

PC

Shortage

For example (continued):• Production Quotas• Subsidies• Taxes• And so forth . . .Such policies prevent the price system from working

and compromise the information conveyed by free market prices.

Each of these, however, is a story for another day . . .

PRICES