Friday, March 09, 2007

The Price Determination Story

Since the Price Determination model is going to be used quite a lot in our study of Microeconomics, we need to learn it carefully. Although it looks simple, it actually contains a lot of assumptions about how things change through time.

Those assumptions are based on the fact that both the supply and demand curves represent quantity responses to all possible prices .

In other words, the quantities consumers buy depend on price alone. The quantities suppliers make respond to price alone. Suppliers do not, according to this model, directly adjust quantity to perceived shortage or surplus. The shortage or surplus causes a price change, and the price change then causes suppliers to adjust quantity.

What you will be asked to do on the exam is TELL A STORY OF PRICE ADJUSTMENT IN THIS MARKET. Like any story it has a beginning, a middle, and an end, and the order matters.

1. In each case we will start with price at equilibrium.

2. Then, something will happen that will affect either producers or consumers. Now, in the end, both sides are going to be affected. So ask yourself: who is affected first? Does this change affect the quantity supplied for each price, or the quantity demanded for each price?

Anything that affects the cost of production of the good affects producers first. It therefore shifts the supply curve on the graph. Reason: the supply curve represents a series of quantity responses to possible prices. But if production costs change, those quantity responses to possible prices will change too.

So: tighter regulation, higher materials costs, higher labor costs, and so forth will reduce supply for each possible price of the good.

On the other hand looser regulation, lower materials costs, lower labor costs, and so forth will raise the supply for each possible price of the good.

Example: Suppose we figure out the supply curve for wheat by asking producers how much wheat they would grow for each possible price of wheat. Then the price of fertilizer fell. We would have to go back and ask them all again, and the quantities of wheat supplied would be higher for each possible price of wheat.

Anything that affects willingness to buy the good affects consumers first. It therefore shifts the demand curve on the graph. Reason: the demand curve represents a series of quantity responses to possible prices. But if willingness to buy changes, those quantity responses to possible prices will change too.

So: lower income, cheaper alternative products, or new bad information about a product will reduce demand for each possible price of the good.

On the other hand higher income, more expensive alternative products, or new good information about a product will raise demand for each possible price of the good produced.

Example: Suppose we figure out the demand curve for bread by asking consumers how much bread they would but for each possible price. Then medical researchers discover that if you eat a lot of bread you live forever. We would have to go back and ask them all again, and the quantities of bread bought would be higher for each possible price.

So, the first step in our story is to figure out which side of the market is first affected.

3. The price has not changed yet. So the next question is to figure out whether, at the old price, we have a surplus or a shortage of the good. You can do this on the graph, but the answer should make sense without looking at a graph:

- If supply increases, the result is a surplus at the old price
- If supply falls, the result is a shortage at the old price
- If demand increases, the result is a shortage at the old price
- If demand decreases, the result is a surplus at the old price.

4. Now we are ready to think about how the price changes:

A shortage will push the price up, as consumers offer to pay more to get hold of a good in short supply.

A surplus will push the price down, as sellers cut price to try to move the inventory that is piling up.

5. And finally, we can talk about how the price change resolves the problem of the surplus or shortage noted in (3).

A rising price will increase quantity supplied and lower quantity demanded. These two effects, working together, eliminate the shortage.

A falling price will reduce quantity supplied and raise quantity demanded. These two effects, working together, eliminate the surplus.

So, for practice, you can begin with Step 1, plus the "something" that will initially affect either producers or consumers. Next, tell the story through parts 2, 3, 4, and 5, showing how to get to the new price and quantity.

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