Study the information above. Explain what you expect to learn from this unit. Pay attention to the vocabulary words as you will be tested on them later on.
In Section 1, you read how supply and
demand interact to determine the equilibrium
price and quantity sold in a market.
You also read about how those prices
change over time. Prices are a key element
of equilibrium. Price changes can move
markets toward equilibrium and solve
problems of excess supply and excess
demand. In this section we will discuss the
importance of prices and the role they play.
In a free market, prices are a tool for
distributing goods and resources
throughout the economy. Prices are nearly
always the most efficient way to allocate,
or distribute, resources. The alternative
method for distributing goods and
resources, namely a centrally planned
economy, is not nearly as efficient as a
market system based on prices.  


Which statement below is true?
Prices are not important when constructing a business model
Prices cannot move markets toward equilibrium
Usually the market ignores prices
Prices can move markets toward equilibrium


Which statement below is true?
In a centrally planned economy price is an important factor
Since Communism believes that everything should be shared by evenly, price is an important factor in making the economy fair to everyone
Free market economies usually ignore price as a factor in the business model
In a free market economy price is a very important factor in supply and demand
Prices in the Free Market
Prices serve a vital role in a free market economy. Prices help move land, labor, and capital into the hands of producers, and
finished goods into the hands of buyers. The following example shows the benefits of a system based on free market prices.

Kevin decides to buy a sweater for his sister for her birthday next month. He goes to a nearby shopping center and compares the prices of several different sweaters. Kevin finds that a department store offers cotton cable-knit sweaters for $30 to $50 and soft cashmere sweaters for $110. He visits other stores and finds that he can spend as little as $20 for an acrylic sweater or as much as $350 for a designer cashmere sweater. Kevin considers his sister’s tastes and his own income and buys his sister one of the less expensive cotton sweaters.

Later, Kevin uses his computer to browse catalogs of mail-order stores. He’s surprised to find a sweater very similar to the one he bought, but it’s on sale for $5 less, shipping included. Kevin decides to buy the sweater on-line with his credit card and return the sweater he bought at the mall.

Kevin’s story, familiar to anyone who has shopped for a gift, demonstrates the importance of prices to the free market system. The simple process of buying a gift for a friend or relative would be much more complicated and inefficient without the price system.


Which statements are true? (pick all that apply)
Prices help to distribute income evenly and fairly
Prices help move land, labor, and capital into the hands of producers
Prices ensure that everyone can afford products
Prices help move finished goods into the hands of buyers


Which statements below are true for Kevin? (pick all that apply)
Price enables him to compare the relative value of different sweaters
Price enable him to choose a sweater that he can afford
Price ensures that he will purchase the least expensive sweater
Price ensures that he will purchase the most expensive sweater
The Advantages of Prices
Prices provide a language for buyers and sellers. Could you conceive of a marketplace without prices? Without prices as a standard measure of value, a seller would have to barter for goods by bidding shoes or apples to purchase a sweater. A sweater might be worth two pairs of shoes to one customer, but another customer might be willing to trade three pairs of shoes for the same sweater. The supplier would have no consistent and accurate way to measure demand for a product.
Price as an Incentive
Buyers and sellers alike look at prices to
find information on a good’s demand and
supply. The law of supply and the law of demand describe how people and firms
respond to a change in prices. In these
cases, prices are a signal that tell a
consumer or producer how to adjust. Prices
communicate to both buyers and sellers
whether goods are in short supply or
readily available.

In the example of the popular doll
discussed in Section 2, the increased
demand for the doll told suppliers that
people wanted more dolls, and soon!
However, the signal that producers respond
to is not simply the demand, but the high
price consumers are willing to pay for the
doll, well above the usual retail price. This
higher price tells firms that people want
more dolls, but also that the firms can earn
more profit by producing more dolls,
because they are in demand. Therefore,
rising prices in a market will cause existing
firms to produce more goods and will
attract new firms to enter a market.
Prices as Signals
Think of prices as a traffic light. A relatively
high price is a green light that tells
producers that a specific good is in demand
and that they should use their resources to
produce more. New suppliers will also join
the market. A low price, however, is a red
light to producers that a good is being
overproduced. In this case, low prices tell a
supplier that he or she might earn higher
profits by using existing resources to
produce a different product.

For consumers, a low price is a green
light to buy more of a good. A low price
indicates that the good carries a low opportunity cost for the consumer, and offers a
good buying opportunity. By the same
token, a high price is a red light to stop and
think carefully before buying.


Which statement is true?
Price is the language of the market place
Price has little effect on market equilibrium
Price effects supply more than demand
Once set, the price of a product rarely changes


Which statements are true? (pick all that apply)
price makes the market unfair to sellers
price is a way that sellers communicate with the market
price is a way that buyers communicate with the market
price makes the market unfair to buyers


Price communicates information to
buyers and sellers
sellers more than buyers
buyers but not sellers
buyers more than sellers
Another important aspect of prices is that
they are flexible. When a supply shift or a
demand shift changes the equilibrium in a
market, price and quantity supplied need to
change to solve problems of too much or
too little demand. In many markets, prices
are much more flexible than output levels.
Prices can be easily increased to solve a
problem of excess demand, and they can
be just as easily decreased to eliminate a
problem of excess supply.

For example, a supply shock is a sudden
shortage of a good, such as gasoline or
wheat. A supply shock creates a problem of
excess demand because suppliers can no
longer meet the needs of consumers. The
immediate problem is how to divide up the
available supply among consumers.

What are the options? Increasing supply
can be a time-consuming and difficult
process. For example, wheat takes time to
plant, grow, and harvest. Rationing, or
dividing up goods and services using
criteria other than price, is expensive and
can take a long time to organize. Rationing
is the basis of central planning, which you
read about in Chapter 2.

Raising prices is the quickest way to
resolve excess demand. A quick rise in prices
will reduce quantity demanded to the same
level as quantity supplied and avoid the
problem of distribution. The people who
have enough money and value the good
most highly will pay the most for the good.
These consumers will be the only consumers
still in the market at the higher price, and
the market will settle at a new equilibrium.
Price System Is “Free”
Unlike central planning, a distribution
system based on prices costs nothing to
administer. Central planning requires
central planners who collect information
on production and decide how resources
are to be distributed. In the former Soviet
Union, the government employed thousands
of bureaucrats in an enormous
agency called GOSPLAN to organize the
economy. During World War II, the United
States government set up the Office of Price
Administration to prevent inflation and
coordinate rationing of important goods.

On the other hand, free market pricing
distributes goods through millions of decisions
made daily by consumers and
suppliers. Kevin, from the beginning of the
section, looks at the prices of sweaters and
decides which one to buy for his sister and which supplier to buy it from. A farmer
reads the reports from the commodity
exchanges and decides whether to grow
corn instead of soybeans next year.
Everyone is familiar with how prices work
and knows how to use them. In short,
prices help goods flow through the
economy without a central plan.


Why are prices flexible?
Because a change in price usually indicates a serious flaw in the market
They can easily increase or decrease to meet the demands of the market
Once set they cannot easily be changed
They can increase but not decrease in meeting the demands of the market


What is a supply shock?
a gradual increase in supply
a gradual shortage of a good
a sudden shortage of a good
a sudden increase in supply


Supply shocks create a problem of
a new equilibrium
excess demand
to little demand
excess supply


What is the quickest way to resolve the problem of too much demand.
Price manipulation
Production expansion
Supply manipulation
Production contraction


How would a central planning socialist go about solving the problem of excess demand?
shoot the consumers until demand fell to normal ranges
price manipulation
decreasing supply


What is the least expensive method of product distribution?
free market pricing
central planning
increasing supply
A Wide Choice of Goods
One of the benefits of a market-based
economy is the diversity of goods and
services consumers can buy. Price gives
suppliers a way to allow consumers to
choose among similar products. Kevin
could buy his sister an acrylic sweater for
$20, a cotton sweater for $40, or a
cashmere sweater for much more. Based on
his income and his sister’s tastes, Kevin
decided on a cotton sweater at the lower
end of the price range. The prices provided
an easy way for Kevin to narrow his
choices to a certain price range. Prices also
allow producers to target the audience they
want with the products that will sell best to
that audience.

In a command economy, however, one
organization decides what goods are
produced and how much stores will charge
for these goods. To limit their costs,
central planners restrict production to a
few varieties of each product. As a result,
consumers in the former Communist states
of Eastern Europe and the Soviet Union
had far fewer choices of goods than
consumers in Western Europe and the
United States. You may ask why
Communist governments used a command
economic system. The answer is, in part,
that they hoped to distribute wealth evenly
throughout their society. As a result, the
government of the Soviet Union built whole
neighborhoods of identical apartment
blocks and supermarkets with names such
as “Supermarket No. 3.”


In which type of economy are you likely to have the widest variety of goods and services?
command economy
free market capitalism
central planning economy


Why did the Soviet Union choose a command economy?
they were striving for equality in all things
they like to give orders
they wanted to keep the population poor so they could control them
it works better than free market capitalism
Rationing and Shortages
Although goods in the Soviet Union were inexpensive, consumers could not always find them. When they did, they often had to wait hours for eggs or soap, years for apartments or telephones. The United States experienced similar problems, although far less severe, when the government instituted temporary price controls during World War II.

Although rationing in the United States was only a short-term hardship, like rationing in the Soviet Union it was expensive and left many consumers unhappy. The needs of the U.S. armed forces for food, metal, and rubber during World War II created tremendous shortages at home,
and the government controlled the distribution of food and consumer goods. Choices were limited, and consumers felt, rightly or wrongly, that some  people fared better than others. However, rationing was chosen because a price-based system might have put food and housing out of the reach of some Americans, and the government wanted to guarantee every civilian a minimum standard of living in wartime.


In which system were prices for goods and services lower?
Soviet command economy
Hollywood California
free market capitalism
La Jolla California


Why did the government institute rationing during World War II?
they wanted to increase the supply of consumer goods
they wanted to eliminate the black market
they wanted to create a bad economy and blame it on the Republicans
they wanted to make sure goods and services were distributed evenly throughout the economy
The Black Market
Despite the ration system, the
federal government was unable to control
the supply of all goods passing through the
economy. A butcher could sell a steak
without asking for ration points, or a
landlord might be willing to rent an apartment
at the rate fixed by the government
only if the renter threw in a cash “bonus”
or an extra two months’ rent as a

When people conduct business without
regard for government controls on price or
quantity, they are said to do business on
black market. Black markets allow
consumers to pay more so they can buy a
good when rationing makes it otherwise
unavailable. Although black markets are a
nearly inevitable consequence of rationing,
such trade is illegal and strongly discouraged
by governments.


Which statement is true?
there was not black market during WWII
the government was unable to control the black market during WWII because they could not control each and every supplier
the government was unable to control the black market during WWII because of rationing
the government was able to control the black market using rationing


What is a black market?
People ignoring government controls over the economy
Central planners attempting to control the market
People using rationing to control the market
The black market is the same as the white market
Efficient Resource Allocation
All of the advantages of a free market
allow prices to allocate resources efficiently.
Efficient resource allocation means
that economic resources—land, labor, and
capital—will be used for their most
valuable purposes. A market system, with
its freely changing prices, ensures that
resources go to the uses that consumers
value most highly. A price-based system
also ensures that resource use will adjust
to the changing demands of consumers.

These changes take place without any
central control, because the people who
own resources—landowners, workers who
sell their labor, and people who provide
capital to firms—seek the largest possible
returns. How do people earn the largest
returns? By selling their resources to the
highest bidder. The highest bidder will be
that firm that produces goods that are in
the highest demand. Therefore, the
resources will flow to the uses that are most
highly valued by consumers. This flow is
the most efficient way to use our society’s
scarce resources.


What are the advantages of a price based system? (pick all that apply)
ensures that resource use will adjust
to the changing demands of consumers
land, labor, and capital—will be used for their most valuable purposes.
ensures that resources go to the uses that consumers value most highly.
allow prices to allocate resources efficiently
Prices and the Profit Incentive
Suppose that scientists predicted extremely hot weather for the coming summer. In most parts of the country, consumers would buy up air conditioners and fans, to prepare for the heat. Power companies would buy reserves of oil and natural gas to supply these appliances with enough power. Since demand would exceed supply, consumers would bid up the price of fans, and power plants would bid up the price of fuel. Suppliers would recognize the possibility for profit in the higher prices charged for these goods, and they would produce more fans and air conditioners. Oil and natural gas fields would hire workers to pump more fuel for power plants. Eventually, more fans, air conditioners, and fuel would move into the market. The potential heat wave would have created a need for certain goods, and the rise in prices would have given producers an incentive to meet this need.
As we previously noted, efficient resource allocation occurs naturally in a market system as long as the system works reasonably well. Landowners tend to use their scarce property in the most profitable manner. Workers usually move toward high-paying jobs, and capital will be invested in the firms that pay the highest returns.


What is the motivating force in the narrative above?
a desire to distribute resources fairly
a desire to help the poor
a desire to increase profits
a desire to help the environment but selling more fans and less fuel oil


Which groups in the narrative above are seeking an advantage and greater profits (pick all that apply)
The Wealth of Nations
Adam Smith made this point in his famous
book The Wealth of Nations, published in
1776. Smith explained that it was not
because of charity that the baker and the
butcher provided people with their food.
Rather, they provide people with bread
and meat because prices are such that they
will profit from doing so. In other words,
businesses prosper by finding out what
people want, and then providing it. This
has proved to be a more efficient system
than any other that has been tried in the
modern era.



What did Adam Smith say motivated business people to provide goods and services to the public?
low prices which increased demand
low prices which made profits possible
a concern for the welfare of mankind
high prices which make profits possible
Market Problems
There are some exceptions to the general
idea that markets lead to an efficient allocation
of resources. The first problem, imperfect
competition, can affect prices, and
higher prices can affect consumer decisions.
If only a few firms are selling a product,
there might not be enough competition
among sellers to lower the market price
down to the cost of production. When only
one producer sells a good, this producer
will usually charge a higher price than we
would see in a market with several competitive
businesses. In the following chapter,
you will read more about how markets
behave under conditions of imperfect


A second problem can involve
also known as externalities, that
include costs of production, such as air
and water pollution, that “spill over” onto
people who have no control over how
much of a good is produced. Since
producers do not have to pay spillover
costs, their total costs seem artificially low,
and they will produce more than the equilibrium quantity of the good. The extra
costs will be paid by consumers

Imperfect information is a third problem
that can prevent a market from operating
smoothly. If buyers and sellers do not have
enough information to make informed
choices about a product, they may not
make the choice that is best for them.  


Because there is only one utility company in San Diego (SDGE), Adam Smith would say that this is an example of
free market capitalism
imperfect competition
efficient utilization of resources
perfect competition


What is the problem with “Spillover Costs?”
they make the price of goods and services higher than they should be
there is no problem with Spillover costs
they result in the costs being paid by the producers
they make the price seem lower than it actually is causing consumers to pay for the hidden costs


Which company below is most responsive to price and market forces?
Otay Water
The School System
spillover costs
black market
search costs
supply shock


a system of allocating scarce goods and services using criteria other than price


a market in which goods are sold illegally


situation in which quantity supplied is greater than quantity demanded; also known as excess supply


a sudden shortage of a good


costs of production that affect people who have no control over how much of a good is produced


situation in which quantity demanded is greater than quantity supplied; also known as excess demand


the financial and opportunity costs consumers pay when searching for a good or service

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