DANBY   |  IA&S 324  |  Price Determination

Price determination in the market model

Models are simplifications of the real world.  Whenever you simplify, you falsify.  You falsify  because you are deliberately ignoring real-world variation and complexity.  We make models because sometimes we can learn important things about the world by simplifying it, but you should always remember that the insights of any model come at a cost.

In the basic market model, perhaps the biggest simplification is the assumption that nobody has any pricing power.  For consumers, this is not, perhaps, too far from reality.  Most of us face are “take it or leave it” prices for most things.  Try going into the QFC and asking them to knock ten cents off the price of English muffins.  But for producers, it’s a serious simplification.  Most real-world producers do have some pricing power.  But in this model, they don’t!  This model assumes that there is a standard commodity that is bought and sold on this market, and that consumers don’t care who they buy it from, so that no producer has any ability to sell the product for a penny more than the prevailing market price.  Because the model assumes that all producers are tiny with respect to the whole market, this also means that at the prevailing price you can sell as much as you like.

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:

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

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

So, on the exam I will give you step 1, plus the "something" that will initially affect either producers or consumers.  Your task is to tell the story through parts 2, 3, 4, and 5, showing how we get to the new price and quantity.

There is a very strong temptation to skip ahead to the end of the story.  But there's a reason to focus on the steps. The power of this model is that it describes a way that a totally decentralized economy can work.  There is no central authority telling people what the right price is, or how much to consume or make.  Immediately after a change, nobody knows what the new "right" price is.  The market "finds" the new price through a process of lots of little producers and consumers interacting.  It is this interaction that we are describing in steps 2-5.  This is what people mean when they talk about the "market mechanism."  Since a lot of arguments about trade and policy are based on the supposed effectiveness of the market mechanism to coordinate economic activity, we need to know what it is.