Chapter 5: Market Clearing Price PDF

# Chapter 5: Market-Clearing Price ## Read to Find Out * How do competitive markets "clear" the amount buyers want to purchase with the amount sellers want to sell? * What are shortages and surpluses and how does market competition eliminate them? * How do market-clearing prices send signals to bu...

# Chapter 5: Market-Clearing Price ## Read to Find Out * How do competitive markets "clear" the amount buyers want to purchase with the amount sellers want to sell? * What are shortages and surpluses and how does market competition eliminate them? * How do market-clearing prices send signals to buyers and sellers? * How do market-clearing prices ration goods and services? * How do market-clearing prices motivate people to produce goods and services? * How do changes in demand and supply bring about changes in market-clearing prices? ## Why It Matters A market economy always undergoes changes and adjustments. If this were not so, we would not have the rich economy we have in the United States. As our economy changes, markets function to allocate scarce resources. Prices serve to help the economy change and adjust. To understand how prices adjust to accommodate changes in the economy, you must understand the interaction of supply and demand. It is important to notice why price changes take place and most important how to anticipate these changes. Understanding the interaction of supply and demand will help you become a better consumer and ultimately a better producer. ## Building On What You Know * You participate in markets everyday when you buy products and services. * Sometimes you notice that the price of a product you regularly buy goes up. * Sometimes that product goes “on sale,” and its price is less. What makes prices go up and down? It's not magic, as you will learn. ## Demand and Supply Together * As you learned in Chapter 3, "Demand,” market demand shows that consumers buy less gasoline if its price goes up. This is the _price effect_ as it applies to demand. * In Chapter 4, "Supply," you learned that oil companies want to sell more gasoline if its price goes up. This is the _price effect_ as it relates to supply. Notice a potential problem. While a higher price makes sellers want to sell more gasoline, it makes buyers want to buy less! It might seem, then, that buyers and sellers won't agree on the amount of gasoline they want to buy and sell. In reality there is one price at which sellers want to sell as much as buyers want to buy. This is the price at which quantity supplied equals the quantity demanded. ## How a Market Clears * Look carefully at the graph in Figure 5-1. Notice at $3.00 per gallon, businesses want to sell and consumers want to buy 19 million gallons per week, as shown on the horizontal axis. Economists call this point the _market-clearing price_, as shown on the vertical axis. The market-clearing price is the price at which the amount supplied is equal to the amount demanded. This is the only price that balances or “clears" the market. * Does this price leave everyone in the market satisfied? No! Everyone who wants to buy more gas at lower prices is not satisfied. Any producer who wants to sell gasoline at a higher price is not satisfied. On the other hand, the market has found a level of activity that allows it to continue. * Do markets always operate at the market-clearing price? Sometimes prices are lower than the market-clearing price. At other times, the prices are higher. However, the prices tend to be close to or moving toward the market-clearing price at all times. Let's examine more carefully how a market clears. ## Market-Clearing Prices * In the next few days, observe and write down the price of regular gasoline at several gas stations or outlets in your community. * Analyze the information you collected. Is there a market-clearing price for regular gasoline in your community? * If the prices per gallon vary slightly, what does that mean? ## Market Shortage * Market competition tends to move prices toward market-clearing levels. Study the graph in Figure 5-2. At $1.00, buyers want to buy 30 million gallons of gasoline, but producers want to sell only 4 million gallons. The difference between these two amounts, 26 million gallons, is a _shortage_. In economics, a shortage is the difference between the amount supplied and the amount demanded when the asking price is less than a market-clearing price. ## Market Surplus * What if the price is above its market-clearing level? In this case, sellers want to sell more than buyers want to buy. The graph in Figure 5-3 shows that at $5.00 per gallon, producers want to sell 27 million gallons of gasoline per week, but buyers as a whole want to buy only 10 million gallons. The difference between these two amounts, 17 million gallons, is a _surplus_. In economics, a surplus is the difference between the amount supplied and the amount demanded when the asking price is greater than a market-clearing price. ## Surplus, Shortage, or Market-Clearing Price * Read the following statements. Indicate whether the markets described are in surplus, in shortage, or in a market-clearing price status. * A rock concert will take place in six months. Tickets are $120 per person. The concert has been sold out for a month, and people are trying to buy tickets on eBay. Some eBay tickets are selling for $500. * A major league baseball team is selling tickets for $50 per seat, per game. You can buy a ticket on the day of the game without waiting in line. Of the 60,000 seats in the stadium, only 20,000 people are attending the game. * Cola has been selling at $3.00 per six-pack for the past eight months at the local grocery store. You can buy a six-pack any time you enter the store, and the store never runs out before the next shipment from the supplier. ## Alfred Marshall * Alfred Marshall was born in 1842 into a middle-class family in Clapham, a London suburb. His father was a cashier with the Bank of England and supervised his son’s classical education with the ultimate goal of Marshall's ordination in the Anglican church. However, Marshall chose to attend St. John’s in Cambridge, where he studied mathematics and became one of the outstanding mathematics students of his time. * Upon graduation, Marshall received a fellowship to pursue his work in mathematics. At Cambridge he became influenced by philosophers who were concerned with the many social problems in England. Marshall realized that poverty in England was a social evil. This led him to the study of economics. * Marshall is best known for his _Principles of Economics_, published in 1890. The influence of the book was significant-so significant that many have called the first quarter of the 20th century in economic thought “the age of Marshall.” * Marshall brought mathematics to bear on economic analysis. He did not view mathematics as the core of economic science. To him, mathematical statements should be only footnotes. He believed that mathematical statements could only help explain big ideas in economics and that economic analysis could be applied to social ills. * Marshall’s definition of economics, “the study of man in the ordinary business of life,” underscores his concern that the discipline should focus on the real world around us. He introduced what economists call _comparative statistics_. That is, to stop the economy at a point in time and examine it. * Comparative statistics led to Marshall defining demand and the concept of diminishing marginal utility that stands behind a downward sloping demand curve. He extended his thinking to the operation of markets, including supply with demand analysis, and the introduction of market price. ## The Functions of Prices in a Market System * Anna wants to buy a new dress for her mother. She visits a nearby shopping mall and compares prices of different dresses. Anna finds a department store that offers dresses for $60, $80, and $120. Anna considers her mother’s tastes and her own income, buys the middle-priced dress for $80, and hopes her mother will like it. * When she gets home, Anna browses some mail-order catalogs. She is surprised to find a dress identical to the one she bought. It is on sale for $10 less than the one she bought, and shipping is included. Anna decides to buy the dress online with her credit card, and then she returns the dress to the mall department store. * Anna’s story demonstrates the importance of prices in a market economy. The process of buying a gift for a relative would be much more difficult and would take more time without a price system. * Prices serve three main functions in a market system. They send signals to both buyers and sellers. They limit or ration the number of buyers who are willing and able to buy or sell a product in a market. Prices, depending on whether they are high or low, motivate sellers to offer more or less product for sale in a market. They also motivate buyers to buy more or less product. ## Prices Send Signals * A market price is like a police officer directing traffic at a busy intersection. If the officer signals you as a seller to "go," the market price is high. As a seller, you know you can produce more and make more sales at high prices. If the officer tells you to "stop,” this is a signal that the market price is low. The signal to you as a seller is to cut back on production and offer less of your product for sale. * For buyers, the police officer’s signals result in the opposite behavior. At a high market price-a “go” signal for sellers-buyers will buy less of a product. To buyers, this is a “stop” signal. At a low market price-a “go” price for buyers—consumers are encouraged to buy more of the product. Sellers, however, may interpret the signal as a “stop.” * Prices send information-signals to both buyers and sellers in a market. Careful buyers and profit-seeking sellers use prices to make their own thoughtful buying and selling decisions. ## Prices Ration * A second function of prices is to ration scarce goods among people who want more goods than are available. Rationing means distributing or allocating a product by a price system. The product is rationed to the person who is willing and able to pay the market-clearing price. * Auctions are a good illustration of rationing. You read about cattle auctions earlier. The United States government also has auctions, but when the government holds an auction, it sells U.S. Treasury bills (T-bills), which are also known as government bonds. Selling Treasury bills is the government’s way of borrowing money because every Treasury bill is an IOU (I Owe You) in which the government promises to repay the person who buys the bonds within a certain time period. ## Prices Motivate * A third function of prices is to provide incentives for people to produce goods and services. In fact, the method used to ration goods and services can have a big effect on the willingness to produce them in the first place. Consider again what happens when gasoline is rationed by waiting in line. In this case, consumers bear an opportunity cost when they sacrifice their time by waiting in line. However, their time isn’t a cost they pay to producers, so producers have no motivation to offer more gasoline for sale. * In contrast, when market-clearing prices are determined by the rationing method, consumers still pay an opportunity cost for the gasoline, but the cost is a monetary cost, not a time cost. By paying money to producers, consumers provide the necessary motivation to producers to increase gasoline production. Of course, there would be no gasoline without crude oil to make it, and there would be no crude oil without market incentives to produce it. As Chapter 4, "Supply," explained, companies produce more oil at higher prices and less oil at lower prices. They are responding to market incentives-to prices that motivate oil production. * Examine the graphs in Figure 5-5. The top graph shows U.S. average per barrel oil prices, and the second graph shows U.S. oil production in thousands of barrels per day. During the period 1980 to 1999, crude oil prices in the United States declined. As might be expected in an oil supply situation, the production of oil also declined during the same period. This example demonstrates that suppliers will produce less of a product when the market price declines. ## Prices of Crude Oil in Two Time Periods, 1985-1989 and 1990-1994 * Check your skill at reading historical line graphs. Study Figure 5-5a and Figure 5-5b, and complete the table below with information from the graphs. ## Changes in Prices and Production * Because a product’s demand or supply can change, each market price is likely to rise or fall over time. Some may go up, and others may go down. But as market-clearing prices vary, they change the incentives to produce particular products or provide certain services. The result is that over time we see changes in the kinds and quantities of items and services produced in our economy. * The Fortune 500, a listing of the top 500 companies in the United States, is a good illustration. Since 1954, Fortune magazine has published a yearly listing of the largest industrial corporations in the United States. The list includes service-producing companies as well as industrial companies. The listings in Figure 5-6 compare the top 10 companies in the Fortune 500 in the years 1955 and 2006. ## Decrease in the Market-Clearing Price of Computers * The graph in Figure 5-7 illustrates a change in market-clearing price for computers. Technological changes enabled businesses to increase the supply of computers. The greater supply then caused the market-clearing price of computers to fall. As the price of computers fell, more people purchased computers for use in their homes and businesses. ## Summary * A market-clearing price exists when the amount of a product that buyers want to buy at that price is the same as the amount that sellers want to sell at that price. At any other price, a shortage or a surplus exists. A shortage occurs at the price at which buyers want to buy more than sellers want to sell. A surplus occurs at the price at which sellers want to sell more than buyers want to buy. Competition among buyers pushes prices up toward their market-clearing levels. Competition among sellers pushes prices down toward market-clearing levels. * Market-clearing prices have important roles in a free enterprise economy. First, they send signals-price information—to buyers and sellers. Second, they ration existing supplies among consumers who want more supplies than an economy’s scarce resources can produce. When doing so, market prices enable people to choose who gets the goods and services produced. Third, market-clearing prices also provide incentives or motivations to producers to produce goods and services. Market prices guide decisions about what (and how much) to produce and how to produce these goods and services. * Demand and supply are continually changing, causing some market-clearing prices to rise and some to fall. These higher and lower prices cause some businesses in our economy to expand and others to contract. A comparison of the Fortune 500 list of businesses over the last 50-plus years illustrates dramatic changes in the economy. * Market-clearing prices provide vital information and incentives in free enterprise. They reveal to businesses the kinds and quantities of goods and services that consumers want produced. They also reveal to consumers the cost of producing the various goods and services they want. Both businesses and consumers use this information when deciding what and how much to produce and consume ## Looking Ahead * Consumer demands are a powerful market force that help guide choices in a free enterprise economy. The next chapter focuses on consumer spending. It discusses the role played by consumers in the U.S. economy and how consumers earn their incomes. It also describes how consumers can get more for their money by spending their incomes wisely. ## How Shifting Demand and Supply Can Affect Prices * Read the following statement. * When clothes are in season, the prices rise. When the season passes, stores put the clothes on sale. However, when fruits and vegetables are in season, the prices fall. When the season passes, the prices rise. * Explain why price changes for seasonal clothing and seasonal produce seem to be contradictory.