Friday, March 14, 2008

How Price Steers Producers Toward Products Consumers Want

In a market economy prices are the mechanism by which consumers indicate their preference for various goods. When consumers buy goods they desire, they bid up the price, which alerts producers to what to produce. Similarly, when consumers ignore and don’t buy certain goods they don’t want, they also signal the producers which products not to produce.

On the demand side, prices also serve to ration goods that are scarce. When a good is in short supply, for whatever reason, the demand by a large number of consumers wanting to purchase the good will drive the price up as they outbid each other to get the good. As the price rises some consumers will drop out of the bidding because they cannot afford the product and others will drop out because the number of other goods they will have to forgo (opportunity cost) if they spend all their money on this good becomes unacceptable.

On the supply side, prices act as an incentive for producers to produce a product. As the price of a product rises, other things being equal, more producers are induced to produce that product. There are two reasons for this. The first is the fact that costs of production vary among producers. A farmer whose farm contains rich soil with all the nutrients for growing good crops, is located along a river that provides a continuous supply of water and is located in an area where the climate is ideal for growing will be able to produce bountiful harvests at a low cost. Contrast this farmer with one trying to grow the same crops in Arizona. The soil is poor, so our farmer has to buy fertilizer. We are in a desert, so our farmer has to pay for the installation and maintenance of an irrigation system plus pay for the water that the system delivers. Finally, with the harsh climate the yield per acre is not as great. Obviously, the Arizona farmer with a lower output per acre and the extra costs for fertilizer and irrigation is going to incur a much higher cost to produce a bushel of crop than the farmer with the ideal land. If it costs the farmer with the good land $1 per bushel to produce, say, corn, and the Arizona farmer $1.50 then the farmer with the good land can afford to produce and sell corn any time the market price is greater than $1 while the Arizona farmer has to wait until the market price rises above $1.50 before he can afford to produce and sell corn.

Because the farmer has with the ideal land has lower costs and higher output per acre, he can afford to sell his crop at a lower price than the Arizona farmer and still make a profit. Therefore, the Arizona farmer will not go to the effort and expense to grow food unless the price is high enough to cover his costs and yield a profit. Thus, as the price of a good increases, more producers can afford to enter the market and the supply of the good available for sale increases. At $1.55 per bushel both the farmer with ideal land and the Arizona farmer can both afford to profitably grow and sell corn. Obviously the profit of the farmer with ideal land will be much greater, but the Arizona farmer will still make a profit and thus have an incentive to produce and sell corn.

A second thing that prices do is attract new sellers into the market. Assume that the machinery owned by a cereal company can produce either corn flakes or wheat flakes (Wheaties) depending upon whether corn or wheat is fed into it. Also assume that both corn flakes and wheat flakes sell for $2 per box and the cereal company spends half the day producing corn flakes and half the day producing wheat flakes. A scientific study is then released showing that eating a bowl of corn flakes every day reduces the risk of getting cancer by 75%, causing millions of consumers to start eating corn flakes. This drives the price of corn flakes up to $4 per box. Since it can make twice as much selling corn flakes as wheat flakes, the cereal company decides to devote all of its production to corn flakes, thereby increasing the supply of corn flakes.

Let's look at another example. A student enters college having both enjoyed math in high school and received very good grades in math. Once in college the student decides to major in math. Since the only profession this student has seen that uses math is teaching, she decides to become a teacher. However, in talking to fellow math majors the student learns that engineering is another profession that requires an extensive math background. Both professions sound equally attractive to the student. Then she then learns that salaries for teachers start at $30,000 per year while engineering salaries start at $55,000 per year. The higher salary in engineering is too good to resist and our student is "pulled" into the engineering profession by the prospect of the higher salary.

Thus, as the demand by consumers for a product increases, the price is driven up. This higher price attracts more sellers by first, making it possible for higher cost sellers to enter the market and still make a profit and then by attracting new producers to the market who are lured by the promise of high returns (which can be high salaries, high rents or high profits - all result from the high prices resulting from increased consumer demand and all work to attract more productive resources to the production of the product the consumers want.)

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