increase supply as long
as the return exceeds the opportunity cost of producing the item. When returns exceed
opportunity costs, capital will flow into the industry and output will expand. This increased
production will cause prices to fall eliminating the excess profits. If opportunity costs exceed
returns from production, firms will remove capital from the production process, thus reducing
supply and causing prices to rise.
f: Explain how shortages and surpluses affect the analysis of supply and demand.
Price ceilings are legally set maximum prices that sellers may charge. Ceilings are usually
initiated during inflationary periods. Ceilings prevent the producer from increasing the selling
price to cover rising costs. This will lead to a reduction in supply that will cause a shortage. A
shortage exists when the amount of a good offered by sellers is less than the amount
demanded by buyers at the existing price. An increase in price would eliminate the shortage,
but since prices are capped, producers will direct resources away from these goods, reducing
supply and increasing the shortage.
Price floors are legally established minimum prices that buyers must pay for a good. Price
floors will stimulate production, since producers are receiving more than the equilibrium price.
Buyers, however, will shift their consumption to lower price alternatives causing supply to
exceed demand, causing a surplus.
g: Explain how the "invisible-hand" principle works.
The invisible hand principle refers to the tendency of market prices to direct individuals
pursuing their own interests into productive activities that also promote the economic well
being of society. The market does this by:
1. Communicating information to decision makers: Without the information provided
by market prices, it would be impossible for decision makers to determine how
intensely a good is desired relative to its opportunity costs.
2. Coordinating actions of market participants: Prices direct producers to undertake
those projects that are demanded most intensely by consumers.
3. Motivating economic players: Market prices establish a reward-penalty structure
that induces the participants to work, cooperate with others, use efficient production
methods, supply goods that are desired, and invest for the future.
4. Pricing products and providing order to the market: The market process works
automatically without the need for any government decision or central planners. The
market system sets prices, determines production, and distribution channels without
any outside control.
1.B: Preliminary Reading: The Economic Role of Government
a: Define economic efficiency and discuss the role of government in achieving economic
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