Question

(Related to Solved Problem 12.6 on page 439) Suppose you read the following item in a newspaper article, under the headline "Price Gouging Alleged in Pencil Market": Consumer advocacy groups charged at a press conference yesterday that there is widespread price gouging in the sale of pencils. They released a study showing that whereas the average retail price of pencils was \(\$ 1.00\), the average cost of producing pencils was only \(\$ 0.50 .\) "Pencils can be produced without complicated machinery or highly skilled workers, so there is no justification for companies charging a price that is twice what it costs them to produce the product. Pencils are too important in the life of every American for us to tolerate this sort of price gouging any longer," said George Grommet, chief spokesperson for the consumer groups. The consumer groups advocate passing a law that would allow companies selling pencils to charge a price no more than 20 percent greater than their average cost of production. Do you believe such a law would be advisable in a situation like this? Explain.

Short answer

From an economic perspective, setting a law that limits the selling price to a percentage over the production cost might not be advisable. It may discourage suppliers from improving their products, limit the supply of products to the market, increase production costs and ultimately interfere with the efficient functioning of the free-market system.

Step-by-step solution

Understanding market mechanics

First, remember that the price of any product in a free market is determined by supply and demand, not just the cost of production. If, for example, the demand for pencils is very high, sellers could naturally charge a premium price.

Considering possible consequences of the proposed law

Next, consider the effects of a law that strictly links selling prices to production costs. This could discourage innovation (because businesses can't get enough return on their investments into making better products), limit supply (because businesses might not find it profitable to produce more), and possibly increase the production costs (because companies will have less incentive to minimize costs).

Formulating an opinion

Considering these aspects regarding possible negative effects of prevailing market mechanisms and potential impacts of the law, one can form an informed opinion regarding its advisability.

Key concepts

Supply and Demand

Understanding the balance between supply and demand is foundational to economics and crucial in determining the price of any commodity, including the humble pencil. Supply refers to the quantity of a product that the market can offer, whereas demand refers to the quantity that consumers are willing and able to purchase at a certain price.

When demand for an item increases, if the supply remains unchanged, a shortage can occur, leading to higher prices. Conversely, if there is an oversupply, the price usually goes down. This interplay can explain why, in our exercise, the price of pencils may be higher than the production cost. It indicates that the demand for pencils may be high or that the supply is restricted in some way, justifying sellers in charging a premium.

Production Costs

Production costs are the expenses incurred to manufacture a product. This includes the cost of raw materials, labor, utilities, and any other expense directly related to the production process. In the exercise, it is revealed that pencils can be made inexpensively at only half the selling price, signaling that there's room for profit.

However, it's important to remember that businesses also need to cover indirect costs such as marketing, distribution, and administrative expenses. A business must be able to earn more than its production costs to be sustainable, and sometimes this difference can be substantial, depending on the market strategy and extra costs involved.

Market Mechanics

Market mechanics encompass the various forces and factors that influence the functioning of a market. This goes beyond just production costs and includes aspects such as competition, consumer preferences, and potential barriers to entry. The steps involved in solving our textbook problem highlight that a price determined solely by production costs does not account for the complexity of market economics.

Moreover, pricing strategies can include charging more to fund research and development for better products, which ties directly into the concepts of innovation and progress. A law that limits the amount a company can charge above production costs, as suggested in the exercise, could inadvertently stifle these aspects of market mechanics.

Consumer Advocacy

Consumer advocacy is the practice of protecting buyers of goods and services, and the rights of consumers within the marketplace. Advocates, like George Grommet in our exercise, argue for fair treatment and protection from unfair business practices. While their goals are noble, it's essential to strike a balance between protecting consumers and allowing businesses to operate freely enough to innovate and grow.

Consumer advocacy groups often push for regulations like the one proposed in the exercise, but such measures can have unintended consequences on market dynamics and consumer choice. Educating consumers about these dynamics can empower them to make informed purchases without necessarily resorting to legislation.

Government Regulation

Government regulation can be a powerful tool for ensuring fair business practices and protecting consumers. It involves creating and enforcing rules to govern market activities. Regulations may aim to prevent price gouging, ensure product safety, or even promote competition. However, as suggested in the textbook example, regulations like price caps could lead to negative economic effects such as reduced incentives for businesses to produce or improve products.

While the intention is to prevent excessive profit margins at the expense of consumers, regulations on pricing must consider the long-term impact on innovation, supply, and overall economic health. The efficacy of such regulations often depends on how well they balance consumer protection with a free, competitive market.