Download Modern Principles of Economics

Modern Principles:
Microeconomics
Tyler Cowen
and Alex Tabarrok
Chapter 5 The Price
System: Signals,
Speculation, and
Prediction
Copyright © 2010 Worth Publishers • Modern Principles: Microeconomics • Cowen/Tabarrok
Markets Link to Each Other
• A simple Valentine’s Day gift becomes
much more complex after closer inspection
and involves, among others, the following:





Kenyan flower growers,
Dutch clocks,
British airplanes,
Colombian coffee,
Finnish cell phones.
Slide 2 of 25
Markets Link to Each Other
• Giving this one gift to a significant other
requires the cooperative effort of millions.
• What economists find amazing is that this
immense cooperation is voluntary and
undirected.
• The millions of people involved in bringing
this gift to market do not care about the
romance of Valentine’s Day but rather their
own self-interest.
Slide 3 of 25
Markets Link to Each Other
• The story above illustrates how markets are
interconnected.
• Furthermore, a change in supply or
demand in one market can influence
markets for entirely different products
thousands of miles away.
• How then are limited resources allocated to
satisfy as many wants as possible when
some market change occurs?
Slide 4 of 25
CHECK YOURSELF
 To encourage the use of alternative energy
sources, the U.S. government offers a subsidy for
the conversion of corn to ethanol, in effect raising
the price of corn used as ethanol. If farmers
receive a higher price for turning corn into
ethanol, what will happen to the price of corn
used in cafeteria meals and in cornbread used in
restaurants? How will cafeterias and restaurants
respond to this?
Slide 5 of 25
CHECK YOURSELF
Sawdust is used for bedding milk cows.
What did the end of the housing boom in
2007 do to the price of milk? Search for
“sawdust” at
http://www.MarginalRevolution.com if you
need a hint.
Slide 6 of 25
Solving the Great Economic Problem
• Central planning is an approach where a single
official or bureaucracy is responsible for the
allocation of limited resources.
• Such an approach suffers from two significant
problems.
1. The substantial amount of information necessary to
optimally allocate limited resources.
2. The lack of incentives necessary to supply and to
apply this information.
Slide 7 of 25
Solving the Great Economic Problem
• Free markets accomplish the task of
allocating resources without any central
planning or control.
• The market solves the information problem
by collapsing all relevant information into
the price.
• It also solves the incentive problem
because consumers will purchase a good
only if its value is greater than the price.
Slide 8 of 25
Solving the Great Economic Problem
• Through the price system, markets force
consumers to compare the value of their
uses of a good with the value of the good in
alternative uses.
• Once that comparison is made, consumers
have an incentive to give up the good if
their uses have a lower value than the
alternative uses.
Slide 9 of 25
Solving the Great Economic Problem
Market Price and Opportunity Cost
Price
of Oil
Supply
Satisfied Demands
The Value of the Good in Its
First Unsatisfied Demand
Market
Price
Unsatisfied Demands
Demand
Market
Quantity
Quantity of
Oil (MBD)
Slide 10 of 25
CHECK YOURSELF
 Consider the peanut. Peanuts are used primarily
for food dishes, but they are also used in bird
feed, paint, varnish, furniture polish, insecticides,
and soap. Rank these uses of peanuts from
higher to lower value taking into account in which
use the peanuts are critical and in which uses
there are good substitutes. Don’t obsess over
this, we know you are not a peanut expert, but
see if you can come up with a sense of higher
and lower value.
Slide 11 of 25
CHECK YOURSELF
What happens to the use of peanuts if
there is a large peanut crop failure in
China, which produces over one-third of the
world’s supply? Which of the uses that you
ranked in the previous question can be cut
back?
Slide 12 of 25
Prices as Signals
• In free markets prices provide powerful signals to
both buyers and sellers.
• An increase in the price of a good signals to
consumers that they need to change their
behavior.
– Consumers are not only encouraged to economize and
use less but also to start thinking about substitutes.
• The same price increase also signals producers
to increase their production.
– Sellers are encouraged to invest more to expand their
capacity or to develop alternatives.
Slide 13 of 25
Prices as Signals
• Price signals (and the accompanying profits or
losses) essentially tell entrepreneurs what areas
of the economy consumers want expanded and
what areas they want contracted.
• At times, however, buyers and sellers view prices
as being either “too high” or “too low” and
demand that policy makers impose price controls.
• Such policies disrupt the signaling role of prices
and can lead to a suboptimal allocation of limited
resources.
Slide 14 of 25
CHECK YOURSELF
 Imagine that whenever the supply of oil rose or
fell, the government sent text messages to every
user of oil asking them to use more or less oil as
the case warranted. Suppose that the messaging
system worked very well. Is such a messaging
system likely to allocate resources as well as
prices? Why or why not? What is the difference
between the messaging system and the price
system?
 Firms in the old Soviet Union never went
bankrupt. How do you think this influenced the
rate of innovation and economic growth?
Slide 15 of 25
Prices and Speculation
• Speculation is the attempt to profit from future
price changes.
– If, for example, a speculator believes the supply of a
good will decrease in the future, driving up its price, the
speculator can make money by buying the good now
when the price is low and selling the good in the future
when the price is higher.
• Speculators may not always be correct, but they
have strong incentives to be as accurate as
possible because when they are wrong, they lose
money, perhaps lots of money.
Slide 16 of 25
Prices and Speculation
Prices Without Speculation
Today
P
Future
S
P S
Price in
Future
with No
Speculation
Today’s
Price with
No
Speculation
b
a
D
Production
D
Q
Production
Q
Slide 17 of 25
Prices and Speculation
Prices With Speculation
Today
P
S
Future
S
Into
Storage
Price with
Speculation
Today’s
Price with
No
Speculation
P S
Price in
Future
with No
Speculation
S
Out of
Storage
b
c
d
Loss
in
Value
Gain
in
Value
a
Production
Consumption =
Production - Storage
D
D
Q
Q
Production
Consumption =
Production + Inventory
Slide 18 of 25
Prices and Speculation
• A Future is a standardized contract to buy
or sell specified quantities of a commodity
or financial instrument at a specified price
with delivery set at a specified time in the
future.
• Futures provide a way to speculate without
having physically to hold the good, which
could be extremely expensive.
Slide 19 of 25
Prices and Speculation
• Futures are also used for reducing risk.
 Buyers can lock in a price for their future
purchases by buying futures contracts today.
 Sellers can lock in a price for their future sales
by selling futures contracts today.
Slide 20 of 25
Prices and Speculation
• A Prediction Market is a speculative
market carefully designed so that prices
can be interpreted as probabilities and
used to make predictions.
 Iowa Electronic Markets
 Hollywood Stock Exchange
Slide 21 of 25
Prices and Speculation
• Despite its image in the popular press,
speculation can play an important role in
markets by smoothing prices.
• Without speculation prices can fluctuate
significantly.
Slide 22 of 25
CHECK YOURSELF
 Speculation occurs in stocks as well as
commodities. In 2008, Lehman Brothers, a Wall
Street investment banking firm, complained that
speculators were driving the price of its stock
lower and lower. During this time, Lehman
continued to give rosy forecasts. Later in 2008,
Lehman Brothers went bankrupt. Why was the
forecast of the speculators more informative on
net than the statements being issued from
Lehman?
Slide 23 of 25
Takeaway
• Markets are interconnected so that a change in
supply or demand in one market can influence
markets for entirely different products thousands
of miles away.
• Central planning is an approach where a single
official or bureaucracy is responsible for the
allocation of limited resources.
• Free markets accomplish the task of allocating
resources without any central planning or
control.
Slide 24 of 25
Takeaway
• In free markets prices provide powerful signals.
• Price signals (and the accompanying profits or
losses) essentially tell entrepreneurs what areas
of the economy consumers want expanded and
what areas they want contracted.
• Speculation is the attempt to profit from future
price changes.
• A prediction market is a speculative market
carefully designed so that prices can be
interpreted as probabilities and used to make
predictions.
Slide 25 of 25