economics book part 7 of modern principles of economics for micro

7CHAPTER

D Y N A M I C P OW E R P O I N T™ S L I D E S B Y S O L I N A L I N D A H L

The Price System: Signals,

Speculation, and Prediction1

CHAPTER OUTLINE

Markets Link the World

Markets Link to Each Other

Solving the Great Economic Problem

A Price Is a Signal Wrapped Up in an Incentive

Speculation

Signal Watching

Prediction Markets

For applications, click here

To Try it!

questions

To

Video

2

Some good blogs and other sites to get the juices flowing:

Food for Thought….

3

B A C K T O

The Price System

“The curious task of economics

is to demonstrate to men how

little they really know about

what they imagine they can

design.”

– F.A. Hayek, The Fatal Conceit

4

B A C K T O

Prices Defined

What are prices?• A price is a signal wrapped up in an incentive.• Prices have a huge information function thatcoordinate actions of buyers and sellers across both markets and time.

• The cooperation afforded by markets is voluntary and undirected; i.e. spontaneous order

• Efforts to intervene on prices usually never recognize the information function of prices, believing that “planners” are smarter than markets (i.e. millions of people) – covered in later chapters

5

B A C K T O

Markets Link the World

Valentine’s Day involves coordinating:

Growers in

Kenya…

Flower markets

in Holland…

Florists…

And You!

6

B A C K T O


• Giving this one gift to a significant other requires the cooperative effort of millions

• Video: I, Pencil –

http://www.youtube.com/watch?v=d6vjrzUplWU

• What economists find amazing is that this immense cooperation is voluntary and undirected

• “Spontaneous order”

7

Take a look…..

Watch how the Icelandic Volcanic eruption

in 2010 affected the Kenyan flower market

by clicking the roses below. (2 minutes)

http://blogs.worthpublishers.com/seetheinvisiblehand/2010/04/20/kenyan-

flowers-coverage/

B A C K T O

B A C K T O


• 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?

• Methods: (1) Political, (2) “Fair” share, (3) Markets, (4) “Might makes right”

9

B A C K T O


Example: Oil and Candy Bars and Asphalt• Oil price increases

• Caused Brazilians to sugar cane for ethanol• Less sugar cane for sugar, costs of sugar

increased• Shifted candy bar supply curve to left• Candy bar prices rose

• Asphalt prices rose• Less asphalt used for driveways• Consumers substituted away to bricks,

concrete, etc• Demand curve for bricks shifted to right• Brick prices rose

10

B A C K T O


Thus, one way that we economize on oil is by eating fewer donuts!

•The price of oil rose.

•Brazil shifted sugar

cane into ethanol

production (rather than

table sugar).

•As a result, table sugar

got more expensive.

11

Try it!

12

Sawdust is used for bedding milk cows.

What did the end of the housing boom in 2007 do to the price of milk?

Click here for a hint.

B A C K T O

Solving the

Great Economic Problem

The GREAT ECONOMIC PROBLEM:

To arrange our limited resources to

satisfy as many of our infinite wants

as possible.

Some solutions:

Central Planning

The Price System

13

B A C K T O

Solving the

Great Economic Problem

• Any economic system, from North Korean Communism to European socialism to free markets has to deal the following problems:

• Scarcity

• Trade-offs

• Incentives

• Efficiency

• What is produced, how is it produced, and to whom are these goods distributed?

14

B A C K T O

Central Planning

Central planning: a single official or

bureaucracy is responsible for allocating

limited resources.

Has two significant problems:

1. Too much information to process.

2. Too few incentives.

15

B A C K T O

Central Planning in the West

16

• “We now turn to a detailed study of the workings of the Soviet economy. This subject is of great importance not only because the Soviet Union is locked in a political struggle with the United States. In addition, the Soviet economy is proof that, contrary to what many skeptics had earlier believed, a socialist command economy can function and even thrive. “

B A C K T O

Central Planning (cont.)

17

• “That is a society in which

the major economic

decisions are made

administratively , without

profits as a central

(goal)....”

- Paul Samuelson,

Economics (1989)

B A C K T O

Central Planning Problems

18

Soviet Economic Planning • “The Soviet economy made more of anything than

anyone else, but nobody wanted any of it.”

• Soviets did not have markets setting prices, rather prices were set by bureaucrats with “scientific planning”

• Soviets did not have “profits” in their system

• i.e. they tried to plan their economy without the right kinds of information

• Soviet production managers were incentivized to please the State, not consumers

B A C K T O


19

Soviet Planning Disasters• Examples of immense problems with central planning,

“fair” distribution of goods, artificial prices, and the prohibition of a profit motive

• Shoes - Most went to landfills, no feedback mechanism (i.e. profit) with consumers

• Rail traffic – five year plans required trains to cover a certain minimum number of miles. Many trains were driven extra miles around the country to meet track mile quotas

• Nails - Sometimes weight quotas were met by producing one ton nails only, had to be shipped by railcar

B A C K T O


20

Soviet Planning Disasters (cont)

• Windows

• Initially, manufacturing quotas set via square footage produced

• Thickness of windows decreased, windows were so thin that many broke in transit

• When quotas were changed and set by weight, windows became very thick and nearly opaque.

• Customer feedback, profit/loss results would have solved this problem easily

B A C K T O


21

Soviet Planning Disasters (cont)

• Furniture –

• Production quotas set via weight, factories added lead weights to couches to meet quotas

• Not a good idea in a country with many tall apartment buildings and few elevators

• “We just need to do it again with the right people”

• Central planning fashion show:• http://www.youtube.com/watch?v=5CaMUfxVJVQ

B A C K T O


22

• The Soviets were rabidly acquiring VCRs so as to watch Western TV shows and movies.

• The people watching were aghast, and not about the show. When they saw a character in the sitcom open the refrigerator door and they saw what was inside the refrigerator, they couldn’t believe the varieties of food and furthermore were astounded that American consumers had cold beer.

• It was like the scene in the movie portrayal of Steinbeck's Grapes of Wrath where the Okies are going west in their cars. The Leftist screen writers in Hollywood were intent on making a statement about poverty in America, but when the movie was seen overseas the viewers were instead incredulous that America's poor had their own cars.

B A C K T O


23

Example: allocation of oil resources

• Would have to know the value of oil in each of its millions of uses

• Would have to know which of its consumers for each use value it more highly

• Needs to know the value of each substitute for oil in each of their alternative uses (and substitutes for the substitutes)

• People would have to give the central planner truthfulinformation and not try to “game” the system

• What are the central planner’s own self-interests and do they align with the social interest of that society?

• Public choice theory addresses this issue

• Oxymoron – “Benevolent Dictator”

B A C K T O

Central Planning

24

• Central planning has failed around the world

• The Soviet Union disintegrated economically, other countries as well

• China abandoned centralized planning and has allowed property rights to create prosperity

• India has moved away from socialism.

• North Korea and Cuba are economic disasters

• Venezuela is rapidly getting poorer

• Over last 20 years, hundreds of millions of people have escaped poverty via the abandonment of central planning

B A C K T O

Central Planning

25

• Why has Central planning has failed around the world?

• Can not solve the problems of incentives and information

• Soviet central planners had to set 26+ million prices for their central plans – an impossible task to perform. Instead they relied on Western European catalogs to find prices to do their central planning – what does that say?

• Lack of economic freedom always coincides with lack of personal and political freedoms

B A C K T O

Central Planning

26

• The lesson of government waste, whether on $16 muffins or $535 million loan guarantees to solar power companies or $48 billion in “improper” Medicare payments, is one worth relearning every day.”

• “Managers whose budgets do not depend on customer satisfaction and who do not face competitive pressure in the marketplace, will not, on balance, spend their money wisely. Vendors selling to those managers know that price matters much less than it does to, say, Wal-Mart. And anywhere there is political urgency and official involvement high up the command chain, conditions will begin resembling a gold rush.”

Matt Welch, CNN Opinion, September 22, 2011

B A C K T O

Central Planning

27

• To paraphrase Winston Churchill:

• Capitalism is the worst economic system ever devised except when compared to all of the rest.

• “Underlying most arguments against the free market is a lack of belief in freedom itself.”

• Milton Friedman

B A C K T O

Central Planning – Hong Kong

28

• “I first visited Hong Kong in 1955, shortly after the initial inflow of refugees. It was a miserable place for most of its inhabitants. The temporary dwellings that the government had thrown up to house the refugees were one-room cells in a multistory building that was open in the front: one family, one room. The fact that people would accept such miserable living quarters testified to the intensity of their desire to leave Red China.

• I met Cowperthwaite [financial secretary of Hong Kong] in 1963 on my next visit to Hong Kong. I remember asking him about the paucity of statistics. He answered:

•“If I let them compute those statistics, they’ll want to use them for planning.’’

B A C K T O


29

“The real lesson of Hong Kong for the United States is that we’re using our resources inefficiently. Our government is spending our money to subsidize tobacco and to penalize smoking; to subsidize childbearing and to discourage childbearing; to build new housing and to tear down housing; to subsidize agriculture and to penalize agriculture; and on and on—not to mention converting square miles of forests into billions of paper forms and spending many man-years of labor filling them out and then filing them.”

- Milton Friedman, “The Hong Kong Experiment”

B A C K T O


30

• “People in these economies have simply studied harder, worked harder, and saved more than people in other countries.“

• - World Bank report

• “The welfare system in rabidly capitalist Hong Kong is more generous than on the Communist mainland.”

• - The Economist (August 21, 2010)

B A C K T O

The Price System

The Price System: a solution where no-one

(or everyone!) is responsible for allocating

limited resources.

Market forces of supply and demand

are the organizing elements.

31

B A C K T O

The Price System

Prices solve the

information and

incentive problems

Prices signal to

resources exactly

WHERE they are most

valued

32

B A C K T O

A Price Is a Signal

Wrapped Up in an Incentive

Prices tell producers what to make:

Profits are higher in industries that consumers want expanded.

Losses are higher in industries that consumers want contracted.

High price of ice in hurricane-devastated areas invites firms to provide more goods where society needs it.

33

B A C K T O

The Price System – Austrian School

34

• Frederick Hayek• Austrian School of Economics

• Nobel prize winner in Economics in 1974

• “Road to Serfdom” 1944

• Chapter 10 – “Why the Worst Get on Top”

• Argued that “the price mechanism serves to share and synchronize local and personal knowledge, allowing society's members to achieve diverse, complicated ends through a principle of spontaneous self-organization.”

• Hayek wrote one of the most famous essays in economics -“The Use of Knowledge in Society”

• http://www.econlib.org/library/Essays/hykKnw1.html

• A must read for anyone wanting a deep understanding of economics

B A C K T O


35

• Frederick Hayek

• “Hayek understood that successful mutual coordination of the economic decisions of millions of people occurs to the extent that prices – which guide people’s economic decisions – accurately reflect underlying economic realities such as resource scarcities and households’ preferences for saving. He reasoned, therefore, that government activities that distort prices cause prices to ‘lie’ about underlying economic reality and, hence, cause prices to mislead economic actors into making an unusually large number of plans that are destined to fail.” – Don Boudreaux

• http://cafehayek.com/2012/09/the-price-of-monetary-meddling.html

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36

“the marvel is that in a case like that of the scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people… are made to use the material or its products more sparingly; i.e., they move in the right direction”

- Nobel Laureate Friedrich Hayek

Hayek saw the

invisible hand

B A C K T O


37

• Ludwig von Mises

• Austrian school, a “classical liberal”

• Hayek was a student of Von Mises

• Mises was famous for his “Socialist calculation” argument in the 1920s

• absent market-based prices, capital formation can not take place efficiently in an economy

Government control of the healthcare industry and the associated pricing will likely yield a confirmation of Mises’s ideas

B A C K T O

How Prices Work

38

• Free markets accomplish the task of allocating resources without any central planning or control.

• Information in any economy is highly dispersed (more information in many brains than in one)

• The market solves the information problem by collapsing all relevant information into the price mechanism.

• It also solves the incentive problem because consumers will purchase a good only if its value is greater than the price.

• Feedback loops exist in the form of prices and profit/loss signals

B A C K T O

How Prices Work

• 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, i.e. make society worse off/poorer

• Power of the Market – Prices (video)• http://www.youtube.com/watch?v=7V9ihC1o7wc&feature=related

39

Try it!

Which is the best way for society to distribute its goods?

a) The free market outcome should not be tampered with.

b) “From each according to his ability to each according to his need”

c) To distribute goods so that society’s total happiness is maximized- even if it requires taking some from the wealthiest to give to the poorest.

To next

Try it!

B A C K T O

Market Price and

Opportunity Cost

The Equilibrium Price is Equal to the Value of the Good in its Next Highest Use

Quantity

Price

The Value of the Good in its Next Highest Use

Unsatisfied Wants

Satisfied Wants

Demand

Supply

Equilibrium Price

Equilibrium Quantity

41

Try it!

The Opportunity cost of a good is:

a) Known as the “elastic” cost

b) Usually less than its money cost

c) the value of the next highest-

valued use of the good

d) All of the above

To next

Try it!

B A C K T O

Speculation

Speculation is the attempt to profit from future price changes.

If 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.

Speculation can smooth prices fluctuations.

43

B A C K T O

Prices and Speculation

Quantity

Price

Price in Future with no Speculation

b

Production Future

Future Supply

Production Today

Today’s Price with no Speculation

a

Current Supply

Demand

Prices Rise Sharply after a Decrease in Supply Without Speculation

44

B A C K T O

Out of Storage

Consumption Future= Production + Storage

= d

Gain in Value

b

Prices and Speculation

Consumption Today= Production - Storage

c

Into Storage

Price with Speculation

Loss in Value

Production Today

Today’s Price with no Speculation

a

Speculation Smoothes Prices when Supply Decreases

Quantity

Price

45

B A C K T O

Futures

A Future: a contract to buy or sell

specified quantities of a commodity or

investment at a specified price and time

in the future.

Futures provide a way to speculate without having physically to hold the good

Hog futures: all investment, no smell.

46

B A C K T O

Signal Watching

Futures prices can be

extraordinarily

informative about future

events.

Sometimes, the signals

are “noisy” and futures

prices are less informative

and accurate.

47

The economist Richard Roll found that the futures price for OJ

was so sensitive to the weather that it could be used to improve

the predictions of the National Weather Service!

B A C K T O

Oil Price Speculation

Speculators misjudged the length of first Gulf War: they bought high and

(after a short war that didn’t disrupt oil flow much) sold low.

Were the signals they were watching too “noisy?”

48

SEE THE SEE THE SEE THE SEE THE INVISIBLEINVISIBLEINVISIBLEINVISIBLE HANDHANDHANDHANDSEE THE SEE THE SEE THE SEE THE INVISIBLEINVISIBLEINVISIBLEINVISIBLE HANDHANDHANDHAND

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 the whole than the statements being issued from Lehman?

49

B A C K T O

Prediction Markets

A prediction market is a speculative market

designed so prices can be interpreted as

probabilities and used to make predictions.

Iowa Electronic Markets sells “shares” of political candidates and predicted the Obama win in 2008

The Iowa markets have been more

accurate than polls.

B A C K T O

Prediction Markets

Intrade (now deceased)

http://www.intrade.com/

Iowa Prediction Markets

http://tippie.uiowa.edu/iem/index.cfm

Hollywood Stock Exchangehttp://www.hsx.com/

B A C K T O

Predicting Movie Revenues

The Hollywood Stock Exchange: not perfectly clairvoyant (but not bad!)

52

Try it!

If investors in the Hollywood Stock Exchange were too optimistic on average, would the dots tend to cluster above the red diagonal line or below?

a) Above

b) Below

B A C K T O

B A C K T O

Other AV Links

Power of the Market - Fairness

http://www.youtube.com/watch?v=SW86iE-ddaI&feature=related

The 4 Ways to Spend Money by Milton Friedman

http://www.youtube.com/watch?v=5RDMdc5r5z8

B A C K T O

A Digression on Prices and Value

• Prices are set at the margin

• i.e. the last unit exchanged in the market sets the price

• Housing market example:

• Appraisals, listing prices based on recent sale prices and are not determined by an average of the expected prices of all nearly comparable homes

• i.e. one low-priced foreclosure/short sale can greatly affect nearby house prices, perhaps a 5 - 10% reduction or more

B A C K T O


• Area underneath demand curve represents total value to consumers

• Area beneath demand curve and above price represents consumer surplus

• At any point on the demand curve, that represents the price that the marginal consumer is willing to pay for that good

• The water-diamond paradox – why is water so cheap and diamonds so expensive?

B A C K T O


• Water is absolutely necessary for life. Without it, people would die. How can its price be so low relative to diamonds?

• Since water is so plentiful, the marginal value of the last quantity of water is relatively low.

• i.e. an extra quart of water provides very little additional satisfaction after basic needs are met

• Diamonds are very scarce and the marginal value (price) is therefore relatively high. However the total value of diamonds is relatively low.

B A C K T O


• If you are lost in the desert, the marginal value of water goes to infinity

• And the marginal value of diamonds may even be negative if you have to carry them with you

Economics & the “Marginal Revolution”

• Ricardo, Marx – “Labor Theory of Value”• the value of a commodity can be objectively measured by the average

number of labor hours required to produce that commodity.

• Could not explain diamond vs water prices until marginal value approach

• Market prices are set “at the margin,” i.e. at the last unit of

Q exchanged

B A C K T O


• With a small supply relative to demand, the price of water is low, however the area under the demand curve (value) is large

B A C K T O


• With a small supply relative to demand, the price of diamonds is high, however the area under the demand curve (value) is small

B A C K T O


• Why are teachers paid less than NBA players?

• Teachers provide much greater “value” to society than NBA players based on welfare analysis

• Teachers are upset that their pay does not reflect their total value to society

• Teacher pay is “priced” at the margin via he intersection of supply and demand in the labor market, not based on the value to society

• All of this is done to the endless frustration of advocates for “fair pay” and “social justice”

• i.e. “Markets are unfair”

B A C K T O


• Fair pay: let’s have the government completely determine everyone’s pay

• Eventually, everyone’s pay will be equal in order to be fair

• Of course, some pay will be more equal than others (to paraphrase George Orwell)

• Since the “leaders” have harder jobs, they’ll be paid more (of course)

B A C K T O


• As with many communist countries, incentives to work hard break down, and the economy breaks down as a result

• Most everyone is worse off than before under these systems

• To the degree that the government intervenes in pay or income redistribution for “fairness” purposes, society will achieve varying degrees of efficiency and experience different incentives in their respective labor markets

• Janitors at $45/hour would create distortions

economics book part 7 of modern principles of economics for micro

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