modern principles of economics third edition the price system: signals, speculation, and predictions...
TRANSCRIPT
MODERN PRINCIPLES OF ECONOMICSThird Edition
The Price System: Signals, Speculation, and Predictions
Chapter 7
Outline
Markets Link the World Markets Link to One Another Solving the Great Economic Problem A Price Is a Signal Wrapped Up in an
Incentive Speculation Signal Watching Prediction Markets
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Introduction
Prices
Are the key force integrating markets and motivating entrepreneurs.
Create rich connections between markets by conveying important information.
Create an incentive to respond to that information in socially useful ways.
Enable societies to mobilize vast amounts of knowledge toward common ends.
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Markets Link the World
Roses grown in Kenya. Transported in cooled trucks and
aircraft. Flown to flower auction in Holland. Sold to buyers from around the world. Become a gift of love in Stillwater,
Oklahoma. Cooperation is voluntary and undirected.
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Markets Link to One Another
Shifts in supply and demand in one market ripple across the worldwide market.
Entrepreneurs are constantly looking for ways to lower costs.
These cost-cutting measures link markets that seem like they are a world away.
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Markets Link to One Another
Example: oil and candy bars. Higher energy costs increase the cost of
producing most products, including candy bars. Also linked in more subtle ways:
• Brazil is the largest producer of both sugar and ethanol (made from corn or sugar cane).
• As the price of oil ↑, Brazil shifts sugar cane from sugar to ethanol production.
• Keeps fuel costs down but increases cost of sugar.
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Self-Check
Markets are linked through:
a. Shortages.
b. Government regulations.
c. Prices.
Answer: c – Markets are linked through prices.
Definition
Great Economic Problem:
to arrange our limited resources to satisfy as many of our wants as possible.
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Solving the Great Economic Problem
Suppose the supply of oil decreases. We should economize on oil by:
• Shifting oil out of low-valued uses, where we can do without or there are good substitutes.
• Supplying oil for high-valued uses, where there are few good substitutes.
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Solving the Great Economic Problem
One option is central planning. • Problems of information and incentives.
Another option is the price system. • Each user of oil compares the value in their
use with the value in alternative uses. • Each user has an incentive to give up the oil
if it has a lower value in their use.
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Solving the Great Economic Problem
11Top photo: ssuaphotos/Shutterstock Bottom: Lew Robertson/Corbis
Solving the Great Economic Problem
A buyer compares the value of the good to its opportunity cost (market price).
Because markets are linked, the price reflects information about many other markets.
The market collapses all relevant information into a single number – the price.
The buyer is deciding whether their use is more valuable than the billions of other uses that are presently unsatisfied.
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Solving the Great Economic Problem
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Friedrich A. Hayek 1899–1992
Friedrich Hayek on prices:
“The marvel is that in a case like that of a 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 whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction.”
HULTON ARCHIVE/GETTY IMAGES
Signal Wrapped in an Incentive
Prices are incentives, signals, and predictions. When price rises, buyers are encouraged to
use less or substitute. It is also a signal to suppliers to provide more. Price signals and the accompanying profits
and losses tell entrepreneurs what areas of the economy consumers want expanded and what areas they want contracted.
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Self-Check
A higher price tells buyers to :
a. Buy more.
b. Buy less.
c. Buy the same amount.
Answer: b – A higher price encourages buyers to use less or substitute.
Signal Wrapped in an Incentive
Example: After a hurricane, prices of goods skyrocket.
Consumers complain of price gouging.
Politicians call for price controls.
The market is just signaling for more resources to come to the rescue!
16ASHLEY COOPER/CORBIS
Signal Wrapped in an Incentive
Losses are also a signal. Entrepreneurs who fail to compete with lower
costs and better products take losses and eventually go bankrupt.
Resources will go to firms that are able to compete.
In a successful economy, there will be many unsuccessful firms.
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Definition
Speculation:
the attempt to profit from future price changes.
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Speculation
Suppose you believe oil prices will be higher in one year.
You can make a profit by buying oil now, storing it, and selling it next year.
This is called speculation. Speculation tends to smooth prices over time
and increases welfare.
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Self-Check
Speculation refers to:
a. An attempt to raise the price of a good.
b. An attempt to create scarcity in a market.
c. An attempt to profit from future price changes.
Answer: c – Speculation is an attempt to profit from future price changes.
Speculation
Prices without speculation
PricePrice
QQProduction
futureProduction
today
SupplySupply
Today’sprice
Price infuture
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Demand
TODAY FUTURE
Demand
Speculation
PricePrice
QQProduction
futureProduction
today
SupplySupply
Today’sprice
Price infuture
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Demand
Demand
TODAY FUTURE
Intostorage
S2
Price withspeculation
Out ofstorage
S2
Price w/ speculation
Consumption = Production minus storage
Prices with speculation
Consumption = Production + inventory
Speculation
PricePrice
QQProduction
futureProduction
today
SupplySupply
Today’sprice
Price infuture
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Demand
Demand
TODAY FUTURE
Intostorage
S2
Price withspeculation
Out ofstorage
S2
Price w/ speculation
Consumption = Production minus storage
Consumption = Production + inventory
Loss in valueGain in value
Prices with speculation
Speculation
Speculators raise prices today but lower prices in the future.
Speculators move goods from today, when they have low value, to the future, when the value is higher.
Although speculators are not always right, they have strong incentives to be accurate.
Overall, society is better off.
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Self-Check
Speculation in a market:
a. Raises prices today but lowers them in future.
b. Lowers prices today but raises them in future.
c. Raises prices today and in the future.
Answer: a – Speculation raises prices today but lowers them in future.
Definition
Futures:
standardized contracts 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.
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Futures Markets
Example: Tyler believes oil prices will be higher in future than people are expecting. • Buys a futures contract for 1,000 barrels to be
delivered in 30 months.• Agrees to pay $50 per barrel on delivery.
Suppose 30 months later the price of oil = $82 Tyler has two options:
• Accept the oil and pay $50,000, sell for $82,000• Accept $32,000 and let seller keep oil
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Futures Markets
Futures allow people to speculate without accepting or delivering the goods.
Futures markets are also used to reduce risk. • Airlines can lock in fuel costs by buying oil on
the futures market. • Farmers can agree to sell crops at harvest
time at a price agreed on today. • Firms can avoid exchange rate risk by
buying/selling currency futures.
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Self-Check
Futures contracts are used to:
a. Take possession of something now, and pay for it at a future date.
b. Buy or sell something at the current price, for delivery in the future.
c. Buy or sell something at a future date.
Answer: c – Futures contracts are used to buy or sell something at a future date.
Signal Watching
Futures prices can be very informative about future events.
Economist Richard Roll found the futures price of orange juice could be used to improve the predictions of the weather service.
Many factors affect futures prices, so they are a noisy signal.
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Definition
Prediction Market:A speculative market designed so that prices can be interpreted as probabilities and used to make predictions.
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Prediction Markets
The best known prediction market is the Iowa Electronic Markets.
Traders use real money to buy and sell “shares” of political candidates.
Example: a share pays $1 if a candidate is elected and nothing if she is not.
If traders believe the candidate has a 75% chance of winning, market price of the share will be 0.75 x $1 = $0.75.
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Prediction Markets
The Hollywood Stock Exchange is a good predictor of future box office revenues.
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Takeaway
Markets are linked geographically, through time and across different goods.
A price is a signal wrapped up in an incentive: • Price signals the value of resources to
consumers, suppliers, and entrepreneurs. • Provides incentives to respond to scarcity in
an appropriate way. Futures prices can help us predict many other
future events.