Chapter 5 The Price System: Signals, Speculation, and Prediction

1. Chapter 5 The Price System: Signals, Speculation, and Prediction

2. 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.

3. 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.

4. 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?

5. 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?

6. 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.

7. 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. The substantial amount of information necessary to optimally allocate limited resources. The lack of incentives necessary to supply and to apply this information.

8. 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.

9. 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.

10. 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 Quantity of Oil (MBD) Market Quantity

11. 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.

12. 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?

13. 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.

14. 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.

15. 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?

16. 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.

17. Prices and Speculation Prices Without Speculation Today Future P S P S Price in Future with No Speculation b Today’s Price with No Speculation a D D Q Q Production Production

18. Prices and Speculation Prices With Speculation Today Future P S S P S S Into Storage Out of Storage Price in Future with No Speculation b Price with Speculation c d Gain in Value Today’s Price with No Speculation Loss in Value a D D Q Q Production Production Consumption = Production - Storage Consumption = Production + Inventory

19. 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.

20. 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.

21. Prices and Speculation A Prediction Marketis a speculative market carefully designed so that prices can be interpreted as probabilities and used to make predictions. Iowa Electronic Markets Hollywood Stock Exchange

22. 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.

23. 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?

24. 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.

25. 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.