Presentation on theme: "The Price System: Signals, Speculation, and Prediction"— Presentation transcript:
1The Price System: Signals, Speculation, and Prediction
2Markets Link to Each Other Solving the Great Economic Problem Markets Link the WorldMarkets Link to Each OtherSolving the Great Economic ProblemA Price Is a Signal Wrapped Up in an IncentiveSpeculationSignal WatchingPrediction MarketsFor applications, click hereTo Try it! questionsTo Video
4– F.A. Hayek, The Fatal Conceit 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
5Prices 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 orderEfforts 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
6Markets Link the World Valentine’s Day involves coordinating: Growers in Kenya…Florists…Flower markets in Holland…And You!
7Markets Link to Each Other Giving this one gift to a significant other requires the cooperative effort of millionsVideo: I, Pencil –What economists find amazing is that this immense cooperation is voluntary and undirected“Spontaneous order”
8Watch how the Icelandic Volcanic eruption in 2010 affected the Kenyan flower market by clicking the roses below. (2 minutes)Back to
9Markets Link to Each Other The story above illustrates how markets are interconnectedFurthermore, a change in supply or demand in one market can influence markets for entirely different products thousands of miles awayHow 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”
10Markets Link to Each Other Example: Oil and Candy Bars and AsphaltOil price increasesCaused Brazilians to sugar cane for ethanolLess sugar cane for sugar, costs of sugar increasedShifted candy bar supply curve to leftCandy bar prices roseAsphalt prices roseLess asphalt used for drivewaysConsumers substituted away to bricks, concrete, etcDemand curve for bricks shifted to rightBrick prices rose
11Markets Link to Each Other The price of oil rose.Brazil shifted sugar cane into ethanol production (rather than table sugar).As a result, table sugar got more expensive.Thus, one way that we economize on oil is by eating fewer donuts!
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.
13Solving the Great Economic Problem To arrange our limited resources to satisfy as many of our infinite wants as possible.Some solutions:Central PlanningThe Price System
14Solving the Great Economic Problem Any economic system, from North Korean Communism to European socialism to free markets has to deal the following problems:ScarcityTrade-offsIncentivesEfficiencyWhat is produced, how is it produced, and to whom are these goods distributed?
15Central PlanningCentral planning: a single official or bureaucracy is responsible for allocating limited resources.Has two significant problems:Too much information to process.Too few incentives.
16Central Planning in the West “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. “
17Central Planning (cont.) “That is a society in which the major economic decisions are made administratively , without profits as a central (goal)....”- Paul Samuelson, Economics (1989)
18Central Planning Problems 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 systemi.e. they tried to plan their economy without the right kinds of informationSoviet production managers were incentivized to please the State, not consumers
19Central Planning Problems Soviet Planning DisastersExamples of immense problems with central planning, “fair” distribution of goods, artificial prices, and the prohibition of a profit motiveShoes - Most went to landfills, no feedback mechanism (i.e. profit) with consumersRail 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 quotasNails - Sometimes weight quotas were met by producing one ton nails only, had to be shipped by railcar
20Central Planning Problems Soviet Planning Disasters (cont)WindowsInitially, manufacturing quotas set via square footage producedThickness of windows decreased, windows were so thin that many broke in transitWhen 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
21Central Planning Problems Soviet Planning Disasters (cont)Furniture –Production quotas set via weight, factories added lead weights to couches to meet quotasNot 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:
22Central Planning Problems 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.
23Central Planning Problems Example: allocation of oil resourcesWould have to know the value of oil in each of its millions of usesWould have to know which of its consumers for each use value it more highlyNeeds 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 truthful information and not try to “game” the systemWhat are the central planner’s own self-interests and do they align with the social interest of that society?Public choice theory addresses this issueOxymoron – “Benevolent Dictator”
24Central Planning Central planning has failed around the world The Soviet Union disintegrated economically, other countries as wellChina abandoned centralized planning and has allowed property rights to create prosperityIndia has moved away from socialism.North Korea and Cuba are economic disastersVenezuela is rapidly getting poorerOver last 20 years, hundreds of millions of people have escaped poverty via the abandonment of central planning
25Central Planning Why has Central planning has failed around the world? Can not solve the problems of incentives and informationSoviet 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
26Central PlanningThe 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
27Central Planning 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
28Central Planning – Hong Kong “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.’’
29Central Planning – Hong Kong “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”
30Central Planning – Hong Kong “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)
31The Price SystemThe 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.NYSE's stock exchange traders floor before the introduction of electronic readouts and computer screens.
32The Price SystemPrices signal to resources exactly WHERE they are most valuedPrices solve the information and incentive problems
33A 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.
34The Price System – Austrian School Frederick HayekAustrian School of EconomicsNobel prize winner in Economics in 1974“Road to Serfdom” 1944Chapter 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”A must read for anyone wanting a deep understanding of economics
35The Price System – Austrian School 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
36Hayek saw the invisible hand “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 HayekHayek saw the invisible hand
37The Price System – Austrian School Ludwig von MisesAustrian school, a “classical liberal”Hayek was a student of Von MisesMises was famous for his “Socialist calculation” argument in the 1920sabsent market-based prices, capital formation can not take place efficiently in an economyGovernment control of the healthcare industry and the associated pricing will likely yield a confirmation of Mises’s ideas
38How Prices WorkFree 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
39How Prices WorkPrice 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 controlsSuch policies disrupt the signaling role of prices and can lead to a suboptimal allocation of limited resources, i.e. make society worse off/poorerPower of the Market – Prices (video)NYSE's stock exchange traders floor before the introduction of electronic readouts and computer screens.
40Which is the best way for society to distribute its goods? The free market outcome should not be tampered with.“From each according to his ability to each according to his need”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.No right answer. This is an extension of chapter 3’s questions… and foreshadows chapter 18’s ethics discussion. A represents Nozick’s libertarian theory, B represents Marx’s (and general Socialist sentiment of) equality, C represents the Utilitarian idea.Have students discuss in small groups. This slide is designed to get students thinking (and talking) about the benefits and costs of a price rationing system.To nextTry it!
41Market Price and Opportunity Cost The Equilibrium Price is Equal to the Value of the Good in its Next Highest UseQuantityPriceThe Value of the Good in its Next Highest UseUnsatisfied WantsSatisfied WantsSupplyDemandEquilibrium PriceEquilibrium Quantity
42The Opportunity cost of a good is: Known as the “elastic” cost Usually less than its money costthe value of the next highest-valued use of the goodAll of the aboveTo nextTry it!
43SpeculationSpeculation 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.
44Prices and Speculation Prices Rise Sharply after a Decrease in Supply Without SpeculationQuantityPriceProduction TodayToday’s Price with no SpeculationaCurrent SupplyDemandPrice in Future with no SpeculationbProduction FutureFuture SupplyInstructor Notes: Figure 5.1: Speculation Tends to Smooth Prices over Time and Increase WelfarePanel A: Prices Without Speculation
45Prices and Speculation Speculation Smoothes Prices when Supply DecreasesQuantityPriceConsumption Today= Production - StoragecInto StoragePrice with SpeculationLoss in ValueOut of StorageConsumption Future= Production + Storage= dGain in ValuebProduction TodayToday’s Price with no SpeculationaInstructor Notes: Figure 5.1: Speculation Tends to Smooth Prices over Time and Increase WelfarePanel B: Prices With SpeculationThe blue areas in the diagram show the value that speculators move from today to the future. The same quantity is more valuable in the future when supplies are low than today when supplies are plentiful.
46FuturesA 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 goodHog futures: all investment, no smell.
47Signal WatchingFutures prices can be extraordinarily informative about future events. Sometimes, the signals are “noisy” and futures prices are less informative and accurate.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!
48Oil Price SpeculationSpeculators 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?”
49Speculation 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?
50Prediction MarketsA 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 2008The Iowa markets have been more accurate than polls.
52Predicting Movie Revenues The Hollywood Stock Exchange: not perfectly clairvoyant (but not bad!)
53If investors in the Hollywood Stock Exchange were too optimistic on average, would the dots tend to cluster above the red diagonal line or below?AboveBelowBack to
54Other AV Links Power of the Market - Fairness The 4 Ways to Spend Money by Milton Friedman
55A Digression on Prices and Value Prices are set at the margini.e. the last unit exchanged in the market sets the priceHousing 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 homesi.e. one low-priced foreclosure/short sale can greatly affect nearby house prices, perhaps a % reduction or more
56A Digression on Prices and Value Area underneath demand curve represents total value to consumersArea beneath demand curve and above price represents consumer surplusAt any point on the demand curve, that represents the price that the marginal consumer is willing to pay for that goodThe water-diamond paradox – why is water so cheap and diamonds so expensive?
57A Digression on Prices and Value 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 metDiamonds are very scarce and the marginal value (price) is therefore relatively high. However the total value of diamonds is relatively low.
58A Digression on Prices and Value If you are lost in the desert, the marginal value of water goes to infinityAnd the marginal value of diamonds may even be negative if you have to carry them with youEconomics & 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 approachMarket prices are set “at the margin,” i.e. at the last unit of Q exchanged
59A Digression on Prices and Value With a small supply relative to demand, the price of water is low, however the area under the demand curve (value) is large
60A Digression on Prices and Value With a small supply relative to demand, the price of diamonds is high, however the area under the demand curve (value) is small
61A Digression on Prices and Value Why are teachers paid less than NBA players?Teachers provide much greater “value” to society than NBA players based on welfare analysisTeachers are upset that their pay does not reflect their total value to societyTeacher pay is “priced” at the margin via he intersection of supply and demand in the labor market, not based on the value to societyAll of this is done to the endless frustration of advocates for “fair pay” and “social justice”i.e. “Markets are unfair”
62A Digression on Prices and Value Fair pay: let’s have the government completely determine everyone’s payEventually, everyone’s pay will be equal in order to be fairOf 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)
63A Digression on Prices and Value As with many communist countries, incentives to work hard break down, and the economy breaks down as a resultMost everyone is worse off than before under these systemsTo 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 marketsJanitors at $45/hour would create distortions