1. The Price System: Signals, Speculation, and Predictions
Chapter 7
The Price System: Signals, Speculation, and Predictions

2. 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

3. Introduction 3

4. Introduction Essential Hayek: Knowledge and Prices (3:26)
I, Pencil (6:32)
I, Pencil Extended Commentary: Spontaneous Order(4:03)
Essential Hayek: Knowledge and Prices (3:26) 4

5. 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. 5

6. Signal Wrapped in an Incentive
What are prices?
Prices have a huge information function that coordinate 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)

7. 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.

8. Signal Wrapped in an Incentive
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
Friedrich A. Hayek 1899–1992 8

9. Friedrich Hayek Frederich Hayek
Austrian School of Economics
Nobel prize winner in Economics in 1974
Most popular book - “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”
A must read for anyone wanting a deep understanding of economics 9

10. Friedrich 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 10

11. Spontaneous Order 11

12. 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. 12

13. 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. 13

14. Solving the Great Economic Problem
Markets are tremendously 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 (rule by AK-47)” 14

15. 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. 15

16. 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. 16

17. Solving the Great Economic Problem
Figure 7-1 (7-1): The Market Price and Opportunity Cost 17
Top photo: ssuaphotos/Shutterstock Bottom: Lew Robertson/Corbis

18. Solving the Great Economic Problem
Example: Oil and Candy Bars and Asphalt
Oil price increases
(1) Caused Brazilians to sugar cane for ethanol
Less sugar cane for sugar, sugar costs increased
Shifted candy bar supply curve to left
Candy bar prices rose
(2) 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 18

19. Signal Wrapped in an Incentive
Losses are also a signal. So are profits.
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.

20. 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!
ASHLEY COOPER/CORBIS

21. Self-Check A higher price tells buyers to : Buy more. Buy less.
Buy the same amount.
Answer: b – A higher price encourages buyers to use less or substitute.

22. Self-Check Markets are linked through: Shortages.
Government regulations.
Prices.
Answer: c – Markets are linked through prices.

23. Definition Two prominent solutions: Central Planning The Price System
Great Economic Problem:
to arrange our limited resources to satisfy as many of our wants as possible.
Two prominent solutions:
Central Planning
The Price System

24. Central Planning vs Markets

25. Solving the Great Economic Problem
Any economic system, from North Korean Communism to European socialism to market-based systems has to address the following problems:
Scarcity
Trade-offs
Incentives
Efficiency
What is produced, how is it produced, and to whom are these goods distributed? 25

26. Solving the Great Economic Problem
Central planning.
Government determines what is produced
Problems of information and incentives.
Markets (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. 26

27. Solving the Great Economic Problem
Central planning: a single official or bureaucracy is responsible for allocating limited resources.
Has two significant problems:
Too much necessary information to process.
Too few incentives. 27

28. Solving the Great Economic Problem
Paul Samuelson (1915 – 2009)
– Nobel Prize in Economics (1970)
“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.“ 28

29. Solving the Great Economic Problem
“That is a society in which the major economic decisions are made administratively , without profits as a central (goal)....”
- Paul Samuelson, Economics (1989) 29

30. Central Planning 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 30

31. Central Planning Soviet Planning Disasters
Examples of immense problems with central planning, “fair” distribution of goods, artificial prices, and the prohibition of a profit motive
Examples: Shoes, Rail traffic, Nails, Furniture, Windows, Computer punch cards
Customer feedback, profit/loss results would have solved this problem easily
Lack of “market discipline” – no direct customer feedback, no profit/loss signals
No “regulation” by market competition 31

32. Central Planning Central planning has failed around the world
Latest ongoing example: Venezuela
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 32

33. Central Planning 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.
Lack of economic freedom always coincides with lack of personal and political freedoms 33

34. No Central Planning in 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.’’  34

35. No Central Planning in 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” 35

36. Free Markets
Are not without their own problems (market failure covered in later chapters)
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. 36

37. Free Markets
Markets solve the incentive problem because consumers will purchase a good only if its value is greater than the price.
Wages/Income determined by market value
Market discipline exists in the form of prices and profit/loss 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.
Consumers “vote” with their dollars
Power of the Market – Prices (video - 1:38) 37

38. Final Words on Central Planning
“Capitalism is the worst economic system ever devised except when compared to all of the rest.”
Winston Churchill
“Underlying most arguments against the free market is a lack of belief in freedom itself.”
Milton Friedman 38

39. Solving the Great Economic Problem
"Nobody planned the global capitalist system, nobody runs it, and nobody really comprehends it. This particularly offends intellectuals, for capitalism renders them redundant. It gets on perfectly well without them. It does not need them to make it run, to coordinate it, or to redesign it. The intellectual critics of capitalism believe they know what is good for us, but millions of people interacting in the marketplace keep rebuffing them. This, ultimately, is why they believe capitalism is ‘bad for the soul’: it fulfills human needs without first seeking their moral approval."  - Peter Saunders 39

40. Definition Speculation:
the attempt to profit from future price changes.

41. 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.

42. Self-Check Speculation refers to:
An attempt to raise the price of a good.
An attempt to create scarcity in a market.
An attempt to profit from future price changes.
Answer: c – Speculation is an attempt to profit from future price changes.

43. Prices without speculation
Supply
Supply
Price
Price
Price in
future
Today’s
price
Demand
Demand Q Q
Production
today
Production
future
TODAY
FUTURE 43

44. Speculation Prices with speculation S2 Supply Supply S2 Price Price
Out of
storage
Into
storage
Price in
future
Price with
speculation
Price w/ speculation
Today’s
price
Demand
Demand Q Q
Production
today
Production
future
Consumption =
Production minus storage
Consumption =
Production + inventory
TODAY
FUTURE 44

45. Speculation Prices with speculation S2 Supply Supply S2 Price Price
Out of
storage
Into
storage
Price in
future
Gain in value
Loss in value
Price with
speculation
Price w/ speculation
Today’s
price
Demand
Demand Q Q
Consumption =
Production minus storage
Production
today
Production
future
Consumption =
Production + inventory
TODAY
FUTURE 45

46. 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. 46

47. Self-Check Speculation in a market:
Raises prices today but lowers them in future.
Lowers prices today but raises them in future.
Raises prices today and in the future.
Answer: a – Speculation raises prices today but lowers them in future.

48. 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.

49. 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 49

50. 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.
Hog futures: all investment, no smell. 50

51. Self-Check Futures contracts are used to:
Take possession of something now, and pay for it at a future date.
Buy or sell something at the current price, for delivery in the future.
Buy or sell something at a future date.
Answer: c – Futures contracts are used to buy or sell something at a future date.

52. Signal Watching
Futures prices can be extraordinarily informative about future events.
Economist Richard Roll found the futures price of orange juice could be used to improve the predictions of the National Weather Service.
Many factors affect futures prices, so they can be a noisy signal.
Future prices are information as well 52

53. Definition Prediction Market:
A speculative market designed so that prices can be interpreted as probabilities and used to make predictions.

54. Prediction Markets
The best known prediction market is the Iowa Electronic Markets.
Traders use real money to buy and sell “shares” of political candidates or other issues.
The Iowa markets have been more accurate than polls. Why? 54

55. Prediction Markets Hollywood Stock Exchange http://www.hsx.com/
“Terrorism” Exchange 55

56. Prediction Markets
Figure 7-3 (7-3): The Hollywood Stock Exchange Is a Good Predictor of Future Box Office Revenues
The Hollywood Stock Exchange is a good predictor of future box office revenues.

57. 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.

58. 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 % reduction or more 58

59. A Digression on Prices and Value
The area underneath demand curve represents total value to consumers (WTP)
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? 59

60. A 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 met
Diamonds are very scarce and the marginal value (price) is therefore relatively high. However the total value of diamonds is relatively low. 60

61. A Digression on Prices and Value
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 61

62. A 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 62

63. A 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 63

64. A 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 economic welfare analysis
Teachers are upset that their pay does not reflect their total value to society
Teacher pay is set at the margin via the intersection of supply and demand in the labor market, not based on the value to society (marginal product of labor concept)
All of this is done to the endless frustration of advocates for “fair pay” and “social justice”
i.e. “Markets are unfair and evil” 64

65. A Digression on Prices and Value
Would government setting wages be “fair”?
Would totally change incentive/reward relationship
Why bother going to med school?
Total economic chaos and poverty would result
Political determination of pay/wages would also be very divisive socially
More on this topic later (Minimum Wage) 65