1. How Markets Work ECO 285 - Dr. D. Foster

2. Three (Economic?) Questions: 1. What to produce? 2. How to produce? 3. For whom to produce? must We must decide! Scarcity Choices Costs

3. Consider the market for gasoline… Supply Demand Price Quantity P e = $3 QeQe How does this help us to answer the what, how & for whom questions?

4. Markets  prices = signals Serves to reward producers for fulfilling our desires. Forces consumers to conserve on the consumption of goods (and services, and resources...).

5. Adam Smith “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their self interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our necessities, but of their advantages.”

6. Prices … are a rationing device! How else to ration? First come, first served? Brute force? Discrimination? No Equal portions? [Marxist? No!] forced When a good is increasingly scarce, its price rises and we are forced to reduce consumption. Equally? Of course not!

7. Scenario Scenario: Kuwait falls into the Gulf. suppliers How do suppliers react to the P=$5 ? consumers How do consumers react to the P=$5 ? What if we fix prices (a ceiling) at $3.00 ? $3.00 S D Quantity $5.00 New S Q2Q2 $10.50 Q1Q1 Q3Q3 In the long run, we expect that producers will search for and find additional supplies,  Q and  P.

8. What will be said of P=$5?  Markets don’t work!  Prices are not fair!  These prices are outrageous!  This is an example of price gouging!  This is an indictment against greedy sellers!

9. Dairy Price Supports 1986 - $1.3 billion to slaughter dairy cows. No effect on milk, but on beef... 1991 - USDA buys butter at $1/lb. to sell abroad at 60 cents/lb. 1996 - Congress approves cartel in New England to raise milk prices 21%. 1999 - Milk price calculation simplified... Began during G. D. of 1930s. 1981 - cheese giveaway. 1983 - $1 billion to “retire” 10,000 dairy cows. No effect. The Inefficiency of Price Floors

10. Basic Formula Price (BFP) = last month's average price paid for manufacturing grade milk in Minnesota and Wisconsin + [current grade AA butter price X 4.27 + current non-dry milk price X 8.07 - current dry-buttermilk price X 0.42] + [current cheddar cheese price X 9.87 + current grade A butter price X 0.238] - [last month's grade A butter price X 4.27 + last month's nondry- milk price X 8.07 + last month's dry-buttermilk price X 0.42] - [last month's cheddar cheese price X 9.87 + last month's grade A butter price X 0.238] + (present butter fat - 3.5) X [current month's butter price X 1.38] - [last month's price of manufacturing grade milk in Minnesota- Wisconsin X 0.028]. Dairy Price Supports

11. Lessons? Plenty of them... Cost to consumers of higher prices: Butter = 2*ROW, Cheese = 1.5*ROW, Milk=1.26*ROW Cost to taxpayers for dairy subsidies: 0 to $2.6 billion, depending on market conditions. Health harm - more expensive for poor and elderly to get calcium. No incentive to innovate in U.S. dairy industry (New Zealand milk is produced at about half our cost). Since 1930, dairy farmers declined by 95%.

12. How Markets Work ECO 285 - Dr. D. Foster