Longwood University 201 High Street Farmville, VA 23901 Personal Finance Scott Wentland wentlandsa@longwood.edu 434-395-2160 Longwood University 201 High Street Farmville, VA 23901

Markets, Information, and Incentives

Markets - Information & Incentives Market prices provide information and incentives Prices guide the behavior of consumers and producers Also create incentives of workers, employers, savors, investors, and anyone else who participates in markets Why is this important? Efficiency and order, without intention Adam Smith called this the “invisible hand” F. A. Hayek called this “spontaneous order”

Last Lecture… Buyers Sellers What happens when they get together? Buyers always want the lowest price they can get from something Sellers Sellers always want the highest price they can get for something What happens when they get together? They agree to exchange End up somewhere in between

Exchange The nature of exchange How do we know it is a win-win? Buyers and sellers agree on a mutually beneficial price Always a win-win (ex ante) How do we know it is a win-win? Exchange is voluntary If the buyer didn’t benefit (on net), s/he wouldn’t buy If the seller didn’t benefit (on net), s/he wouldn’t sell Do you really have to buy an iPhone? Yes? You value iPhone > iPhone’s price No? It wasn’t worth it to you…

Exchange Example Suppose we agree on a price of, say, $30 Another Example: Seller (me): I can produce a barrel of oil for $10 Buyer (you): You want a barrel of oil, and are willing to pay up to $60 Result: we agree to a price so that we both win Suppose we agree on a price of, say, $30 I win because I get $30 for something that cost me $10 PRODUCER SURPLUS (Profit) = $20 You win because you get something you value for $60 for only $30 CONSUMER SURPLUS = $30

Gains from Trade Are Maximized at Equilibrium Price and Quantity A Free Market Maximizes Producer plus Consumer Surplus (the gains from trade) Price of Oil per Barrel Demand Curve Supply Curve $30 65 Buyers Non-Sellers Consumer Surplus Equilibrium Price Producer Surplus Sellers Instructor Notes: Figure 3.4: A Free Market Maximizes Producer Plus Consumer Surplus (the Gains from Trade) A free market maximizes the gains from trade because (1) buyers are willing to pay more for the good than non-buyers, (2) sellers are willing to sell the good at a lower price than non-sellers, and (3) there are no mutual profitable deals between non-sellers and non-buyers. Non-Buyers Quantity of Oil (MBD) Equilibrium Quantity

Other Conclusions Markets are efficient Lowest cost producers are the sellers Highest value consumers are the buyers No more mutually advantageous trades can take place Producer surplus (profit) and consumer surplus are maximized This is all done voluntarily, because people just want to better themselves Both buyers and sellers are self-interested

Equilibrium: How do we get there? Up to this point: Buyers and sellers get together in markets Negotiate price…an equilibrium emerges Presto! Efficiency! The story is a bit more complicated… How markets work  more interesting than just the outcome or equilibrium

Equilibrium: How do we get there? Supply and demand helps us understand how markets work Helps show us how prices emerge, not just that markets are efficient What if a market is not in equilibrium? How does it get there? How do buyers and sellers figure out how to get to the right price?

Quantity Supplied > Quantity Demanded Price: Too High? What happens if the price is too high? At prices greater than the equilibrium price: Quantity Supplied > Quantity Demanded Economists refer to this as Excess Supply or Surplus. Note that prices convey information The high price gives buyers an incentive to cut back Law of demand: buyers want less when price is high The high price gives sellers an incentive to produce more Law of supply: sellers want to sell more at a higher price Result: surplus

Excess Supply Drives Prices Down Quantity of Oil (MBD) Price per Barrel Demand Curve Supply Curve $50 Surplus 32 100 65 $30 Equilibrium Price Equilibrium Quantity Instructor Notes: Figure 3.2: A Surplus Drives Prices Down At a price of $50 there is a surplus of oil. When there is a surplus, sellers have an incentive to decrease their price and buyers have an incentive to offer lower prices. The price decreases until at $30 the quantity demanded equals the quantity supplied and there is no longer an incentive for price to fall.

Prices, Information, & Incentives In this situation sellers must reduce their prices to induce buyers to purchase all of this extra product. The lower price gives buyers an incentive to buy more and sellers to produce less As prices fall, the surplus disappears When there’s no surplus, and S = D  equilibrium

Prices, Information, & Incentives How do sellers know the price is too high and they are out of equilibrium? Quantities convey information too  check your shelves With a surplus on the market, sellers know to lower price The lower price will attract more buyers If the price was too high, the market was wrong, temporarily Why temporarily? What if they lower the price too much?

Prices, Information, & Incentives What happens if the price is too low? At prices less than the equilibrium price Quantity Supplied < Quantity Demanded Economists refer to this as Excess Demand or Shortage. Again, prices convey information! The low price gives buyers an incentive to buy more Law of demand: buyers want more when price is low The low price gives sellers an incentive to produce less Law of supply: sellers want to sell less at a low price Result: shortage

Excess Demand Drives Prices Up Quantity of Oil (MBD) Price per Barrel Demand Curve Supply Curve 65 $30 Equilibrium Price Equilibrium Quantity Instructor Notes: Figure 3.2: A Shortage Drives Prices Up At a price of $15 there is a shortage of oil. When there is a shortage, sellers have an incentive to increase the price and buyers have an incentive to offer higher prices. The price increases until at a price of $30 the quantity supplied equals the quantity demanded and there is no longer an incentive for the price to rise. $15 Shortage 24 95

Prices, Information, & Incentives How do sellers know the price is too low and they are out of equilibrium? Quantities convey information too  Are there lines? Back orders? With a market shortage, sellers know to raise price Sellers would always like to charge more…a shortage tells them that they can, and they will still have customers!

Prices, Information, & Incentives Prices guide behavior in markets Buyers know to economize when the price is too high Sellers know to make more when the price is high And, vice versa Prices are important and create order out of chaos Buyers and sellers are guided by self-interest to reach efficient outcomes No one tells them to reach an equilibrium, they go to it spontaneously…order emerges out of buyers and sellers reacting to prices

Spontaneous Order Markets create order, from the bottom up Order emerges in markets through individuals acting out of self-interest The result: a more efficient allocation of societal resources than any (centrally planned) design could possibly achieve Why?

Spontaneous Order Markets create order, from the bottom up Why? Without prices and markets, people don’t have a good incentive to take care of shortages and surpluses Centrally planned, communist countries: plagued by shortages (of good things) and surplus (less useful things) Prices are information, coming from market participants  impossible for government to know all!

Self Interest & the Invisible Hand The economist F.A. Hayek focused on prices as information and incentives Adam Smith had a similar idea, but focused on the motivation of buyers/sellers: "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 own self interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.“ – Adam Smith, The Wealth of Nations

Invisible Hand Prices guide actions of individuals Prices emerge from individuals participating in markets In a free market, no central authority “sets” prices “[one’s] own gain is led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of it. By pursuing his own interest [an individual] frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the [common] good.“ – Adam Smith, The Wealth of Nations

Tampering with the market Can we do better? What if we don’t like the market outcome? What if we don’t think self-interested individuals should be left to their own device? Example Some people don’t get paid enough The market wage (determined by supply and demand) is very low for some jobs Solution: minimum wage (a type of “price floor”)

Price Floors Quantity Wage ($) Supply Labor surplus (Unemployment) Minimum wage (floor) (Unemployment) Conclusion: the greater the difference between the minimum wage and the market wage, the greater is unemployment Market wage Demand Quantity demanded at minimum wage Market employment Quantity supplied at minimum wage Quantity

Tampering with the market Can we do better? What if we don’t like the market outcome? What if we don’t think self-interested individuals should be left to their own device? Example Some stuff is too expensive  sellers “gouge” The market price might seem to high Solution: price ceiling  government mandated ceiling on price…the market cannot charge higher than the set price

How Price Ceilings Affect Market Outcomes Example: rent in NYC is “too high” The price ($1000) is above the ceiling and therefore illegal. The ceiling is a binding constraint on the price, causes a shortage. P Q S D $1000 Price ceiling $500 250 400 shortage In this case, the price ceiling is binding. In the new equilibrium with the price ceiling, the actual price (rent) of an apartment will be $500. It won’t be more than that, because any higher price is illegal. It won’t be less than $500, because the shortage would be even larger if the price were lower. The actual quantity of apartments rented equals 250, and there is a shortage equal to 150 (the difference between the quantity demanded, 400, and the quantity supplied, 250). 26

Tampering with the market Sometimes we don’t like the market outcome Policies that interfere with market forces often have unintended consequences Is all market interference bad? No. But policymakers need to be very careful about the effects of various policies Have to weigh unintended consequences against other social goals

Tampering with the market Studying markets is like studying physics Is gravity bad? Is motion good?  nonsense Like gravity, market forces simply exist. How can we make market forces work for us? Understanding how markets work (through supply and demand) helps us understand the world we live in

Thank You http://en.wikipedia.org/wiki/Supply_and_demand http://en.wikipedia.org/wiki/Invisible_hand http://en.wikipedia.org/wiki/Spontaneous_order http://en.wikipedia.org/wiki/Price_ceiling http://en.wikipedia.org/wiki/Price_floor