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

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. Instructor Notes: The parable from the text is based on “I, Pencil” by Leonard Read. This short essay is readily available on the internet and may be useful for outside reading. A possible in class exercise would be to ask students about a good they typically buy and walk through all the stages of its production and the many players involved.

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. Instructor Notes:

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? Instructor Notes:

To encourage the use of alternative energy sources, the U. S 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? Instructor Notes:

Sawdust is used for bedding milk cows 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. Instructor Notes:

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. Instructor Notes:

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. Instructor Notes:

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. Instructor Notes: It may be necessary to expand on point one - that consumers, themselves, provide a good deal of information by simply participating in the market.

Solving the Great Economic Problem Market Price and Opportunity Cost Quantity of Oil (MBD) Price of Oil The Value of the Good in Its First Unsatisfied Demand Unsatisfied Demands Satisfied Demands Market Price Demand Supply Market Quantity Instructor Notes: Figure 5.1 The Market Price and Opportunity Cost The market price splits the uses of a good in two. Above the price are the uses of oil whose value is greater than the price; in a free market, these demands will be satisfied. Below the price are uses whose value is less than the price; in a free market, these are the unsatisfied demands. Notice the value of the oil in the first unsatisfied demand is just slightly below the market price.

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. Instructor Notes:

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? Instructor Notes:

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. Instructor Notes:

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. Instructor Notes: Chapters 6 & 7 examine these price controls in detail.

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? Instructor Notes:

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. Instructor Notes:

Prices and Speculation Q Prices Without Speculation Today Future P Price in Future with No Speculation Today’s Price with No Speculation D S Production a b Instructor Notes: Figure 5.2 (Top Panel): Prices Without Speculation This panel shows the price of oil, oil consumption, and oil production in an economy without speculation. In the left graph, labeled Today, the equilibrium is at point a, the price is low, and oil consumption and production are high. In the right graph, labeled Future, the price of oil is high because a disruption has reduced the production of oil. Since no oil was stored from the previous period, the consumption of oil is also reduced.

Prices and Speculation Q Prices With Speculation Today Future P Price in Future with No Speculation Today’s Price with No Speculation D S Production a b Consumption = Production - Storage Price with Speculation S Into Storage Out of Production + Inventory c d Gain in Value Loss in Value Instructor Notes: Figure 5.2 (Bottom Panel): Prices With Speculation This panel shows what happens with speculation. In the left graph, labeled today, oil speculators buy oil and put it in storage pushing up the price of oil and reducing consumption today – thus, the equilibrium shifts from point a to point c. In the future when the price of oil is high (at point b), speculators sell their oil from storage. The oil flowing out of storage pushes the price down and allows people to consume more oil even though production is low. Consumer surplus (in blue) falls today when oil is put into storage but rises by an even larger amount in the future when oil is in short supply and speculators move their stocks out of storage. Q

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. Instructor Notes:

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. Instructor Notes: From the USA Today, “Can Fuel Hedges Keep Southwest in the Money?” by Dan Reed, July 24,2008” “Using some simple and some complex investment strategies, Southwest has for a decade locked in the prices it pays for large amounts of jet fuel months and even years ahead of time. Its success at that has protected it from run-ups in crude oil prices and dramatically cut its fuel expenses. Since 1998, it has saved $3.5 billion over what it would have spent if it had paid the industry's average price for jet fuel. That's equal to about 83% of the company's profits over the last 9½ years. … A hedge is a financial instrument that reduces risk. It can be a futures contract, an option to buy or sell a commodity or an agreement to trade commodities that's tied to specific dates or prices. For example, if a company anticipated jet fuel would increase to $4.50 a gallon next year, it could agree now to pay $4.25 a gallon for that fuel on specific dates next year. If the hedge works, it saves 25 cents a gallon on the average price next year. The oil producer selling the hedge would agree to sell at $4.25 as a hedge against a possible drop in prices next year.”

Prices and Speculation A Prediction Market is a speculative market carefully designed so that prices can be interpreted as probabilities and used to make predictions. Iowa Electronic Markets Hollywood Stock Exchange Instructor Notes: From Forbes, “The Odds for Obama, Biden, Palin, and McCain” by Joshua Zumbrun, September 3, 2008” “St. Paul, Minn. - As most political pundits gab about who will win and why, and how much of a bounce John McCain will get from Sarah Palin, or Barack Obama from his convention, others quietly put their money where their mouth is. On Intrade.com, armchair pundits can place bets on the likelihood that a political outcome will come to pass. A low-volume market has developed for who will win the presidency, whom candidates will select as their vice presidents, who will win control of Congress and many other bets. The idea is that a market like Intrade will be predictive--that if enough people play, it will become a leading indicator of public sentiment, much as a publicly traded stock might move up in anticipation that a merger will be completed. The prediction market's track record is mixed. In early August, Intrade suggested a 30% chance that the Democratic running mate would be Virginia Gov. Tim Kaine, and a 40% chance it would be former Sen. Birch Bayh. But as August progressed, before Obama made an announcement, Sen. Joe Biden's stock began, literally, to rise. From under 20% at the beginning of the month his shares rose steadily. By Aug. 22, when the announcement finally came, the market had identified Biden as far and away the most likely candidate. But with the Republican vice presidential candidate, the market missed spectacularly, seeing virtually no chance that Palin would be chosen. Mitt Romney was heavily favored prior to the announcement. A criticism of Intrade, spelled out by market researcher and blogger Barry Ritholtz, is that people make million- and billion-dollar bets in real markets, whereas at Intrade the bets are maybe in the thousands. This means bettors might be influenced by wishful thinking more than a make-or-break incentive to be correct or go bankrupt, and the knowledge of the market participants might be mostly limited to what they're seeing in the news. Wednesday morning, Intrade added a new wager: the odds that Palin will be withdrawn from the ticket. Since the surprise announcement about her selection last week, she has announced that her 17-year-old daughter is pregnant, and an ongoing ethics investigation in which she is involved has received a great deal of publicity. At the time of writing, Intrade said there was a 14% chance she would be withdrawn. A withdrawal would likely be a catastrophe. George McGovern announced, and later withdrew, Thomas Eagleton as his vice presidential running mate in 1972. In the middle of the Vietnam War, McGovern and Sargent Shriver, Eagleton's replacement, went on to win 17 electoral votes. The best-traded political market is for the result of the presidential election. Intraders give Obama a 60% chance of winning, a figure that has budged little in recent weeks. Sound like biased nonsense? All wishful thinking on the part of liberal traders, who would be delighted with a Palin withdrawal and Obama victory? If so, the strategy would be to sign up and bet against them. If bettors are systematically making biased bets, you could still pocket a pretty penny correcting the market. The volume may be small, but the money people win is quite real.”

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. Instructor Notes:

Speculation occurs in stocks as well as commodities 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? Instructor Notes:

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. Instructor Notes:

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. Instructor Notes: