1. Longwood University 201 High Street Farmville, VA 23901
Personal Finance
Scott Wentland
Longwood University 201 High Street Farmville, VA 23901

2. Markets, Information, and Incentives

3. 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”

4. 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

5. 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…

6. 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

7. 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

8. 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

9. 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

10. 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?

11. 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

12. 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.

13. 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

14. 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?

15. 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

16. 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

17. 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!

18. 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

19. 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?

20. 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!

21. 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

22. 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

23. 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”)

24. 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

25. 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

26. 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

27. 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

28. 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

29. Thank You http://en.wikipedia.org/wiki/Supply_and_demand