Given the first two principles of economics (We live in a universe of scarcity and We have unlimited desires), we have to make choices about how to allocate scarce resources. Resources can be allocated through the Market or the Government, see page 55. Economics is largely the study of resource allocation (analysis of decision making, choice), and can be used to study both how the Market allocates scarce resources and how the Government allocates scarce resources. For example, the important economic concept of OPPORTUNITY COST applies equally to the market and government decisions.
Also, since perfection is never an option: Under what conditions might the Market fail and under what conditions might the Government fail? Fail = fail to achieve efficient or optimal results from the overall viewpoint of society as a WHOLE. Failure to maximize overall social welfare of society.
Chapters 3 and 4 cover the Market Economy.
CHAPTER 3: QUOTES - "From the point of view of physics, it is a miracle that 7m New Yorkers are fed each day without any control mechanism other than sheer capitalism." Also quote by Hayek.
Market mechanism is so efficient at coordinating econ activity, that we take it for granted. Consider:
Soviet story - they thought that there was a central command post somewhere sending out orders. They couldn't believe that our economy could operate so efficiently without some type of central planning.
We look at a pure market economy and analyze the market process, even though most societies have some combination of government intervention. We assume that the market is totally free from intervention. Prices are set by market forces without interference, for example.
Hayek: "Spontaneous Order." Think of the English language or the Internet. Who is in charge of the English language or the Internet? Order comes about spontaneously, without conscious control, or central planning. Perhaps much of the economy operates similarly, without the need for control or interference?
Most economic goods and services (houses, food, clothing, cars, appliances, computer, etc.) in the market get allocated by PRICES. Economics is also called Price Theory, especially Micro. The market forces of Supply and demand describe how the price system works, and helps us understand how the market allocates scarce resources. We look at basic micro price theory, to understand the basis of econ activity, the micro foundations of macro.
Question: Only several thousand Steinway grand pianos are
built each year worldwide. How does the market allocate these pianos?
CONSUMER CHOICE AND THE LAW OF DEMAND
The Scientific Revolution was based on the fact that we finally understood that there were irrefutable, universal scientific laws that govern the physical universe and we had to determine what those laws were - Law of Gravity, the Law of Thermodynamics, the Laws of the Physical Universe, etc. The Scientific Revolution provided the framework and foundation for the later Industrial Revolution, the rise of the Machine Age.
There are also irrefutable, universal Laws that govern the Econ universe. We look at some of those now.
Law of Demand - Inverse relation between price and quantity demanded. We want to get as much satisfaction (utility) from our limited income, so we choose to maximize our purchasing power. Ceteris paribus, the lower the price of something, the greater the probability that we will buy it, or we will buy more of it. The higher the price, the less likely that we will buy it, or we will buy less of it.
Example - when grapes are $3/lb., we either don't buy grapes, or we buy fewer. If grapes are $1/lb.. we are more likely to buy grapes and we also buy more.
Example - When airfares are on sale, we are more likely to travel and we may travel more often. Two trips vs. one trip.
Example - VCRs used to be $1000-1400, only 1/2m were sold. Price fell to $200 and 12m were sold!
We can represent the Law of Demand graphically, using S and D analysis, like on page 59 showing the Demand curve or schedule for Cell Phones. When cell phones cost $143/month, only 2.1m Consumers, being price sensitive (WHY??), purchased cell phones. When prices came down to $41/month, 69m consumers bought cell phones.
Law of Demand and the cell phone example reflect the fact that as Consumers, we like LOW PRICES, ceteris paribus. However, consumers aren't ONLY interested in price, we also consider what? What is it that we want to MAXIMIZE?
The availability of substitutes dramatically influences our behavior as consumers. Part of the reason, we buy less at higher prices is the availability of substitutes. Substitutes are competitive or similar products. Consumers will switch from one product to a substitute product, depending largely on PRICE. Examples of substitutes?????
Remember: THERE ARE SUBSTITUTES FOR EVERYTHING!!
Examples: The price of butter goes up, we buy less butter and more margarine. The price of grapes goes up, we buy bananas. Airfares go up, we travel by car or train. Gas prices go up, we substitute carpools, bicycling, smaller cars, fewer trips, walking, motorcycles for gasoline. Marriage is a substitute for oil?
Availability of good, close substitutes determines consumer responsiveness to price changes.
Few substitutes available - consumers are NOT as responsive/sensitive
to price changes.
Many good substitutes - consumers are VERY responsive/sensitive
to price changes.
Examples: Dental services. Assume that prices double. How would consumers respond: Fewer trips to the dentist. Substitutes? Limited: painkillers, live with missing teeth, faith healers, UM Dental school, etc. Poor substitutes for dental services, or health services in general. Consumers are not very responsive to price increases. What close substitutes exist for going to a physician, or a surgeon?
Florida vacation. Assume that prices double. How would consumers respond? Many good substitutes: vacation in Michigan/Canada, Chicago, Detroit, stay home and watch movies, etc. Consumers are very responsive to price changes.
See page 61. The steepness/flatness of a demand curve reflects HOW sensitive consumers are to prices for different goods/services. When consumers are VERY price sensitive, when there are LOTS of good substitutes, the Demand Curve is FLAT, and we say that demand is ELASTIC (sensitive, responsive) to price changes.
When consumers are NOT very sensitive to prices, NOT good substitutes available, then demand is called INELASTIC, and the Demand Curve is STEEP. Examples on page 61. For tacos, SMALL price changes result in LARGE changes in quantity purchased. For gasoline, LARGE price changes result in SMALL changes in the amount purchased.
In both cases, the Law of Demand tells us that Price Increases
result in a reduction in Quantity Demanded. Elasticity is a more precise
measure that tells us HOW MUCH quantity demanded will fall with a price
increase.
CONSUMER SURPLUS (CS)
An important concept describing consumer choice, reflecting the difference between the MAX Price a consumer is willing to pay and the actual price - the Market Price.
Consumer Surplus = MAX PRICE YOU WOULD PAY - MARKET PRICE
Example: You find an item at a garage sale that you would secretly be willing to pay $3 for, and it is marked $1. Your consumer surplus is $3 - 1 = $2. It is an estimate of your gain from voluntary exchange, which is always WIN-WIN. Or you buy a $100 sweater on sale at Marshall Fields for $20, you may have actually been willing to pay $25, you get a $5 consumer bonus, or Consumer Surplus.
The total value of Consumer Surplus (CS) to ALL consumers can
be reflected using the Demand Curve, as on page 60. It is the area
underneath the Demand Curve, above the Market Price of P1, and
represents the Net Gain to all consumers from market exchange at a price
of P1. If the price falls, CS increases, and if the price
rises, CS falls.
SHIFTS (CHANGES) IN DEMAND VS. CHANGES IN QUANTITY DEMANDED
The Demand curve isolates the effect that price has on Qd (Law of Demand), holding everything else constant, ceteris paribus. With a Demand Curve, you give me a Price and I can tell you how much will be purchased at that Price.
Qd = f (P) ONLY!!!
D (f) = (Price of subs, Price of complements, Income, Tastes, Demographics,
expected P, etc.)
A change in quantity demanded is a movement along the curve, shows (isolates) the response of Qd to a change in Price. Due to graphical constraints (two dimensions, we are restricted to showing the relation of two variables along the curve). All other changes we show with a shift in the ENTIRE demand curve.
Example of common mistake: "As a result of higher gas prices, the demand for gas fell." This is technically incorrect. A change in prices caused the Quantity Demanded to change!! It should read: "As a result of higher gas prices, the quantity demanded fell."
RULE: A change in PRICE leads to a CHANGE IN QUANTITY DEMANDED (movement along the demand curve), a change in any other variable leads to a CHANGE IN DEMAND (shift in the entire demand curve.
See graph page 62: Movement A (change or reduction in Qd)
versus Movement B (Increase in Demand).
INCREASE in Demand: Demand curve shifts to the RIGHT.
DECREASE in Demand: Demand curve shifts to the LEFT.
Notice visually that Movement A is MUCH different than Movement B. To be economically precise, we need a different term for each separate, distinct movement or change. We are trying to understand, model and analyze dynamic change in the economy, and need to be able to distinguish between two VERY different changes.
WHAT CAUSES DEMAND for X TO SHIFT (CHANGE)?
Changes in other variables BESIDES THE PRICE of X, that also affect consumer choice, affect DEMAND: Changes in income, changes in the size of the market (# of consumers), changes in the Prices of Related Goods (Y) - goods that are either Substitutes or Complements, changes in the expected price of X in the future, demographic changes, and changes in tastes and preferences (fads, fashion, trends in lifestyles, music, food, clothing, etc.). See page 64 for a summary:
1. A rise (fall) in consumer income will increase (decrease) demand. (Economic conditions, recession or expansion, affect demand)
2. An increase (decrease) in the number of consumers in the market would increase (decrease) demand. (Is the market expanding or contracting?) See page 63 - when student population falls in summer, the Demand for pizza falls.
3a. If the Price of Substitute product (Y) goes up (down), D for X increases (decreases). Example: Price of Pepsi goes up, Quantity demanded for Pepsi goes down, Demand for Coke INCREASES.
3b. If the Price of a product (Y) that is a complement for X goes down (up), Demand for X INCREASES . Complements: products used together, like CDs and CD players, VCRs and videotapes, cars and gas, etc. If the price of CD Players goes down, demand for CDs will INCREASE. If the price of gas falls, the demand for cars would go up.
Price of listening to music = price of CDs + price
for CD player
Price of driving = price of car + price of gas
4. Expectations about future price influence our decision to buy NOW or LATER. The Demand Curve reflects our willingness to BUY NOW (vs. later). If we expect price of cars to go up in the future, we INCREASE our demand now. Example: Russia announced that vodka prices would rise in one month. What happened? If we expect prices to fall (go on sale) in the future, we will DECREASE demand now. What happens when computer prices are expected to fall?
5. Demographic changes that are either favorable to a market will INCREASE demand. Example: People are living longer, so the number of retired people (as a percent of the population) has increased. Demand has increased for retirement homes in Florida, RVs, cruise vacations, etc.
6. Changes in Consumer Tastes/Preferences in food, fashion, music, etc. Example: People are more health conscious now, Demand has INCREASED for what? Demand has DECREASED for what?
PRODUCER CHOICE AND THE LAW OF SUPPLY
Producers/suppliers/firms transform raw materials into goods desired by households and sell final products to consumers. GM transforms raw materials like steel and plastic and glass and fabric into automobiles. All those materials could be used for other purposes/production, so that those materials have to be "bid away" from other potential uses. The cost of production and the final retail price must represent the OPPORTUNITY COST of those materials if they had been used elsewhere.
Example: if gold is made into jewelry, it has to be bid away from alternative uses in dentistry. To use gold in dentistry, it has to be bid away from jewelry production. If redwood is used to build houses, it has to be bid away from the production of picnic tables. If universities hire accounting professors, they have to be bid away from accounting practice.
Example: If a firm leases a building, it pays rent. If it buys a building by financing it with a mortgage, it pays interest. Rent and interest are accounting business expenses. However, if a firm owns its own building outright (no debt), there is still an economic cost for the building in the form of OPP COST. What is the OPP COST of using the building? Illustrates the difference between ECON COST and ACCTG COST.
Firms in a market economy operate under a Profit and Loss system. Profits occur when a firm has sales revenue that exceeds all costs of production (TR > TC). Losses occur when a firm's revenue is less than its cost of production (TR < TC).
Profits and losses provide discipline by rewarding successful firms with profits and products and penalizing unsuccessful firms and products. Firms that are successful at pleasing consumers expand and those that don't please consumers will contract or go out of business. Resources are allocated away from unsuccessful firms toward successful firms and products.
"Consumer sovereignty" Consumers are kings and queens in the market.
Examples: Two unsuccessful products - New Coke in 1985 and Cadillac Allante in 1987. In both cases, consumers rejected these products and they were taken off the market. Coke and GM were disciplined by the market in the form of losses on these products.
Examples: one restaurant is very successful, makes profits and one is very unsuccessful, loses money. Profits of the successful restaurant allow it to expand, get bigger, open up a new branch, start franchising, etc. Profits are a signal that the owners are pleasing consumers. Profits provide resources to successful firms to expand. Many national chains and franchises started originally with ONE STORE - Wal-Mart, McDonalds, Dominos Pizza, etc.
The restaurant that loses money is disciplined. Either they figure out how to make money/please consumers or they go out of business. If they go out of business, resources are freed up to go to successful firms/restaurants - workers, land, building, equipment, capital (business loans), etc.
Profit/loss system guides and directs market activity without any central control. Decentralized organization.
Law of Supply - there is a direct/positive relation between Price and the Quantity Supplied by firms. At a higher price, the producer has a greater incentive to supply goods and services.
Examples: If milk (corn, soybeans, etc.) prices are high, farmers will try to produce more. If oil prices are higher, oil producers will try to supply more. If overtime wages are high, workers will supply more labor. 45 hours vs. 40 hours.
Supply curve, page 67. Represents two things:
PRODUCER SURPLUS - A concept similar to Consumer
Surplus, applied to the Supply (Sellers) side of the market. Producer
Surplus = Market Price - MIN Price a Seller/Supplier is willing to accept.
Example: A musician would be willing to play for $50 and actually
gets offered $200, creating $150 surplus. See page 68. PS represents
the net gains to producers from production and exchange, and includes the
net gains to all resource owners. Example: PS for GM represents
the gains to the workers, owners (shareholders), and owners of all inputs
and resources used to build cars.
ELASTIC AND INELASTIC SUPPLY CURVES
From the Law of Supply, we know that an increase in Price
will lead to an increase in the Quantity Supplied. The degree of elasticity
tells us how much Quantity Supplied will increase, measure the responsiveness
of suppliers to price changes. See page 69, illustrates the difference
between Elastic Supply (very responsive to price changes) in Panel a, and
Inelastic Supply (very unresponsive to price changes) in Panel b.
Panel a: Price goes from $1 to $1.50, Elastic Supply goes
for soft drinks goes from 100 to 200 (2x increase) for soft drinks.
Panel b: Price goes from $100 to $150 (same percentage
increase as for soft drinks, 50%), and inelastic supply of physician services
only goes from 10 to 12 (1.2x increase).
Example: Wages for unskilled labor goes from $5 to $10/hour because of a new mall or factory or a special event (Buick Open) vs. Wages for skilled computer programmers goes from $50,000 to $100,000 because of Y2K. Illustrates the important concept of SHORT RUN vs. LONG RUN.
Long run (LR) - time period long enough to make changes in property, plant, equipment, education, training, etc.. Example: build a new factory addition, close a factory/plant, get training as a computer programmer, engineer, etc. Time period that allows major expansion or contraction of operation.
Short run (SR) - time period short enough that major changes cannot be made in property, plant or equipment. Can make changes in labor and/or raw materials. Capacity constraint of some sort. One year or less, arbitrary period.
In the above example, the supply of unskilled workers should
be fairly elastic (responsive) in the SR since no training is required for
these jobs. Many currently unemployed people would be willing to work
part-time if the wages were high enough, like whom?????? Skilled work
many times requires years of training (engineering, software design, physicians,
etc.), so it would time to get trained or retrained to take advantage of
the higher wages.
SHIFTS (CHANGES) IN SUPPLY VS CHANGES IN QUANTITY SUPPLIED
Supply curve summarizes the willingness of producers to offer a product at different prices. We distinguish between a 1) Change in Quantity Supplied and 2) a Shift/Change in Supply. See page 70.
Change in Quantity Supplied - movement along a supply curve. Change in Supply - entire supply curve shifts. What causes a movement along a supply curve? What causes supply curve to shift?
INCREASE IN SUPPLY: Supply curve shifts to the RIGHT.
DECREASE IN SUPPLY: Supply curve shifts to the LEFT.
(HINT: Remember that the horizontal axis (Q) is the reference. A shift to the RIGHT is an INCREASE for both D and S, a shift to the LEFT is a DECREASE for both D and S.)
Profit seeking producers will only produce goods when price is greater than cost. TR (SLS) > TC. Factors that INCREASE the OPP COST of producers will discourage production - Decrease supply - shift to left.
Factors that DECREASE the OPP COST of production will make suppliers more willing to produce, and supply curve will shift to the right.
Factors that will Shift Supply:
1. Changes in Resource (Input) Prices - wages, parts,
supplies, raw material, interest rates, etc.
If resource prices fall, the Supply Curve shift out (increases).
If resource prices rise, the Supply Curve shifts back (decreases).
Example: Page 70. Gasoline is produced from crude oil, so crude oil is an input for gasoline. If the price of crude oil increases, the supply curve for Gasoline decreases (shifts to the LEFT). If the price of crude oil falls, the Supply Curve would Increase of shift out, shift to the RIGHT.
Most resources have gotten cheaper, so that supply curves have shifted out over time, resulting in lower prices.
2. Changes in technology. Like lower resource prices, technological improvements - discovery of new, lower cost production reduce the OPP COST of production, and INCREASE SUPPLY and shift the supply curve to the right.
Example: VCRs. Technological improvement reduced the opp cost of producing VCRs, making it more profitable/attractive to make VCRs. Also, more firms entered the industry, shifting the supply curve. VCR prices went from $1400 to less than $200.
Example: chicken egg industry. Costs were reduced by 80% over the last 50 years. In this case, there was a reduction in number of suppliers from thousands of chicken farmers to less than one hundred.
Falling prices for electronic goods, computers, appliances, etc. reflect improvements in technology, leading increased efficiency and lower costs of production, and lower retail prices.
3. Nature and Politics can affect Supply. Unfavorable weather (droughts, floods, freezes, earthquakes, etc.) and political disruptions (Gulf War crisis, OPEC, trade barriers) can DECREASE SUPPLY, shift the Supply Curve to the LEFT. Favorable weather and favorable political events (e.g. reduction of trade barriers) can INCREASE Supply and shift it to the RIGHT.
4. Changes in Taxes affect Supply. Taxes on producers (excise taxes, VATs) increase the cost of production, and will DECREASE the Supply, shifting it to the LEFT. Lower taxes will INCREASE supply and shift Supply to the RIGHT.
5. Changes in the Number of Firms in the Market. If
the number of firms increases, Supply increases (shifts to the right), ceteris
paribus. If the number of firms decreases, Supply decreases (shifts
to the left), ceteris paribus. When profits ($) or returns (%) are
above average in an industry, the number of firms in that industry will
increase. When profits or returns are below average, the number of firms
in that industry will decrease.
SUMMARY: Anything that lowers the cost of production (lower resource prices, more efficient product because of technology, favorable weather, lower taxes) or increases the number of firms will INCREASE SUPPLY. Anything that raises the cost of production (higher resource prices, less efficient production, unfavorable weather, higher taxes) or decreases the number of firms will DECREASE SUPPLY.
If PRICE goes up (down), the Quantity Supplied will increase
(decrease).
See Thumbnail Sketch, page 72.
MARKET PRICES AND THE INTERACTION OF SUPPLY AND DEMAND
MARKET: Abstract concept describing trade that takes
place according to the laws of supply and demand. Example: the labor
market, the academic labor market, the market for economics professors, the
market for college grads, the market for engineering grads, the stock market,
the market for used pianos/used cars, the farmers market, the foreign exchange
market, Ebay, etc. Equilibrium - when the conflicting forces of Supply
and Demand are in balance, the market is in Equilibrium. The natural
state of a market, or the state that the market is always moving towards.
Equilibrium = Market-clearing = (Qd = Qs). No shortages,
no surplus. See page 73, for an example of equilibrium in the market
for calculators. At a price of $10, the market is in equilibrium, there
is "market clearing," balance between supply and demand, Qd =
Qs, no shortage, no surplus, etc. At all other prices besides $10, the market is out of
equilibrium. Usually can only happen in the LR with artificial price
controls, might happen in the SR if the producer or store overprice or underprice
a new product. The market will naturally gravitate towards equilibrium.
Example: Price is initially set at $13 per calculator, $3 over the
market clearing price. At $13, suppliers want to supply 625/month, consumers
are only willing to purchase 400/month. There is excess supply, Qs
> Qd. The excess supply puts downward pressure on price.
What would the conditions be like at Target if this was the case (P=$13)???
At a price of $7, consumers want to buy 700 calculators,
but suppliers only are willing to supply 475. Qd > Qs.
There is a shortage of calculators. What would the conditions be like
at Target if this was the case (P=$7)??? Economists generally support market prices and oppose price
controls because a) unregulated market prices generally result in equilibrium
outcomes and b) price controls almost always prevent the market from reaching
equilibrium. What are the indications that a market is out of equilibrium?
EFFICIENCY AND MARKET EQUILIBRIUM
Market equilibrium is important because it represents an
outcome where Economic Efficiency is present. Economic efficiency is
achieved if all the gains from trade have been realized, the amount of voluntary
exchanges have been maximized. We can also discuss economic efficiency
in terms of Cost-Benefit analysis. Activity and actions where the Benefits
> Costs are desirable/efficient, and actions where the Costs > Benefits
are undesirable/inefficient, and should be avoided. See page 74, the Net Gain to Buyers and Sellers is the
shaded area, which represents CS + PS. Market equilibrium is important,
because it represents the amount of trade that MAXIMIZES the Net Gain to
Society. For example, any deviation from the market price in the form
of a price control (Min Wage or Rent Control) would reduce the Net Gain to
Buyers and Sellers, by preventing some mutually beneficial exchanges from
taking place. MARKET ADJUSTMENT TO CHANGES IN SUPPLY AND DEMAND
See page 75. Demand and
Supply schedules for eggs. Demand INCREASES annually around Easter.
Demand increases from D1 to D2, causing equilibrium
to move from point A to B. Price goes up from P1 to P2,
Quantity from Q1 to Q2. (Sequence of changes: D increases,
P rises, Qs increases - movement along the ORIGINAL Supply Curve.
Note that Supply has NOT changed.) Eggs typically increase by 20 cents
per dozen around Easter. Higher prices benefit society by transmitting information
about scarcity, changing incentives, and coordinating economic activity.
Assume we start to run out of oil, resulting in higher prices for gas. Higher
prices reflect an increase in relative scarcity (or relative desirability),
and change incentives. For example, how do consumers respond to higher
prices? By switching to substitutes and conserving on their purchases
of the now more precious, scarce resource. How do producers respond
to higher oil prices? By trying to produce more, find more, etc. and
by trying to find alternative, substitute products ( like what for oil???).
A decrease in Demand has the opposite effect: Lower prices
and a reduction in Quantity Supplied. Changes in Demand transmit information
from consumers to producers, and help coordinate economic activity through
the PRICE SYSTEM. See page 77 for an illustration of a DECREASE in SUPPLY,
using the shortage of Romaine lettuce in 1998 as an example. Unfavorable
weather caused a DECREASE in Supply from S1 to S2,
leading to higher prices and a reduction in Qd (movement along
demand curve D). Sequence of events: S falls, P rises, Qd decreases.
D is CONSTANT. Incentives: Consumers now moderate purchases, conserve
on lettuce, switch to Substitutes. Producers try to increase production,
find alternatives. SEE Thumbnail Sketch, Page 77. TIME AND THE ADJUSTMENT PROCESS
In the long run there is more time for adjustment of behavior,
adjustment of demand, supply, etc. Graphically - Example, page 78. Late 1970s, political
turmoil in Middle East, led to sharp reduction in supply. Price went from
70 cents/gal to $1.20 in short run, from point a to point b. Quantity demanded
went down from 7.4 to 7m bbls. gas/day in the short run. Given time to adjust,
consumers changed behavior, found SUBS to cut down on their previous consumption.
In the long run, consumers responded more than in the short run. Price fell
to $1 and the amount of gas purchased fell to 6.6m, as Demand became MORE
ELASTIC, flattened out. Supply side - Example: Page 79. Increase in demand
for notebook computers. Point a to Point b in SR, and from Point b to Point
c in LR, as Suppliers had more time to adjust, increase production.
Supply is MORE ELASTIC in the LR than in the SR. POINT: DEMAND AND SUPPLY ARE MORE ELASTIC IN THE LR
THAN IN THE SR. Important economic principle stated by Adam Smith in 1776.
By trying to make your own life better, you make society better off.
Why? To make your life better, you pursue what you are best at. And
by pursuing your own self- interest, you automatically benefit others. See
Adam Smith quote on p. 80. Textbook p. 80: "The tendency of market
prices to direct individuals pursuing their own interests into productive
activities that also promote the economic well-being of society." Another way to think of the invisible hand: "It is something of
a miracle that individual selfish decisions must lead to a collectively
efficient outcome." (Steven Landsburg in the book "Armchair Economist,
p. 198.) Example: think of inventions. Washing machine, microwave
oven. Producers exploit consumers? How can Target exploit anyone?
Consumers exploit producers? The value to society of Microsoft is greater
than the wealth of Bill Gates? The value to society of the washing machine
is far greater than the wealth of the inventor. Only way to make money in the market is to serve others....
ROLE OF MARKET PRICES AND THE INVISIBLE HAND
1. Transmit information - information content of prices.
We cannot directly observe consumer preferences. Even if we took a lengthy
survey, it would be hard to get consumers to reveal exactly what it is that
they want. For example: Questions: If we want to know whether consumers like ballet more than
pro wrestling, we see how they voted in the marketplace. If we want to see
whether people like Lee or Levis jeans, we look at how much they spent. Spending
money transmits very valuable information to producers about what we like.
And there is no guessing or estimating, it is very accurate information.
Information about our preferences is in our heads, and
the only way to extract it is to observe our econ decisions. Suppliers are
able to extract our desires through the price system. They can get inside
our heads. Marketplace is like a process of a continual, ongoing referendum
about consumer preferences. Market economy is a "virtual voting booth."
Market prices are a consensus of the opinions of millions of consumers.
And suppliers send us information about the opp cost of
production. If production becomes cheaper, it is reflected in lower prices.
If production becomes more expensive, it is reflected in higher prices. Or
if the supply is increased (oil, corn), prices transmit that info to us.
Prices are a measure of relative scarcity, they transmit very valuable information
about the relative scarcity of a good. Market prices are an important summary statistic
of all available information about the conditions of supply and demand,
and provide market participants with very valuable, very accurate and up-to-date
information about consumer preferences, relative scarcity, opp costs of
production, future supply, technology, political conditions, weather, etc.
Giant feedback loop. Self-correcting mechanism. 2. Prices coordinate Economic activity between buyers and
suppliers. If suppliers make more than consumers want to buy, there will
be an excess supply, prices will be forced down, producers will supply less,
and balance will be restored. Activities of consumers/producers are coordinated.
If consumers want more that is being supplied, that desire is transmitted
because there is a shortage. Producers supply more, the price goes up, consumers
start to economize and demand less, and equilibrium is restored.
Entrepreneurs are constantly engaged in a "discovery" process,
where they are trying to figure out what we want. Our tastes are always changing,
so it is a continual process of searching for successful products. Every
year, there are new fashions, new movies, new music releases, new cars, new
food products, new appliances, new books, new software, new electronics goods,
new TV shows, etc. Prices and "dollar votes" express our opinions, and it
is like there is a continual flow of information between buyers and sellers
through the price system. Market prices thus coordinate econ activity....
3. Prices correctly influence incentives, or Prices
motivate people. a. Market prices create an atmosphere of incentives that
motivate people. Prices are the foundation of the profit/loss system that
creates a reward/penalty system of econ organization. Market prices for our
labor service motivate us to study and prepare for years through education
and training to develop our human capital. No one has to force you to be
here - expectation of a financial reward provides motivation.
b. No one has to tell GM to find the least cost method
of production. Profit system guarantees that they will automatically.
c. If prices change, incentives change automatically and
behavior changes are always correct. For example, oil supplies are disrupted
for whatever reason: political problems, OPEC, running out, etc., oil supplies
are cut in half. Oil prices double reflecting the increased scarcity. No
one has to be told to conserve. People conserve automatically to save money.
By conserving a now more precious resource, consumers are responding exactly
appropriately. At a higher price, suppliers are now more willing to supply
a now more precious resource. They will try to find more oil, increase exploration.
It will also automatically stimulate search for alternative fuels sources
- wind, solar, etc. 4. By transmitting information, coordinating econ activity,
and providing incentives and motivation, $11T of GDP gets coordinated without
any form of central planning or control with market prices. Supermarkets
almost never have shortages or surpluses. You could go to almost any restaurant
in any city in the US and order anything off the menu. You could move to
any city in US and find a house or hotel. None of this is planned in any formal,
systematic way. Prices and profits guide the invisible hand of self interest
and maximize consumer satisfaction, optimize production and maximize our
standard of living. Prices are the basis of the self-correcting mechanism of
the free market by transmitting valuable, accurate information as part of
the feedback loop of the market. People associate order in the market with central direction
or planning. Not the case. "Spontaneous order" - think of language,
for example. Internet. No zoning - where? Our discussion of the efficiency of the market economy
is dependent on 1) competitive markets and market prices and 2) well-defined
property rights. Competition, the GREAT REGULATOR, protects both the buyer
and the seller. As consumers, we have many firms competing for our business.
We can shop at Target, Wal-Mart or KMart, and the intense competition forces
the suppliers to offer us low retail prices, good service and high quality.
The fact that Target, KMart and WalMart have alternative suppliers, puts
competitive pressure on wholesalers to offer low wholesale prices to suppliers.
The fact that there is competition between employers to hire workers puts
upward pressure on wages, and forces firms to pay competitive wages for workers.
Market prices help the market economy to self-correct,
by providing an automatic feedback loop. Private property rights force owners
to pay the full cost of any misuse, and guarantee that potential buyers
will have to pay the market price for private property. Example:
real estate. Problems 1, 6, 12, 13, 14
INVISIBLE HAND PRINCIPLE
Answers to these questions could be misleading or inaccurate,
because we are very fickle as consumers, we change our mind all of the time.
Talk is cheap, but when we spend our own money, we make very strong statements
about what we like/dislike. You our dollar votes transmit very valuable
information about our preferences. We tell producers/suppliers what we like
by what we spend money on and how much we spend.
QUALIFICATIONS