QUOTE - "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."
Market mechanism is so efficient at coordinating econ activity, that we take it for granted. Consider:
There are 260m people, 67m families, 135m workers and 7m companies in US. How does $8T of annual economic activity get coordinated? What prevents constant surpluses and shortages?
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.
Scarcity Requires Rationing
When goods are scarce, rationing becomes necessary. How to ration?
Price - highest bidder (auction, job market, sports) or willingness to pay (McDonald's, Hudson's, Aretha Franklin tickets, Steinway pianos, etc.)
Most economic goods and services (houses, food, clothing, cars, appliances, computers, CDs, dry cleaning, piano tuning, gasoline etc.) get allocated by PRICE. Econ is Price Theory. Supply and demand describe how the price system works. We look at basic micro price theory, to understand the basis of econ activity, the micro foundations of macro.
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.
There are also Laws that govern the econ universe. We look at 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 less. If grapes are $1/lb. we are more likely to buy grapes and we 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 $400 and 12m were sold!
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. 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 substitutes determines consumer responsiveness to price
Few substitutes - consumers are not as responsive/sensitive to price changes.
Many 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 service. Consumers are not very responsive to price increases.
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.
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 opp 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.
Firms operate under a profit and loss system. Profits occur when a firm has sales revenue that exceeds all costs of production. Losses occur when a firm's revenue is less than its cost of production.
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.
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 quantity supplied by firms. At a higher price, the producer has a greater incentive to supply goods and services.
Example: if milk prices are high, dairy 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.
Supply curve, page 62. Represents two things:
Example: Supply of labor. The wage(price) paid is the value of your talents in terms of opportunity cost, your next highest valued opportunity.
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, etc.
Equilibrium - supply and demand are in balance. Market-clearing. Qd=Qs. No shortages, no surplus.
Short run vs. long run - important distinction in econ.
Long run - time period long enough to make changes in property, plant and equipment. Example: build a new factory addition, close a factory/plant. Time period that allows major expansion or contraction of operation.
Short run - 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.
See p. 64 Example. Playing cards
At a price of $10, there is equilibrium, market clearing, balance between supply and demand, Qd=Qs, no shortage, no surplus.
At all other prices besides $10, the market is out of equilibrium. Usually only happens due to price control. Example: price is set at $13, $3 over the market clearing price. At $13, suppliers want to supply 625/month, consumers only want 400/month. There is excess supply, Qs>Qd. The excess supply puts downward pressure on price.
At a price of $7, consumers want to buy 700, and suppliers want to supply 475. Qd > Qs. There is a shortage of cards.
Examples: Price ceiling. Rent control in NYC, Berkeley, 200 cities in US. Common in Canada and Europe.
Econ theory predicts the following from rent control (page 77):
Rent control seems like a good idea, but the long term consequences have been disastrous. The only way to more efficiently destroy a city than rent control is to bomb it.
Price Equalization Principle - the tendency for prices to
the world due to market forces (except for price differences due to transport
costs and tax differences).
Example: Price of gold should equalize and sell for the same price all over the world. What would happen if P=$300/oz in Canada and P=$325 in U.S.?
Example: cigarettes should sell for about the same price in every state, except for tax differences and transportation costs.
Point: costs of transportation are usually so low, that price differences due to transportation costs are usually small.
Price discrepancies create "arbitrage" opportunities. Profit seeking traders will buy low and sell high to make riskless profits. The "smell of profits" attracts profit seekers.
Rate-of-return equalization principle. Rates of return on investments will tend to equalize towards a risk-adjusted normal rate of return. Smell of profits attracts investors. If one industry is very profitable, generates high rates of return, it attracts investors, and returns are lowered.
Example: hotel industry in Orlando is very profitable, investors in hotel are generating very high rates of return of return. Smell of profits attracts investment, more hotels are built, returns fall to a normal level.
Example: coffee houses very profitable.
Example: investments in Turkey generating high rate of return. Attracts investment.
Example: certain industry is very unprofitable. Too much competition, or a declining industry results in very low rates of return. Firms exit the industry. Less competition, remaining firms become more profitable, returns increase.
Example: piano industry. Baldwin, Steinway.
SHIFTS IN DEMAND VS. CHANGES IN QUANTITY DEMANDED
Qd is a function of many factors. Demand curve isolates the effect that price has on Qd, holding everything else constant.
Qd = f(P)
D(f) = (P subs, P complements, Income, Tastes, Demographics, expected P)
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 vars along the curve). All other changes we show with a shift in the demand curve.
See page 68. Movement along the demand curve (change in quantity demanded) vs. a shift in the demand curve. Doorknobs. If price of doorknobs fall, quantity demanded will increase, Arrow A. If income increases and there is a housing boom, the demand curve will shift out, Arrow B.
MARKET ADJUSTMENT TO AN INCREASE IN DEMAND
See page 68. Demand schedule for bicycles. Shift in demand due to increased interest in exercise. Shift from D1 to D2, go from point A to B. P1 to P2, Q1 to Q2.
SHIFTS IN SUPPLY
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.
Change in quantity supplied - movement along a supply curve. Change in supply - entire supply curve shifts. What causes supply curve to shift?
Profit seeking producers will only produce goods when price is greater than cost. SLS > TC. Factors that increase the opportunity cost of producers will discourage production - decrease supply - shift to left.
Factors that decrease the opportunity cost of production will make suppliers more willing to produce, and supply curve will shift to the right.
Examples: Changes in Resource (Input) Prices
Example: reduction in supply of low skilled workers causes a change in supply of workers (resource). See page 70. Wages go from $4.55 to $5.45 hour, quantity of labor demanded goes down. The increase in the price of an input (labor) will cause the supply curve for hamburgers to shift back, raising the price of hamburgers.
Most resources have gotten cheaper, so that supply curves have shifted out.
Example: changes in technology. Technological improvements - discovery of new, lower cost production reduces the opp cost of production 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. See p. 71. VCR prices went from $1400 to less than $400.
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.
Example: Atlantic haddock. Overfishing - no prop rights. Drastic reduction in supply. see page 72. Price more than doubled. People switched to subs - other fish, beef, chicken, etc.
Thumbnail sketch - page 73.
Hurricane - price gougers, page 80.
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 74. Late 1970s, turmoil in Iran, led to sharp reduction in supply. Price went from 70 cents/gal to $1.20 in short run. Quantity demanded went from 7.4 to 7m bbls gas/day in short run. Given time to adjust, consumers changed behavior, found more subs. Car pools, smaller cars, public transportation, bikes, walking, four day work weeks, etc. In the long run, consumers responded more than in the short run. Price and Qd went down.
Supply side - Examples:
1. Page 75. Increase in demand for notebook computers. Point a to Point b to point c.
2. Jax Jaguars T-shirts. Demand went up. Supply gradually shifted down as producers expanded production.
REPEALING THE LAWS OF SUPPLY AND DEMAND
Price Ceiling (Rent Control) SCARCITY IS DIFFERENT THAN A SHORTAGE. Scarcity is unavoidable. Shortage is avoidable.
Price Floor (Min Wage, Farm Subsidies)
MARKET ANSWERS THE THREE QUESTIONS
INVISIBLE HAND PRINCIPLE
By trying to make your life better, you make society better off. To make your life better, you pursue what you are best at. And by pursuing your own self- interest, you automatically benefit others.
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 PRICES IN THE MARKET
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:
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.
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 a summary statistic of all available information about the conditions of supply and demand, and provide market participants with very valuable, very accurate 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 correctly influence incentives. 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.
3. Prices coordinate Econ 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....
4. By transmitting information, coordinating econ activity, and providing incentives and motivation, $8T 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.
Spontaneous order - think of language, for example. Internet. No zoning
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, WalMart 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, 14, 16