DYNAMIC P OWERP OINT S LIDES

CHAPTER

BY

S OLINA L INDAHL

The Price System: Signals,

Speculation, and Prediction
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CHAPTER OUTLINE
Markets Link the World
Markets Link to Each Other
Solving the Great Economic Problem
A Price Is a Signal Wrapped Up in an Incentive
Speculation
Signal Watching
Prediction Markets
For applications, click here
To Try it!
questions

To
Video
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Food for Thought.

Some good blogs and other sites to get the juices flowing:

The Price System

The curious task of economics

is to demonstrate to men how
little they really know about
what they imagine they can
design.
F.A. Hayek, The Fatal Conceit
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Prices Defined
What are prices?
A price is a signal wrapped up in an incentive.
Prices have a huge information function that
coordinate actions of buyers and sellers across both
markets and time.

The cooperation afforded by markets is voluntary

and undirected; i.e. spontaneous order

Efforts to intervene on prices usually never

recognize the information function of prices,
believing that planners are smarter than markets
(i.e. millions of people) covered in later chapters
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Markets Link the World

Valentines Day involves coordinating:
Florists
Flower markets
in Holland
And You!
Growers in
Kenya

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Markets Link to Each Other

Giving this one gift to a significant other requires
the cooperative effort of millions
Video: I, Pencil
http://www.youtube.com/watch?v=d6vjrzUplWU
What economists find amazing is that this
immense cooperation is voluntary and undirected
Spontaneous order

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Take a look..
Watch how the Icelandic Volcanic eruption
in 2010 affected the Kenyan flower market
by clicking the roses below. (2 minutes)

http://blogs.worthpublishers.com/seetheinvisiblehand/2010/04/20/kenyanflowers-coverage/

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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?

Methods: (1) Political, (2) Fair share, (3) Markets, (4)

Might makes right

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Markets Link to Each Other

Example: Oil and Candy Bars and Asphalt
Oil price increases
Caused Brazilians to sugar cane for ethanol
Less sugar cane for sugar, costs of sugar
increased
Shifted candy bar supply curve to left
Candy bar prices rose

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Asphalt prices rose

Less asphalt used for driveways
Consumers substituted away to bricks,
concrete, etc
Demand curve for bricks shifted to right
Brick prices rose
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Markets Link to Each Other

The price of oil rose.
Brazil shifted sugar
cane into ethanol
production (rather than
table sugar).
As a result, table sugar
got more expensive.
Thus, one way that we economize on oil is by eating fewer donuts!
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Try it!
Sawdust is used for bedding milk
cows.
What did the end of the housing
boom in 2007 do to the price of
milk?
Click here for a hint.
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Solving the
Great Economic Problem

The GREAT ECONOMIC PROBLEM:

To arrange our limited resources to
satisfy as many of our infinite wants
as possible.

Some solutions:
Central Planning
The Price System
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Solving the
Great Economic Problem

Any economic system, from North Korean

Communism to European socialism to free
markets has to deal the following problems:

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Scarcity
Trade-offs
Incentives
Efficiency
What is produced, how is it produced, and to whom
are these goods distributed?

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Central Planning

Central planning: a single official or

bureaucracy is responsible for allocating
limited resources.
Has two significant problems:
1. Too much information to process.
2. Too few incentives.
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Central Planning in the West

We now turn to a detailed study of the
workings of the Soviet economy. This
subject is of great importance not only
because the Soviet Union is locked in a
political struggle with the United States. In
addition, the Soviet economy is proof that,
contrary to what many skeptics had
earlier believed, a socialist command
economy can function and even thrive.

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Central Planning (cont.)

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That is a society in which

the major economic
decisions are made
administratively , without
profits as a central
(goal)....
- Paul Samuelson,
Economics (1989)

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Central Planning Problems

Soviet Economic Planning

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The Soviet economy made more of anything than

anyone else, but nobody wanted any of it.
Soviets did not have markets setting prices, rather
prices were set by bureaucrats with scientific
planning
Soviets did not have profits in their system
i.e. they tried to plan their economy without the right
kinds of information
Soviet production managers were incentivized to
please the State, not consumers
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Central Planning Problems

Soviet Planning Disasters

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Examples of immense problems with central planning,

fair distribution of goods, artificial prices, and the
prohibition of a profit motive
Shoes - Most went to landfills, no feedback mechanism
(i.e. profit) with consumers
Rail traffic five year plans required trains to cover a
certain minimum number of miles. Many trains were
driven extra miles around the country to meet track mile
quotas
Nails - Sometimes weight quotas were met by producing
one ton nails only, had to be shipped by railcar
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Central Planning Problems

Soviet Planning Disasters (cont)
Windows
Initially, manufacturing quotas set via square
footage produced
Thickness of windows decreased, windows
were so thin that many broke in transit
When quotas were changed and set by weight,
windows became very thick and nearly
opaque.
Customer feedback, profit/loss results would
have solved this problem easily
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Central Planning Problems

Soviet Planning Disasters (cont)
Furniture
Production quotas set via weight, factories
added lead weights to couches to meet quotas
Not a good idea in a country with many tall
apartment buildings and few elevators
We just need to do it again with the right
people
Central planning fashion show:

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http://www.youtube.com/watch?v=5CaMUfxVJVQ

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Central Planning Problems

The Soviets were rabidly acquiring VCRs so as to watch
Western TV shows and movies.
The people watching were aghast, and not about the show.
When they saw a character in the sitcom open the
refrigerator door and they saw what was inside the
refrigerator, they couldnt believe the varieties of food and
furthermore were astounded that American consumers had
cold beer.
It was like the scene in the movie portrayal of Steinbeck's
Grapes of Wrath where the Okies are going west in their
cars. The Leftist screen writers in Hollywood were intent on
making a statement about poverty in America, but when
the movie was seen overseas the viewers were instead
incredulous that America's poor had their own cars.
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Central Planning Problems

Example: allocation of oil resources
Would have to know the value of oil in each of its millions
of uses
Would have to know which of its consumers for each use
value it more highly
Needs to know the value of each substitute for oil in each
of their alternative uses (and substitutes for the substitutes)
People would have to give the central planner truthful
information and not try to game the system
What are the central planners own self-interests and do
they align with the social interest of that society?
Public choice theory addresses this issue
Oxymoron Benevolent Dictator
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Central Planning
Central planning has failed around the world
The Soviet Union disintegrated economically,
other countries as well
China abandoned centralized planning and has
allowed property rights to create prosperity
India has moved away from socialism.
North Korea and Cuba are economic disasters
Venezuela is rapidly getting poorer
Over last 20 years, hundreds of millions of people
have escaped poverty via the abandonment of
central planning
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Central Planning
Why has Central planning has failed around the
world?
Can not solve the problems of incentives and
information
Soviet central planners had to set 26+ million
prices for their central plans an impossible task
to perform. Instead they relied on Western
European catalogs to find prices to do their
central planning what does that say?
Lack of economic freedom always coincides with
lack of personal and political freedoms
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Central Planning
The lesson of government waste, whether on $16 muffins
or $535 million loan guarantees to solar power companies
or $48 billion in improper Medicare payments, is one
worth relearning every day.
Managers whose budgets do not depend on customer
satisfaction and who do not face competitive pressure in
the marketplace, will not, on balance, spend their money
wisely. Vendors selling to those managers know that price
matters much less than it does to, say, Wal-Mart. And
anywhere there is political urgency and official involvement
high up the command chain, conditions will begin
resembling a gold rush.
Matt Welch, CNN Opinion, September 22, 2011
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Central Planning
To paraphrase Winston Churchill:
Capitalism is the worst economic system ever
devised except when compared to all of the
rest.
Underlying most arguments against the free
market is a lack of belief in freedom itself.
Milton Friedman

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Central Planning Hong Kong

I first visited Hong Kong in 1955, shortly after the initial
inflow of refugees. It was a miserable place for most of its
inhabitants. The temporary dwellings that the government
had thrown up to house the refugees were one-room cells
in a multistory building that was open in the front: one
family, one room. The fact that people would accept such
miserable living quarters testified to the intensity of their
desire to leave Red China.
I met Cowperthwaite [financial secretary of Hong Kong] in
1963 on my next visit to Hong Kong. I remember asking
him about the paucity of statistics. He answered:

If I let them compute those statistics, theyll

want to use them for planning.
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Central Planning Hong Kong

The real lesson of Hong Kong for the United States is that
were using our resources inefficiently. Our government is
spending our money to subsidize tobacco and to penalize
smoking; to subsidize childbearing and to discourage
childbearing; to build new housing and to tear down
housing; to subsidize agriculture and to penalize
agriculture; and on and onnot to mention converting
square miles of forests into billions of paper forms and
spending many man-years of labor filling them out and
then filing them.
- Milton Friedman, The Hong Kong Experiment

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Central Planning Hong Kong

People in these economies have simply studied harder,
worked harder, and saved more than people in other
countries.
- World Bank report

The welfare system in rabidly capitalist Hong Kong is

more generous than on the Communist mainland.
- The Economist (August 21, 2010)

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The Price System

The Price System: a solution where no-one
(or everyone!) is responsible for allocating
limited resources.

Market forces of supply and demand

are the organizing elements.

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The Price System

Prices signal to
resources exactly
WHERE they are most
valued
Prices solve the
information and
incentive problems
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A Price Is a Signal
Wrapped Up in an Incentive
Prices tell producers what to make:
Profits are higher in industries that consumers
want expanded.
Losses are higher in industries that consumers
want contracted.
High price of ice in hurricane-devastated
areas invites firms to provide more goods
where society needs it.

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The Price System Austrian School

Frederick Hayek

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Austrian School of Economics

Nobel prize winner in Economics in 1974
Road to Serfdom 1944
Chapter 10 Why the Worst Get on Top
Argued that the price mechanism serves to share and
synchronize local and personal knowledge, allowing
society's members to achieve diverse, complicated ends
through a principle of spontaneous self-organization.
Hayek wrote one of the most famous essays in economics The Use of Knowledge in Society
http://www.econlib.org/library/Essays/hykKnw1.html

A must read for anyone wanting a deep

understanding of economics
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The Price System Austrian School

Frederick Hayek
Hayek understood that successful mutual coordination
of the economic decisions of millions of people occurs
to the extent that prices which guide peoples
economic decisions accurately reflect underlying
economic realities such as resource scarcities and
households preferences for saving. He reasoned,
therefore, that government activities that distort prices
cause prices to lie about underlying economic reality
and, hence, cause prices to mislead economic actors
into making an unusually large number of plans that
are destined to fail. Don Boudreaux

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http://cafehayek.com/2012/09/the-price-of-monetarymeddling.html
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SEE THE INVISIBLE HAND

Hayek saw the

invisible hand

the marvel is that in a case like

that of the scarcity of one raw
material, without an order being
issued, without more than
perhaps a handful of people
knowing the cause, tens of
thousands of people are made
to use the material or its
products more sparingly; i.e.,
they move in the right direction
- Nobel Laureate Friedrich Hayek
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The Price System Austrian School

Ludwig von Mises
Austrian school, a classical liberal
Hayek was a student of Von Mises
Mises was famous for his Socialist calculation
argument in the 1920s
absent market-based prices, capital formation can
not take place efficiently in an economy

Government control of the healthcare industry and the

associated pricing will likely yield a confirmation of
Misess ideas
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How Prices Work

Free markets accomplish the task of allocating
resources without any central planning or control.
Information in any economy is highly dispersed
(more information in many brains than in one)
The market solves the information problem by
collapsing all relevant information into the price
mechanism.
It also solves the incentive problem because
consumers will purchase a good only if its value is
greater than the price.
Feedback loops exist in the form of prices and
profit/loss signals
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How Prices Work

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, i.e. make society worse off/poorer
Power of the Market Prices (video)

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http://www.youtube.com/watch?v=7V9ihC1o7wc&feature=related
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Try it!
Which is the best way for society to
distribute its goods?
a) The free market outcome should not
be tampered with.
b) From each according to his ability to
each according to his need
c) To distribute goods so that societys
total happiness is maximized- even if
it requires taking some from the
wealthiest to give to the poorest.
To next
Try it!

Market Price and

Opportunity Cost
The Equilibrium Price is Equal to the Value of the Good in its Next Highest Use
Price
Satisfied Wants
Supply

The Value of the Good in

its Next Highest Use

Equilibrium
Price

Unsatisfied Wants

Demand
Quantity
Equilibrium
Quantity
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Try it!
The Opportunity cost of a good is:
a) Known as the elastic cost
b) Usually less than its money cost
c) the value of the next highestvalued use of the good
d) All of the above
To next
Try it!

Speculation
Speculation is the attempt to profit from future
price changes.
If 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.
Speculation can smooth prices fluctuations.
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Prices and Speculation

Prices Rise Sharply after a Decrease in Supply Without Speculation
Price

Future Supply
Price in Future
with no
Speculation

Current Supply

Todays Price
with no
Speculation

a
Demand
Quantity
Production
Future

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Production
Today
B

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Prices and Speculation

Speculation Smoothes Prices when Supply Decreases
Price
Out of
Storage

Into
Storage

b
Price with
Speculation

Todays Price
with no
Speculation

c= d

Gain in
Value

Loss in
Value

a
Quantity

Consumption Today
Production
= Production - Storage
Today
Consumption Future
= Production + Storage
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Futures
A Future: a contract to buy or sell
specified quantities of a commodity or
investment at a specified price and time
in the future.
Futures provide a way to speculate without
having physically to hold the good

Hog futures: all investment, no smell.

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Signal Watching
Futures prices can be
extraordinarily
informative about future
events.
Sometimes, the signals
are noisy and futures
prices are less informative
and accurate.
The economist Richard Roll found that the futures price for OJ
was so sensitive to the weather that it could be used to improve
the predictions of the National Weather Service!
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Oil Price Speculation

Speculators misjudged the length of first Gulf War: they bought high and
(after a short war that didnt disrupt oil flow much) sold low.
Were the signals they were watching too noisy?
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SEE THE INVISIBLE HAND

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 the whole than the statements
being issued from Lehman?
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Prediction Markets
A prediction market is a speculative market
designed so prices can be interpreted as
probabilities and used to make predictions.
Iowa Electronic Markets sells shares of political
candidates and predicted the Obama win in
2008
The Iowa markets have been more
accurate than polls.

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Prediction Markets
Intrade (now deceased)
http://www.intrade.com/

Iowa Prediction Markets

http://tippie.uiowa.edu/iem/index.cfm

Hollywood Stock Exchange

http://www.hsx.com/

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Predicting Movie Revenues

The Hollywood Stock Exchange: not perfectly clairvoyant (but not bad!)
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Try it!
If investors in the Hollywood Stock Exchange
were too optimistic on average, would the
dots tend to cluster above the red diagonal
line or below?
a) Above
b) Below

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Other AV Links
Power of the Market - Fairness
http://www.youtube.com/watch?v=SW86iE-ddaI&feature=related
The 4 Ways to Spend Money by Milton Friedman
http://www.youtube.com/watch?v=5RDMdc5r5z8

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A Digression on Prices and Value

Prices are set at the margin
i.e. the last unit exchanged in the market sets the
price
Housing market example:
Appraisals, listing prices based on recent sale prices
and are not determined by an average of the
expected prices of all nearly comparable homes
i.e. one low-priced foreclosure/short sale can greatly
affect nearby house prices, perhaps a 5 - 10%
reduction or more

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A Digression on Prices and Value

Area underneath demand curve represents
total value to consumers
Area beneath demand curve and above price
represents consumer surplus
At any point on the demand curve, that
represents the price that the marginal
consumer is willing to pay for that good
The water-diamond paradox why is water so
cheap and diamonds so expensive?
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A Digression on Prices and Value

Water is absolutely necessary for life. Without it,
people would die. How can its price be so low
relative to diamonds?
Since water is so plentiful, the marginal value of the
last quantity of water is relatively low.
i.e. an extra quart of water provides very little
additional satisfaction after basic needs are met
Diamonds are very scarce and the marginal value
(price) is therefore relatively high. However the total
value of diamonds is relatively low.

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A Digression on Prices and Value

If you are lost in the desert, the marginal value of water

goes to infinity
And the marginal value of diamonds may even be
negative if you have to carry them with you
Economics & the Marginal Revolution
Ricardo, Marx Labor Theory of Value

the value of a commodity can be objectively measured by the average

number of labor hours required to produce that commodity.

Could not explain diamond vs water prices until marginal

value approach
Market prices are set at the margin, i.e. at the last unit of
Q exchanged
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A Digression on Prices and Value

With a small supply relative to demand, the price of water is

low, however the area under the demand curve (value) is large

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A Digression on Prices and Value

With a small supply relative to demand, the price of diamonds is
high, however the area under the demand curve (value) is small

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A Digression on Prices and Value

Why are teachers paid less than NBA players?
Teachers provide much greater value to society than NBA
players based on welfare analysis
Teachers are upset that their pay does not reflect their total
value to society
Teacher pay is priced at the margin via he intersection of
supply and demand in the labor market, not based on the value
to society
All of this is done to the endless frustration of advocates for fair
pay and social justice
i.e. Markets are unfair

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A Digression on Prices and Value

Fair pay: lets have the government completely determine
everyones pay
Eventually, everyones pay will be equal in order to be fair
Of course, some pay will be more equal than others (to
paraphrase George Orwell)
Since the leaders have harder jobs, theyll be paid more (of
course)

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A Digression on Prices and Value

As with many communist countries, incentives to work hard
break down, and the economy breaks down as a result
Most everyone is worse off than before under these systems
To the degree that the government intervenes in pay or income
redistribution for fairness purposes, society will achieve
varying degrees of efficiency and experience different
incentives in their respective labor markets
Janitors at $45/hour would create distortions

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