The Price System: Signals, Speculation , and Prediction

1. The Price System: Signals, Speculation, and Prediction

2. 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

4. 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

5. 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

6. Markets Link the World • Valentine’s Day involves coordinating: Florists… Flower markets in Holland… And You! Growers in Kenya…

7. 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”

8. 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/kenyan-flowers-coverage/ Back to

9. 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?

10. 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 • 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

11. 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!

12. ; 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.

13. 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

14. Solving the Great Economic Problem • Any economic system, from North Korean Communism to European socialism to free markets has to deal the following problems: • Scarcity • Trade-offs • Incentives • Efficiency • What is produced, how is it produced, and to whom are these goods distributed?

15. Central Planning • Central planning: a single official or bureaucracy is responsible for allocating limited resources. • Has two significant problems: • Too much information to process. • Too few incentives.

16. Central Planning Problems • Soviet Planning Disasters • Examples of immense problems with central planning, “fair” distribution of goods, artificial prices, and the prohibition of 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

17. 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

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

19. 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 planner’s own self-interests and do they align with the social interest of that society? • Oxymoron – “Benevolent Dictator”

20. Central Planning • Central planning has failed around the world • The Soviet Union disintegrated economically, other countries as well • China abandoned centralized planning and allowed property rights to create prosperity • India has moved away from socialism. Why? • 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

21. 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

22. 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

23. 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

24. 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, they’ll want to use them for planning.’’

25. Central Planning – Hong Kong • “The real lesson of Hong Kong for the United States is that we’re 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 on—not 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”

26. 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)

27. The Price System • The Price System: a solution where no-one (or everyone!) is responsible for allocating limited resources. • Market forces of supply and demandare the organizing elements.

28. The Price System • Prices solve the information and incentive problems Prices signal to resources exactly WHERE they are most valued

29. 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.

30. The Price System – Austrian School • Frederick Hayek • 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

31. The Price System - Hayek • Frederick Hayek • “Hayek understood that successful mutual coordination of the economic decisions of millions of people occurs to the extent that prices – which guide people’s 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 • http://cafehayek.com/2012/09/the-price-of-monetary-meddling.html

32. “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 Hayek saw the invisible hand

33. The Price System – Austrian School • Ludwig von Mises • Austrian school, a “classical liberal” • Von Mises very much influenced Hayek • Mises famous for his “Socialist calculation” argument • absent market-based prices, capital formation can not take place efficiently in an economy • government control of the healthcare industry may yield a confirmation of Mises’s ideas • Mises masterwork: “Human Action”

34. The Price System • Free markets accomplish the task of allocating resources without any central planning or control. • Information in any economy is highly dispersed • 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

35. The Price System • Through the price system, markets force consumers to compare the value of their uses of a good with the value of the good in alternative uses. • Once that comparison is made, consumers have an incentive to give up the good if their uses have a lower value than the alternative uses. • The price mechanism could be considered analogous to the world wide web in its coordination/communication role

36. The Price System • In free markets prices provide powerful signals to both buyers and sellers. • An increase in the price of a good signals to consumers that they need to change their behavior. • Consumers are not only encouraged to economize and use less but also to start thinking about substitutes. • The same price increase also signals producers to increase their production. • Sellers are encouraged to invest more to expand their capacity or to develop alternatives.

37. The Price System • 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) • http://www.youtube.com/watch?v=7V9ihC1o7wc&feature=related

38. To next Try it! Which is the best way for society to distribute its goods? The free market outcome should not be tampered with. “From each according to his ability to each according to his need” To distribute goods so that society’s total happiness is maximized- even if it requires taking some from the wealthiest to give to the poorest.

39. 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

40. To next Try it! The Opportunity cost of a good is: Known as the “elastic” cost Usually less than its money cost the value of the next highest-valued use of the good All of the above

41. 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.

42. Prices and Speculation Prices Rise Sharply after a Decrease in Supply Without Speculation Price Price in Future with no Speculation b Future Supply Current Supply Today’s Price with no Speculation a Demand Quantity Production Future Production Today

43. Prices and Speculation Speculation Smoothes Prices when Supply Decreases Price Into Storage Out of Storage b Price with Speculation c = d Today’s Price with no Speculation a Gain in Value Loss in Value Quantity Consumption Today = Production - Storage Production Today Consumption Future = Production + Storage

44. 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.

45. 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!

46. Oil Price Speculation Speculators misjudged the length of first Gulf War: they bought high and (after a short war that didn’t disrupt oil flow much) sold low. Were the signals they were watching too “noisy?”

47. 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?

48. 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.

49. 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/

50. Predicting Movie Revenues The Hollywood Stock Exchange: not perfectly clairvoyant (but not bad!)