Markets 101: The Case for Markets

1. Markets 101: The Case for Markets Sabina Shaikh University of Chicago CIS Summer Teacher Institute Understanding the Global Economy: Bringing the World Market into your Classroom June 22, 2009

2. Why Markets and Globalization? • The Benefits of Competition and Trade • More Choices • Lower Prices and Rising Incomes • Productivity, Efficiency • Innovation • But, Competition Necessarily Creates Winners and Losers • Does Economics Ignore the Losers? $20 $480 $100 $100

3. The Study of Economics • Resources are Scarce • “There is no such thing as a free lunch” • Opportunity Cost: What did you give up to be here today? • Individuals see to Maximize Utility • Abstract Measure of Satisfaction • Is it Happiness? Not exactly • Preferences and Choice • Comparison of Benefits and Costs • Maximize Benefits • Minimize Costs • Incentives Affect Behavior • Economics tries to be positive not normative • Economics has no morals?

4. Specialization, Advantage and Trade • Specialization • Parents send kids to school instead of home schooling • You visit a doctor when you’re sick • Pay a plumber to fix a leak • Absolute Advantage and Comparative Advantage in Production • Specialization by Comparative Advantage can lead to mutually-beneficial trades • Gains from Trade Example

5. Competitive Markets • Demand for Goods and Services • Price and Value (Marginal Benefit) • Marginal Benefit is Diminishing • Supply of Goods and Services • Price and Marginal Cost • Marginal Cost is Increasing • Invisible Hand and Market Equilibrium • Assumptions of a Competitive Market • Price Takers • No Market Power • No Government Intervention • “Perfect” Information • No Externalities or Public Goods • Homogenous Goods

6. The Graphical Market Supplynew • Equilibrium will change with shifts in Supply or Demand • Supply Shifts: Input prices, technology, weather • Demand Shifts: Income, tastes, prices of other goods P Supply = Marginal Cost Pnew P* Demandnew Demand = Marginal Benefit Q Q* Qnew Qnew

7. Market Impacts: Global Food Prices CORN SOY MILK P P P Snew Snew S S S • Could we have predicted these impacts? • Could we have predicted the magnitude of these impacts? Dnew D D D Qmilk Qcorn Qsoy Subsidy to Ethanol Blenders Increases the Demand for Corn: Price of Corn goes up Higher Price of Corn increases the demand for land for corn. Land diverted from other crops. Supply of Soy decreases. Price of Soy goes up. (Same happened to CRP land) Higher Price of Corn increases the costs of feeding dairy cows raising the price of milk. (Think about the substitution effects here)

8. Measuring Market Impacts: Elasticity and Welfare Measurement • The slope of the curves represent the elasticity of demand or supply to price. • Elasticity measures how much demand or supply change for a 1% change in price? • Elasticity can also be used for income or prices of substitutes or complements Consumer Surplus measures the extra value to the consumer: Value – Expenditure Producer Surplus measures the extra value to the producer: Price – Cost Together the two comprise the total market value or the net benefit. Efficiency requires that this net benefit be maximized. P S P* D Q Q*

9. Sources of Market Failure In an otherwise efficient competitive market, the following can induce market failure: • Government Intervention • Price or Quantity Controls • Price Ceilings, Price Floors, Quotas • International Trade: Tariffs, Quotas, Protectionist Measures • Subsidies and Taxes • Market Power: Loss of Competition • “Imperfect” Information • Externalities and Public Goods

10. Government Intervention as Market Failure: Minimum Wage Plabor=Wage S Pmin=6 P*=5 D 35 80 100 115 Qlabor At the minimum wage, there is a surplus of labor: the Quantity of labor supplied exceeds the Quantity demanded. This is an inefficient market condition or market failure.

11. Government Intervention as Market Failure: Minimum Wage Snew S So, the theory says that minimum wages can lead to unemployment and less affordable consumer goods. Pnew P* D Qgoods Qnew Q* The increased cost of labor shifts the supply curve (which is also the cost of production curve). Consumer prices go up. This is the market impact.

12. Another Example: Rent Controls Krugman and Wells, 2006

13. Externalities as Market Failure: Why Regulate Greenhouse Gases? • Consider the market for coal-based electric power • What are the costs and benefits of generating electricity to the power company? • What are the costs and benefits of purchasing electricity to the consumer? • Who bears the costs of pollution? • How to “internalize” this externality? • An important note: the externality arises from the market for electric power. The power company would not be able to sell electricity at current prices without the consumers.

14. Market-Based Solutions to Market Failure • The Role of Incentives • People respond to changes in price • Can we appeal to conscience? • Government Intervention • Wait! Wasn’t this a source of market failure? • Yes. Remember how we predicted the market impacts from minimum wage, price supports, etc. • We can use this to restore market efficiency as well. • Incentives: Price and Quantity Instruments • Property Rights and the Coase Theorem • Ronald Coase (1960): The Problem of Social Cost • As long as property rights are established, mutually-beneficial transactions exist even in the presence of externalities.

15. Simple Coase Theorem Example One bedrooms = $800/month, two bedrooms = $1400. Sally smokes causing Jim costs of $150/month. Can they still live together? Options Cost ($) Net Gain ($) Sally Jim Sally Jim Live Alone 800 800 0 0 Live Together 700 700+150 100 -50 Sally is willing to pay X<100 since she will still have a positive gain from sharing. Jim is willing to accept X>50 since then he will have a positive gain from sharing. Take $75 as an example. Options Cost ($) Net Gain ($) Sally Jim Sally Jim Live Alone 800 800 0 0 Live Together 700+75 700+75 25 25

16. Internalizing the Externality from CO2: A Market for Carbon? • Recall the coal-based electric power example. • Now, given the market failure from the externality, suppose that we implement a market-based solution • Carbon Tax Vs Cap and Trade • Substitution Effects • Supply Response: Wind, Solar, Carbon Capture • Demand Response: Energy Efficiency • We should be able to predict these. A market could work but there’s a good chance an inefficient market will be established. • Economics does not always make good politics. • Does the Coase Theorem work for pollution?

17. Examples from Global Markets • U.S. Auto Companies (Naked Economics) • Increased competition from Japanese automakers in 1980’s • US auto company response • Market Solution: Make more fuel-efficient cars to compete OR • Political Solution: Lobby the government for tariffs and quotas and avoid fuel economy laws • This could have been a success story for globalization • Ethanol • The Impact of Corn for Fuel • Sugarcane and Tariffs: Positive? Negative? • The Kyoto Protocol • China and India exempt from Emissions Reductions. Why? • Marginal Costs of Environmental Protection: Specialization and Trade • Income Elasticity of Environmental Protection

18. Recommended References • Naked Economics by Charlie Wheelan • The Economist • The New York Times: Freakonomics, Economix • Textbook: Krugman and Wells, Economics • www.theclimatecommunity.com