Chapter 7
The Price System:
Signals, Speculation,
and Predictions
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline
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Markets Link the World
Markets Link to One Another
Solving the Great Economic Problem
A Price Is a Signal Wrapped Up in an
Incentive
 Speculation
 Signal Watching
 Prediction Markets
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Introduction
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Introduction
I, Pencil (6:32)
https://www.youtube.com/watch?t=337&v=IYO3tOqDISE
I, Pencil Extended Commentary: Spontaneous Order(4:03)
https://www.youtube.com/watch?v=yFeGNX06Zmk&list=PLEQF5yIYgywT4o2T2slLwwCzBABHRYUe&index=2
Essential Hayek: Knowledge and Prices (3:26)
https://www.youtube.com/watch?v=mr2fexYutY&list=PLFV2PTn7E9mE02aPH3LILX8GJHa7F0XTN
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Introduction
Prices
 Are the key force integrating markets and
motivating entrepreneurs.
 Create rich connections between markets by
conveying important information.
 Create an incentive to respond to that
information in socially useful ways.
 Enable societies to mobilize vast amounts of
knowledge toward common ends.
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Signal Wrapped in an Incentive
 What are prices?
 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)
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Signal Wrapped in an Incentive
 Prices are incentives, signals, and predictions.
 When price rises, buyers are encouraged to
use less or substitute.
 It is also a signal to suppliers to provide more.
 Price signals and the accompanying profits
and losses tell entrepreneurs what areas of the
economy consumers want expanded and what
areas they want contracted.
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Signal Wrapped in an Incentive
Friedrich Hayek on prices:
“The marvel is that in a case like that of a
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 whose
identity could not be ascertained by
months of investigation, are made to use
the material or its products more sparingly;
i.e., they move in the right direction.”
HULTON ARCHIVE/GETTY IMAGES
Friedrich A. Hayek
1899–1992
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Friedrich Hayek
• Frederich Hayek
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Austrian School of Economics
Nobel prize winner in Economics in 1974
Most popular book - “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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Friedrich 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-ofmonetary-meddling.html
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Spontaneous Order
https://www.youtube.com/watch?v=aljypA3UdCc
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Markets Link the World
 Roses grown in Kenya.
 Transported in cooled trucks and
aircraft.
 Flown to flower auction in Holland.
 Sold to buyers from around the world.
 Become a gift of love in Stillwater,
Oklahoma.
 Cooperation is voluntary and undirected.
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Markets Link to One Another
 Shifts in supply and demand in one market
ripple across the worldwide market.
 Entrepreneurs are constantly looking for ways
to lower costs.
 These cost-cutting measures link markets that
seem like they are a world away.
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Solving the Great Economic Problem
• Markets are tremendously 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 (rule by AK-47)”
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Solving the Great Economic Problem
 A buyer compares the value of the good to its
opportunity cost (market price).
 Because markets are linked, the price reflects
information about many other markets.
 The market collapses all relevant information
into a single number – the price.
 The buyer is deciding whether their use is more
valuable than the billions of other uses that are
presently unsatisfied.
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Solving the Great Economic Problem
 Suppose the supply of oil decreases.
 We should economize on oil by:
• Shifting oil out of low-valued uses, where we
can do without or there are good substitutes.
• Supplying oil for high-valued uses, where
there are few good substitutes.
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Solving the Great Economic Problem
Top photo: ssuaphotos/Shutterstock Bottom: Lew Robertson/Corbis
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Solving the Great Economic Problem
Example: Oil and Candy Bars and Asphalt
• Oil price increases
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(1) Caused Brazilians to sugar cane for ethanol
Less sugar cane for sugar, sugar costs increased
Shifted candy bar supply curve to left
Candy bar prices rose
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(2) 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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Signal Wrapped in an Incentive
 Losses are also a signal. So are profits.
 Entrepreneurs who fail to compete with lower
costs and better products take losses and
eventually go bankrupt.
 Resources will go to firms that are able to
compete.
 In a successful economy, there will be many
unsuccessful firms.
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Signal Wrapped in an Incentive
 Example: After a hurricane,
prices of goods skyrocket.
 Consumers complain of
price gouging.
 Politicians call for price
controls.
 The market is just signaling
for more resources to come
to the rescue!
ASHLEY COOPER/CORBIS
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Self-Check
A higher price tells buyers to :
a. Buy more.
b. Buy less.
c. Buy the same amount.
Answer: b – A higher price encourages buyers
to use less or substitute.
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Self-Check
Markets are linked through:
a. Shortages.
b. Government regulations.
c. Prices.
Answer: c – Markets are linked through prices.
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Definition
Great Economic Problem:
to arrange our limited resources to
satisfy as many of our wants as
possible.
Two prominent solutions:
• Central Planning
• The Price System
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Central Planning vs Markets
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Solving the Great Economic Problem
• Any economic system, from North Korean
Communism to European socialism to marketbased systems has to address 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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Solving the Great Economic Problem
 Central planning.
• Government determines what is produced
• Problems of information and incentives.
 Markets (price system)
• Each user of oil compares the value in their
use with the value in alternative uses.
• Each user has an incentive to give up the oil
if it has a lower value in their use.
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Solving the Great Economic Problem
Central planning: a single official or
bureaucracy is responsible for allocating
limited resources.
Has two significant problems:
1. Too much necessary information to process.
2. Too few incentives.
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Solving the Great Economic Problem
 Paul Samuelson (1915 – 2009)
• – Nobel Prize in Economics (1970)
 “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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Solving the Great Economic Problem
•
“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
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
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
Examples: Shoes, Rail traffic, Nails, Furniture,
Windows, Computer punch cards
Customer feedback, profit/loss results would have
solved this problem easily
Lack of “market discipline” – no direct customer
feedback, no profit/loss signals
No “regulation” by market competition
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Central Planning
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Central planning has failed around the world
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Latest ongoing example: Venezuela
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.
• Lack of economic freedom always coincides
with lack of personal and political freedoms
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No Central Planning in 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.’’
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No Central Planning in 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”
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Free Markets
 Are not without their own problems (market
failure covered in later chapters)
• 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.
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Free Markets
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Markets solve the incentive problem because
consumers will purchase a good only if its value is
greater than the price.
Wages/Income determined by market value
Market discipline exists in the form of prices and
profit/loss signals
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.
Consumers “vote” with their dollars
Power of the Market – Prices (video - 1:38)
•
http://www.youtube.com/watch?v=7V9ihC1o7wc&feature=related
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Final Words on Central Planning
“Capitalism is the worst economic system
ever devised except when compared to all
of the rest.”
Winston Churchill
“Underlying most arguments against the
free market is a lack of belief in freedom
itself.”
Milton Friedman
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Solving the Great Economic Problem
 "Nobody planned the global capitalist system,
nobody runs it, and nobody really comprehends it.
This particularly offends intellectuals, for capitalism
renders them redundant. It gets on perfectly well
without them. It does not need them to make it run,
to coordinate it, or to redesign it. The intellectual
critics of capitalism believe they know what is good
for us, but millions of people interacting in the
marketplace keep rebuffing them. This, ultimately,
is why they believe capitalism is ‘bad for the soul’: it
fulfills human needs without first seeking their moral
approval." - Peter Saunders
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Definition
Speculation:
the attempt to profit from future price changes.
Definition: investment in stocks, property,
or other ventures in the hope of gain but
with the risk of loss.
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Speculation
Definitely associated with a negative connotation:
“We are going to provide free tuition to public
colleges and universities by imposing a tax on
Wall Street speculation.” – major US
presidential candidate in 2015
Sweden tried a 0.5% “speculation” tax in 1984
Any guesses as to what happened?
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Speculation
Result:
Not only affected speculative trades but ALL
trades:
90-99% of traders in bonds, equities, and derivatives
moved out of Stockholm to London.
Basically, no tax revenue was collected
(immense deadweight loss)
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Speculation
People see speculation as being bad and yet:
People speculate on buying homes
People load up on emergency supplies before a storm
Play the Lotto
And many others
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Speculation
 Suppose you believe oil prices will be higher
in one year.
 You can make a profit by buying oil now,
storing it, and selling it next year.
 This is called speculation.
 Speculation tends to smooth prices over time
and increases welfare.
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Self-Check
Speculation refers to:
a. An attempt to raise the price of a good.
b. An attempt to create scarcity in a market.
c. An attempt to profit from future price changes.
Answer: c – Speculation is an attempt to profit
from future price changes.
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Speculation
Prices without speculation
Supply
Price
Price
Supply
Price in
future
Today’s
price
Demand
Demand
Q
Production
today
TODAY
Production
future
FUTURE
Q
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Speculation
Prices with speculation
Price
S2 Supply
Into
storage
Price with
speculation
Price
Price in
future
Supply S2
Out of
storage
Price w/
speculation
Today’s
price
Demand
Demand
Q
Production
Consumption =
Production minus storage
today
TODAY
Q
Production Consumption =
Production + inventory
future
FUTURE
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Speculation
Prices with speculation
Price
S2 Supply
Into
storage
Price with
speculation
Loss in value
Price
Price in
future
Supply S2
Out of
storage
Gain in value
Price w/
speculation
Today’s
price
Demand
Demand
Q
Production
Consumption =
Production minus storage
today
TODAY
Q
Production Consumption =
Production + inventory
future
FUTURE
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Speculation
 Speculators raise prices today but lower prices in
the future.
 Speculators move goods from today, when they
have low value, to the future, when the value is
higher.
 Although speculators are not always right, they
have strong incentives to be accurate.
 Overall, society is better off.
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Self-Check
Speculation in a market:
a. Raises prices today but lowers them in future.
b. Lowers prices today but raises them in future.
c. Raises prices today and in the future.
Answer: a – Speculation raises prices today but
lowers them in future.
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Definition
Futures:
standardized contracts to buy or sell
specified quantities of a commodity or
financial instrument at a specified price,
with delivery set at a specified time in
the future.
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Futures Markets
 Example: Tyler believes oil prices will be higher
in future than people are expecting.
• Buys a futures contract for 1,000 barrels to be
delivered in 30 months.
• Agrees to pay $50 per barrel on delivery.
 Suppose 30 months later the price of oil = $82
 Tyler has two options:
• Accept the oil and pay $50,000, sell for $82,000
• Accept $32,000 and let seller keep oil
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Futures Markets
 Futures allow people to speculate without accepting or
delivering the goods.
 Futures markets are also used to reduce risk.
• Airlines can lock in fuel costs by buying oil on the
futures market.
• Farmers can agree to sell crops at harvest time at a
price agreed on today.
• Firms can avoid exchange rate risk by buying/selling
currency futures.
Hog futures: all investment, no smell.
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Futures Markets
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Futures Markets
 Explaining Commodities (1:30)
• https://www.youtube.com/watch?v=ySxHud7abko
 Trading Places – Futures Pit (6:35)
• https://www.youtube.com/watch?v=RLySXTIBS3c
 “Trading Places” 30 Years later (thru 2:45)
• https://www.youtube.com/watch?v=RLySXTIBS3c
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Self-Check
Futures contracts are used to:
a. Take possession of something now, and pay for it
at a future date.
b. Buy or sell something at the current price, for
delivery in the future.
c. Buy or sell something at a future date.
Answer: c – Futures contracts are used to buy or
sell something at a future date.
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Signal Watching
 Futures prices can be extraordinarily informative
about future events.
 Economist Richard Roll found the futures price of
orange juice could be used to improve the
predictions of the National Weather Service.
 Many factors affect futures prices, so they can be
a noisy signal.
 Future prices are information as well
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Definition
Prediction Market:
A speculative market designed so that
prices can be interpreted as probabilities
and used to make predictions.
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Prediction Markets
 The best known prediction market is the Iowa
Electronic Markets.
 http://tippie.uiowa.edu/iem/
 Traders use real money to buy and sell
“shares” of political candidates or other
issues.
 https://iemweb.biz.uiowa.edu/quotes/Pres16_
quotes.html
 The Iowa markets have been more accurate
than polls. Why?
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Prediction Markets
 Hollywood Stock Exchange
 http://www.hsx.com/
 “Terrorism” Exchange
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Prediction Markets
The Hollywood Stock Exchange is a good predictor
of future box office revenues.
Takeaway
 Markets are linked geographically, through time
and across different goods.
 A price is a signal wrapped up in an incentive:
• Price signals the value of resources to
consumers, suppliers, and entrepreneurs.
• Provides incentives to respond to scarcity in
an appropriate way.
 Futures prices can help us predict many other
future events.
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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
• The area underneath demand curve
represents total value to consumers (WTP)
• 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
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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”
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•
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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 economic welfare analysis
• Teachers are upset that their pay does not reflect their total
value to society
• Teacher pay is set at the margin via the intersection of
supply and demand in the labor market, not based on the
value to society (marginal product of labor concept)
• All of this is done to the endless frustration of advocates for
“fair pay” and “social justice”
• i.e. “Markets are unfair and evil”
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A Digression on Prices and Value
 Would government setting wages be “fair”?
• Would totally change incentive/reward
relationship
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Why bother going to med school?
• Total economic chaos and poverty would result
 Political determination of pay/wages would also
be very divisive socially
 More on this topic later (Minimum Wage)
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