How Markets Work
ECO 285 - Dr. D. Foster
Three (Economic?) Questions:
1. What to produce?
2. How to produce?
3. For whom to produce?
We must decide!
Scarcity
Choices
Costs
Consider the market for gasoline…
Price
Supply
Pe = $3
Demand
Quantity
Qe
How does this help
us to answer the
what, how & for
whom questions?
Markets  prices = signals
 Serves to reward producers
for fulfilling our desires.
 Forces consumers to conserve
on the consumption of goods (and
services, and resources . . .).
Adam Smith
“It is not from the benevolence of the
butcher, the brewer, or the baker that
we expect our dinner, but from their
regard to their self interest.
We address ourselves, not to their
humanity, but to their self-love, and
never talk to them of our necessities,
but of their advantages.”
Prices … are a rationing device!
 When a good is increasingly scarce, its price
rises and we are forced to reduce
consumption.
 Equally? Of course not!
 How else to ration?




First come, first served?
Brute force?
Discrimination?
Equal portions? [Marxist? No!]
Scenario: Kuwait falls into the Gulf.
New S
$10.50
S
$5.00
$3.00
D
Q1 Q2 Q3
Quantity
 How do suppliers react to the P=$5 ?
 How do consumers react to the P=$5 ?
 What if we fix prices (a ceiling) at $3.00 ?
In the long run, we
expect that producers
will search for and
find additional
supplies, Q and P.
What will be said if P=$5?
 Markets don’t work!
 Prices are not fair!
 These prices are outrageous!
 This is an example of price gouging!
 This is an indictment against greedy sellers!
All are incorrect/meaningless:
$5 is an equilibrium price what it takes to allocate this scarce resource!
Macro lesson – The Law of Unintended Consequences
Dairy Price Supports
 Began during G. D. of 1930s.
 1981 - cheese giveaway.
 1983 - $1 billion to “retire” 10,000
dairy cows. No effect.
 1986 - $1.3 billion to slaughter dairy cows.
 No effect on milk, but on beef . . .
 1991 - USDA buys butter at $1/lb. to sell abroad at
60 cents/lb.
 1996 - Congress approves cartel in New England to
raise milk prices 21%.
 1999 - Milk price calculation simplified . . .
Macro lesson – The Law of Unintended Consequences
Dairy Price Supports
Basic Formula Price (BFP)
= last month's average price paid for manufacturing grade
milk in Minnesota and Wisconsin
+ [current grade AA butter price X 4.27 + current non-dry milk
price X 8.07 - current dry-buttermilk price X 0.42]
+ [current cheddar cheese price X 9.87 + current grade A butter
price X 0.238]
- [last month's grade A butter price X 4.27 + last month's nondrymilk price X 8.07 + last month's dry-buttermilk price X 0.42]
- [last month's cheddar cheese price X 9.87 + last month's grade
A butter price X 0.238]
+ (present butter fat - 3.5) X [current month's butter price X 1.38]
- [last month's price of manufacturing grade milk in MinnesotaWisconsin X 0.028].
Macro lesson – The Law of Unintended Consequences
Dairy Price Supports
Lessons? Plenty of them . . .
 Cost to consumers of higher prices:
 Butter = 2*ROW, Cheese = 1.5*ROW, Milk=1.26*ROW
 Cost to taxpayers for dairy subsidies:
 0 to $2.6 billion, depending on market conditions.
 Health harm - more expensive for poor and elderly
to get calcium.
 No incentive to innovate in U.S. dairy industry (New
Zealand milk is produced at about half our cost).
 Since 1930, the number of dairy farmers
have declined by 95%.
How Markets Work
ECO 285 - Dr. D. Foster