Transcript Economics on Main Street: Concepts for American Voters

Markets are Perfect,
Except When They’re Not
the invisible hand
of market allocation
Feeding Illinois for a Week
There are about 13 million people in Illinois and we spend between
$350 to $700 Million on eating each week.
Almost half of that spending is in restaurants and Illinois restaurants
employ more than 500,000 people. Illinois grocery stores employ
over 100,000 people, and there are 270 farmer’s markets.
About 96% of what we eat comes from out-of-state, our fruits &
vegetables travel an average of 1,500 miles.
Chicago has less than a week’s worth of food on hand.
Consider the range of resources involved and the simple transport
& logistics of this weekly challenge.
Add the complexity of satisfying diverse individual tastes and
solving every piece of this puzzle in a timely fashion.
Try to get this done without evident shortages or waste.
Free Markets at Work
Adam Smith (1776) claimed the following:
“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
own interest.”
We respond to incentives (MB & MC) and are led by an invisible
hand (market prices) to promote an end (society’s well-being)
despite that not being our intention.
Alfred Marshall (1890) provided a useful framework:
The first step in economic reasoning is to examine demand and
supply, and their connection to price adjustments.
Consumer Demand
& Producer Supply
Consumer Demand
• Quantity Demanded (Qd)
– willing and able to buy at a given price
• Demand (D)
– the relationship between Qd and price of a good
or service holding all else constant.
BBQ Sandwiches
individual consumers
price
kate
michael
total bbq
alison
$5.00
1
0
0
1
$4.00
1
1
0
2
$3.00
2
1
0
3
$2.00
2
1
1
4
$1.00
2
2
1
5
Demand for BBQ Sandwiches
Price ($ per sandwich)
$5.00
$4.00
$3.00
$2.00
$1.00
1
2
3
4
5
Quantity
Demand for BBQ Sandwiches
Price ($ per sandwich)
$5.00
$4.00
$3.00
$2.00
$1.00
1
2
3
4
5
Quantity
Demand for BBQ Sandwiches
Price ($ per sandwich)
$5.00
$4.00
$3.00
$2.00
D
$1.00
1
2
3
4
5
Quantity
Moving Along the Demand Curve
Price ($ per sandwich)
$5.00
Qd change
in response to price
$4.00
$3.00
$2.00
D
$1.00
1
2
3
4
5
Quantity
Moving Along the Demand Curve
Price ($ per sandwich)
$5.00
Qd change
in response to price
$4.00
$3.00
$2.00
D
$1.00
1
2
3
4
5
Quantity
Moving Along the Demand Curve
• Consumer Response to Price Change?
– substitution effect
– income effect
Consumer Demand
• Moving Along the Demand Curve
– response to a change in price
• Shifting the Demand Curve?
– response to a change in something else
– (other things that alter consumer decision)
Shifting the Demand Curve
Price ($ per sandwich)
shift entire curve
in response to something else
$5.00
$4.00
$3.00
$2.00
$1.00
D0
1
2
3
4
5
Quantity
Shifting the Demand Curve
Price ($ per sandwich)
“increase demand”
(more Qd at every price)
$5.00
$4.00
$3.00
$2.00
$1.00
D0
1
2
3
4
5
D1
Quantity
Shifting the Demand Curve
Price ($ per sandwich)
“decrease demand”
(less Qd at every price)
$5.00
$4.00
$3.00
$2.00
$1.00
D0
D2
1
2
3
4
5
Quantity
Shifting the Demand Curve
• Change in Consumer Preferences
– tastes, trends and new information
• Change in Consumer Income
– normal goods and inferior goods
• Other
– change in price of substitutes or complements
– change in number of potential buyers
– change in expectations of future prices
BBQ Sandwiches
individual producers
price
stateline
little pigs
total bbq
starnes
$5.00
20
18
15
60
$4.00
12
16
14
50
$3.00
8
10
12
40
$2.00
0
4
12
30
$1.00
0
0
0
0
Price ($ per sandwich)
5
producer choice?
(decision to sell)
4
3
2
1
0
20
40
60
80
100
Quantity (barbecue sandwiches)
Price ($ per sandwich)
Supply
5
producer choice
(decision to sell)
4
3
2
1
0
20
40
60
80
100
Quantity (barbecue sandwiches)
Supply (a quick peek)
• Quantity Supplied (Qs)
– what producers make available at a given price
• Producer Response to Price Change?
– opportunity cost & MB of a higher price
• Moving Along the Supply Curve
– response to a change in price
• Shifting the Supply Curve
– input costs, technical change, number of sellers
Price ($ per sandwich)
Supply
5
producer choice
(decision to sell)
4
3
2
1
0
20
40
60
80
100
Quantity (barbecue sandwiches)
Price ($ per sandwich)
5
consumer choice
(decision to buy)
4
3
2
1
0
Demand
20
40
60
80
100
Quantity (barbecue sandwiches)
Market for BBQ Sandwiches
Price ($ per sandwich)
Supply
5
4
buyers & sellers together
3
2
1
0
Demand
20
40
60
80
100
Quantity (barbecue sandwiches)
Shift Which Curve?
Increase or Decrease?
(1) market for bbq sandwiches . . .
new information that bbq prevents heart disease
(2) market for apple juice . . .
decline in price for cranberry juice
(3) market for fresh baked bread . . .
increase in wages of bakery workers
(4) market for barbecue sandwiches . . .
new smokehouse technology (reduce cost, same quality)
Exploring Market Outcomes
Price
Market for BBQ Sandwiches
6
S
5
4
P*
3
2
1
0
D
20
40
Q*
60
80
100
Quantity (barbecue sandwiches)
Market Allocation
• at equilibrium price
Qd equals Qs
who buys & who sells?
• why do prices move toward equilibrium?
if price is too low . . . .
if price is too high . . . .
Price
Market for BBQ Sandwiches
6
S
5
4
P*
3
2
1
0
D
20
40
Q*
60
80
100
Quantity (barbecue sandwiches)
Market Allocation
• demand shifts & market responses
why would demand shift?
how do P & Q change?
what leads to movement along S?
• scarce resources & unlimited wants
prices, incentives, choices (decentralized)
Price
Demand Shift
6
S
5
event?
medical research reveals
health benefits of bbq.
4
3
2
1
D0
0
20 40 60 80 100 120 140
Quantity (barbecue sandwiches)
Price
Demand Increase
6
S
5
event?
medical research reveals
health benefits of bbq.
4
3
2
D1
1
D0
0
20 40 60 80 100 120 140
Quantity (barbecue sandwiches)
A Note on Oil Prices
• what may have shifted? which direction?
– 2001 to 2004, Spring 2012: prices rising, consumption rising
– Aug 2008 to April 2009: prices falling, consumption declining
• demand issues
–
–
–
–
economic growth (US, China & India, World)
global recession (2008-09)
industrialization vs. conservation, preferences
alternative energy sources, price of substitutes
Market Allocation
• supply shifts & market responses
why would supply shift?
how do P & Q change?
what leads to movement along D?
• scarce resources & unlimited wants
prices, incentives, choices (decentralized)
Price
Supply Shift
S0
6
5
4
event?
costs of hiring bbq cooks
increase for all producers.
3
2
1
D
0
20 40 60 80 100 120 140
Quantity (barbecue sandwiches)
Price
Supply Decrease
6
S0
S1
5
4
event?
costs of hiring bbq cooks
increase for all producers.
3
2
1
D
0
20 40 60 80 100 120 140
Quantity (barbecue sandwiches)
A Note on Oil Prices
• what may have shifted? which direction?
– 1979 to 1981: prices rising, consumption declining
– Dec 2004 to Sept 2005: prices rising, consumption declining
• supply issues
– coordinated decisions (OPEC), “number” of producers
– global/regional conflicts, production costs (& uncertainty)
– constraints on refinery capacity (Katrina & Rita), opportunity costs
Understanding Price Movements
Bananas, Weather in Honduras
Shift Which Curve? Increase or Decrease?
What Happens to Price and Quantity?
(1) market for bbq sandwiches . . . (D increase)
new information that bbq prevents heart disease
(2) market for apple juice . . . (D decrease)
decline in price for cranberry juice
(3) market for fresh baked bread . . . (S decrease)
increase in wages of bakery workers
(4) market for barbecue sandwiches . . . (S increase)
new smokehouse technology (reduce cost, same quality)
(1) Increase Demand
Price
S
D
Quantity
(1) Increase Demand
S
Price
P1
P0
Dbefore
Q0
Q1
Dafter
Quantity
(4) Increase Supply
Price
S
D
Quantity
(4) Increase Supply
Price
S (initial)
S (tech advance)
D
Quantity
What Markets Do Well
What Markets Do Well
• use information
relevant information, decentralized sources,
conveyed through price, helpful incentive
• respond to changing conditions
response to price (self), solution to problem (society)
• deliver efficiency
satisfy most wants from given resources,
(the promise of markets under ideal conditions)
Market for Coffee
Price
S (initial)
initial price
D
initial quantity
Quantity
Market for Coffee
S (weather event)
Price
S (initial)
new price
information, incentives,
helpful responses,
(efficient reallocation
of society’s resources).
initial price
D
Q1
Q0
Quantity
Q decline
Efficient Outcomes
• what is efficiency?
satisfying the most wants from given resources
(markets provide gains from voluntary exchange)
• consumer surplus
what you get is worth more than you pay
marginal benefit above price
• producer surplus
producer gets paid more than they sacrifice
price above marginal opportunity cost
Market for Coffee
Price
S
consumer surplus
for coffee lovers
P1
D
Q1
Quantity
Market for Coffee
Price
S
P1
producer surplus
for coffee firms
D
Q1
Quantity
Market for Coffee
Price
efficient allocation
of society’s resources.
S
consumer surplus
for coffee lovers
CS
P1
producer surplus
for coffee firms
PS
D
Q1
Quantity
Consequences of Intervention?
• price ceiling (holding prices below equilibrium)
Qd exceeds Qs, shortage, non-price allocation
– ATMs in SF
– ice in disaster area
– gasoline prices in 1973
Markets are Perfect,
Except When They’re Not
dysfunctional incentives
and the case for regulation
Market Allocation
• competitive market outcome
– price mechanism leads to equilibrium
– equilibrium represents efficient outcomes
– social choice through individual decisions
• reallocation of resources
information, incentives, & the invisible hand
Market Allocation
(opportunity cost
faced by producers)
(and society?)
S
e
d
at equilibrium
(balance mb,mc)
c
D
0
(value to consumers)
(and society?)
quantity
Key Assumptions of Free Markets
•
•
•
•
many producers
perfect information
limited “transactions” costs
no "third party" effects
important implications when not valid
Inefficient Outcome (too much Q)
S
Price
deadweight loss (DWL)
from overproduction.
D
0
Qc
Qhigh
Quantity
third party costs (negative externalities)
society mc
producer mc
Price
deadweight loss (DWL)
from overproduction.
D
0
Qc
Qhigh
Quantity
Policy Applications
• third party costs
– neighborhood land use (local zoning codes)
– producing electricity & pollution
legal liability & litigation (courts)
regulatory limit on pollution (EPA)
tax on pollution (carbon tax)
market for pollution permits (cap & trade)
• third party risks
– cell phones & driving (prohibition)
– uninsured & driving (legal mandate)
– financial risks & incentives (history & current debate)
Inefficient Outcome (not enough Q)
Price
deadweight loss from
underproduction.
S
CS
Pc
PS
D
0
Qlow
Qc
Quantity
Policy Applications
• third party benefits (positive externalities)
– honey production & fruit orchards
– education
public provision (public K-12, public support for higher ed)
public subsidy (Head Start, GI Bill, Pell Grants, Student Loans)
tax expenditure (educational vouchers, tax credits)
– technology spillovers (industrial policy)
• other cases where markets underproduce
– monopoly (antitrust, price regulation, patents)
– asymmetric information (food & drug safety regulation,
toxic materials, insurance contracts, deposit insurance
& audit reqs, government information provision)
Health Care Policy?
• asymmetric information
– physicians & fee-for-service (restructure rewards)
– short term choices & long term consequences
• third party risks
– immunizations (subsidize or mandate)
– treatment of uninsured (subsidize and mandate)
• large unspoken issue
– income matters in free markets
– HC as a human right, society’s willingness to pay
– advances open possibilities, unsustainable costs
Sessions & Topics
• Fundamental Tradeoffs and Economic Growth
• Markets Are Perfect, Except When They’re Not
• Income Inequality & Jobless Recoveries
• Public Goods & Sustainable Social Contracts