Microeconomics (notes and study guides)
Microeconomics (notes and study guides) Econ 1014
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Date Created: 09/27/15
Ch 7 The Price System Signals Speculations and Prediction Lecture Notes and Book Notes I Ch 7 The Price System Signals Speculations and Prediction almportant Overview Information i Prices are Signals conveying information ef ciently 1 A price is a signal wrapped in an incentive a Price tells important information about the economy b Prices represent the collective wisdom of tons of participants c They signal valuable information about where resources are more needed and less needed d That s why many economists take a less harsh view on price gouging for example making money by bringing ice ashlights batteries generators etc to places hit by natural disasters than most people First it is hard to de ne when a price is too highquot Furthermore the high prices and pro t incentives associated with them lead to the supplies being shipped to exactly where they are needed As the supplies increase the prices will start to fall Paying 5 for a bottle of water may feel like you are getting ripped off but it might well be better than the alternative especially in the absence of a solid government disaster response ii Making use of localized information 1 An important question to consider a How do we make use of Particular circumstances of time and place b Example i The close links of markets ii When the price of oil rose 1 Brazil shifted sugar cane into ethanol production rather than table sugar 2 As a result table sugar got more expensive 3 Prices and markets create a web of connections throughout the global economy Some other examples of how the increasing price of oil in uenced seeming unrelated markets 4 Flowers Increased oil prices made greenhouse ower production too expensive heaUngHenceeven though it involves shipping from halfway around the world it became cheaper to shift ower production to Kenya 5 Driveways As gasoline prices rose oil re neries increased the relative production of gasoline decreasing the production of asphalt As a result people switched to paving their driveways with brick or concrete 6 Beef Similar to the sugarcane issue mentioned above corn farmers in the US shifted some corn production towards ethanol increasing the price of corn used for other purposes feed This led to increased prices for beef and pork This was further enhanced by federal farm subsidies for ethanol 7 iii Speculation The attempt to pro t from future price changes 1 If a 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 also smooth prices uctuations iv Futures markets Markets for future delivery or purchase of a good 1 Usually commodities like corn oil soybeans gold 2 Various future dates future prices 3 Spot Market a Current market price spot price Signal Watching a Future prices can be extraordinary informative about future events b Sometimes the signals are noisy and future prices are less informative and accurate v Prediction markets 1 Book Notes Chapter 7 7172 7374 lowa Electronic Markets a U Iowa for educational purposes b Betting markets pool information Can produce better forecasts MARKETS LINK THE WORLD A Price is a signal wrapped up in an incentive aTo understand the market of a good understand that the prices are incentives i When the prices rise 1 All users are encouraged to economize by using less but also by thinking about substitutes 2 An increase in the price of oil is a signal to suppliers to invest more in exploration for alternatives 3 Price signals and the accompanying pro ts and losses tell entrepreneurs what areas of the economy consumers want expanded and what areas they want contracted 4 Losses may be an even more important signal than pro ts When entrepreneurs fail to compete with lower costs and better products take losses and their businesses contract or even go bankrupt Bankruptcy is bad for a business but can be good for capitalism In a free market no rm is so powerful that it does not daily face the market test As a result in a successful economy there will be many unsuccessful rms B Speculation 1 Example a If you knew the future of a price say its supply increase or decrease you could make money by buying low and selling high so you could buys a good when the price is low hold the good in storage and then sell it next year when the price is higher This process is called Pirieee witheut Speculatien T d l s quot F Future EMF P Hy Price in v 1 future with v 39 rie eipertulatien i retiiey39e price K ea zxaeue erre 5F etulet ien Dexmeind Demand Predue tien lireductieri teeiemr future Fricee with Speculation Tedey Future Slijpzieligir Euppiy Supplyquot Supier Inte Gui ei eterege a 1 eterege Price in a future with a a r m r a me SPEJELJJIE39UGIH 39V F iiee witih apetuieti ee Te dey e price Wiihrie Hewett epetuietiee Eme d 39Demam F redlu Eltiein Fire uCti n Ceneumptien E Eeris uri iptien ipreduetien minus prediuetiein Heine eteirege ii39itier39i ieeir39gir It is important to gain from these graphs the concept of how speculation tends to smooth prices over time and increase welfare The top panel indicates the price of oil oil consumption and oil production in an economy without speculation In the panel on the left Taken from the book Today the equilibrium is at point a the price is low and oil consumption and production are high In the panel on the right Future the price of oil is high because the disruption has reduced the production of oil Since no oil was stored from the previous period the consumption of oil is also reduced The bottom panel shows what happens with speculation In the left panel oil speculators buy oil and put it into storage pushing up the price of oil and reducing consumption today thus the equilibrium shifts from point I to point In the future when the price of oil is high at point I speculators sell their oil from storage The oil owing out of storage pushes the price down and allows people to consume more oil even though production is low The value of oil to consumers in blue falls today when oil is put into storage but rises by an even larger amount in the future when oil is in short supply and speculators move their stocks out of storage A Speculators raise prices today but lower prices in the future a Overall speculators aren t always correct b Speculators tend to make prices more informative even though in particular instances many speculators are wrong c Speculators can buy futures i Contracts to buy or sell a given quantity of a good at a speci c price with delivery set at a speci ed time and place in the future ii Almost all futures contracts actually settle in cash Example from e book Suppose Tyler believes that the price of oil will be higher in the future than what other people are expecting Tyler buys an oil contract that gives him the right to 1000 barrels of oil to be delivered in Cushing 30 months in the future Tyler agrees that on delivery he will pay the seller Alex 50 per barrel or 50000 Similarly Alex has agreed to deliver 1000 barrels of oil in Cushing in 30 months Thirty months from now Tyler s expectation is proven correct the actual or spot price of oil is 82 If Tyler went to Cushing he could physically accept the oil from Alex give him 50000 and then turn around and sell the oil to someone else for 82 per barrel for a profit of 32 per barrel or 32000 Instead of doing that however Tyler and Alex could agree to cash settlement Alex has agreed to give Tyler 1000 barrels of oil which are currently worth 82000 for a price of 50000 Instead of giving Tyler the oil suppose that Alex gives Tyler the cash difference 32000 and they call it even The advantage of cash settlement is that Tyler and Alex can both speculate on the price of oil without ever accepting or delivering oil B Future markets are used for speculation and for reducing risk To avoid price risk a buyer can sell futures in preparation for a future decline 76 Signal watching 1 If the futures price is higher than the spot or current price this is an indication that individuals believe their own money invested believe that supply disruptions may soon occur 2 Future prices can be considerably informative about future events a noisy signals b 77 a Prediction Markets a Speculative markets designed so that prices can be interpreted as probabilities and used to make predictions Iowa Electronic Markets example of prediction market Market Predictions are sometimes a little high and sometimes a little low they are centered around the 45degree line which means that they are correct on average REMEMBER Market prices are signals that convey valuable information Buyers and sellers have an incentive to pay attention to and respond to prices and in so doing they direct resources to their highestvalue uses That means everyone can make the most out of limited resources c IMPORTANT TAKEAWAYS FROM THIS CHAPTER i Markets are linked geographically through time and across different good ii examples taken from the book The price of oil today is linked to the expectations about the market for oil in the future and through investment to the market for oil in the past Markets in one good are linked to markets in other goods iii The complexity of the world wide market is complex and therefore neither designed or completely comprehensible invisible hand iv A price is a signal wrapped in an incentive the prices signal the value of resources to consumers suppliers and entrepreneurs and they incentivize everyone to take appropriate actions to respond to scarcity and changing circumstances v Free market prices work as signals because through buying and selling prices come to re ect important pieces of information The futures price of oil can signal wars in various Middle Eastern countries vi Market prices can be so informative that new markets predictive markets are bing created to help businesses governments and scientist Predict future events d Important vocabulary Great economic problem ii Speculation Futures Prediction Market
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