Scott Wentland wentlandsa@longwood 434-395-2160

Scott Wentland wentlandsa@longwood.edu 434-395-2160 Longwood University201 High StreetFarmville, VA 23901

Markets, Information, and Incentives

Market prices provide information and incentives • Prices guide the behavior of consumers and producers • Also create incentives of workers, employers, savors, investors, and anyone else who participates in markets • Why is this important? • Efficiency and order, without intention • Adam Smith called this the “invisible hand” • F. A. Hayek called this “spontaneous order”

Buyers • Buyers always want the lowest price they can get from something • Sellers • Sellers always want the highest price they can get for something • What happens when they get together? • They agree to exchange • End up somewhere in between

The nature of exchange • Buyers and sellers agree on a mutually beneficial price • Always a win-win (ex ante) • How do we know it is a win-win? • Exchange is voluntary • If the buyer didn’t benefit (on net), s/he wouldn’t buy • If the seller didn’t benefit (on net), s/he wouldn’t sell • Do you really have to buy an iPhone? • Yes? You value iPhone > iPhone’s price • No? It wasn’t worth it to you…

Another Example: • Seller (me): I can produce a barrel of oil for $10 • Buyer (you): You want a barrel of oil, and are willing to pay up to $60 • Result: we agree to a price so that we both win • Suppose we agree on a price of, say, $30 • I win because I get $30 for something that cost me $10 • PRODUCER SURPLUS (Profit) = $20 • You win because you get something you value for $60 for only $30 • CONSUMER SURPLUS = $30

Gains from Trade Are Maximized at Equilibrium Price and Quantity A Free Market Maximizes Producer plus Consumer Surplus (the gains from trade) Price of Oil per Barrel Supply Curve Buyers Non-Sellers Consumer Surplus Equilibrium Price $30 Producer Surplus Sellers Non-Buyers Demand Curve Quantity of Oil (MBD) 65 Equilibrium Quantity

Marketsare efficient • Lowest cost producers are the sellers • Highest value consumers are the buyers • No more mutually advantageous trades can take place • Producer surplus (profit) and consumer surplus are maximized • This is all done voluntarily, because people just want to better themselves • Both buyers and sellers are self-interested

Up to this point: • Buyers and sellers get together in markets • Negotiate price…an equilibrium emerges • Presto! Efficiency! • The story is a bit more complicated… • How markets work  more interesting than just the outcome or equilibrium

Supply and demand helps us understand how markets work • Helps show us how prices emerge, not just that markets are efficient • What if a market is not in equilibrium? How does it get there? • How do buyers and sellers figure out how to get to the right price?

What happens if the price is too high? • At prices greater than the equilibrium price: Quantity Supplied > Quantity Demanded • Economists refer to this as Excess Supply or Surplus. • Note that prices convey information • The high price gives buyers an incentive to cut back • Law of demand: buyers want less when price is high • The high price gives sellers an incentive to produce more • Law of supply: sellers want to sell more at a higher price • Result: surplus

Excess Supply Excess Supply Drives Prices Down Price per Barrel Supply Curve Surplus $50 $30 Equilibrium Price Demand Curve Quantity of Oil (MBD) 32 100 65 Equilibrium Quantity

In this situation sellers must reduce their prices to induce buyers to purchase all of this extra product. • The lower price gives buyers an incentive to buy more and sellers to produce less • As prices fall, the surplus disappears • When there’s no surplus, and S = D  equilibrium

How do sellers know the price is too high and they are out of equilibrium? • Quantities convey information too  check your shelves • With a surplus on the market, sellers know to lower price • The lower price will attract more buyers • If the price was too high, the market was wrong, temporarily • Why temporarily? • What if they lower the price too much?

What happens if the price is too low? • At prices less than the equilibrium price Quantity Supplied < Quantity Demanded • Economists refer to this as Excess Demand or Shortage. • Again, prices convey information! • The low price gives buyers an incentive to buy more • Law of demand: buyers want more when price is low • The low price gives sellers an incentive to produce less • Law of supply: sellers want to sell less at a low price • Result: shortage

Excess Demand Excess Demand Drives Prices Up Price per Barrel Supply Curve Equilibrium Price $30 $15 Shortage Demand Curve Quantity of Oil (MBD) 24 95 65 Equilibrium Quantity

How do sellers know the price is too low and they are out of equilibrium? • Quantities convey information too  Are there lines? Back orders? • With a market shortage, sellers know to raise price • Sellers would always like to charge more…a shortage tells them that they can, and they will still have customers!

Prices guide behavior in markets • Buyers know to economize when the price is too high • Sellers know to make more when the price is high • And, vice versa • Prices are important and create order out of chaos • Buyers and sellers are guided by self-interest to reach efficient outcomes • No one tells them to reach an equilibrium, they go to it spontaneously…order emerges out of buyers and sellers reacting to prices

Markets create order, from the bottom up • Order emerges in markets through individuals acting out of self-interest • The result: a more efficient allocation of societal resources than any (centrally planned) design could possibly achieve • Why?

Markets create order, from the bottom up • Why? • Without prices and markets, people don’t have a good incentive to take care of shortages and surpluses • Centrally planned, communist countries: plagued by shortages (of good things) and surplus (less useful things) • Prices are information, coming from market participants  impossible for government to know all!

The economist F.A. Hayek focused on prices as information and incentives • Adam Smith had a similar idea, but focused on the motivation of buyers/sellers: • "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 self interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.“ – Adam Smith, The Wealth of Nations

Prices guide actions of individuals • Prices emerge from individuals participating in markets • In a free market, no central authority “sets” prices • “[one’s] own gain is led by an invisible handto promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of it. By pursuing his own interest [an individual] frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the [common] good.“ – Adam Smith, The Wealth of Nations

Can we do better? • What if we don’t like the market outcome? • What if we don’t think self-interested individuals should be left to their own device? • Example • Some people don’t get paid enough • The market wage (determined by supply and demand) is very low for some jobs • Solution: minimum wage (a type of “price floor”)

Price Floors Wage ($) Supply Labor surplus Minimum wage (floor) (Unemployment) Conclusion: the greater the difference between the minimum wage and the market wage, the greater is unemployment Market wage Demand Quantity Quantity supplied at minimum wage Quantity demanded at minimum wage Market employment

Can we do better? • What if we don’t like the market outcome? • What if we don’t think self-interested individuals should be left to their own device? • Example • Some stuff is too expensive  sellers “gouge” • The market price might seem to high • Solution: price ceiling  government mandated ceiling on price…the market cannot charge higher than the set price

How Price Ceilings Affect Market Outcomes Example: rent in NYC is “too high” The price ($1000) is above the ceiling and therefore illegal. The ceiling is a binding constrainton the price, causes a shortage. P S Price ceiling $500 shortage D Q 400 250 $1000

Sometimes we don’t like the market outcome • Policies that interfere with market forces often have unintended consequences • Is all market interference bad? • No. But policymakers need to be very careful about the effects of various policies • Have to weigh unintended consequences against other social goals

Studying markets is like studying physics • Is gravity bad? Is motion good?  nonsense • Like gravity, market forces simply exist. • How can we make market forces work for us? • Understanding how markets work (through supply and demand) helps us understand the world we live in

http://en.wikipedia.org/wiki/Supply_and_demand http://en.wikipedia.org/wiki/Invisible_hand http://en.wikipedia.org/wiki/Spontaneous_order http://en.wikipedia.org/wiki/Price_ceiling http://en.wikipedia.org/wiki/Price_floor

Scott Wentland wentlandsa@longwood 434-395-2160