Chapter 3. Second Edition. Supply and Demand

Transcription

1 Chapter 3 Second Edition Supply and Demand

2 Introduction Most important tools in economics: Supply Demand Equilibrium Oil market: arguably the most important market in the world. We will learn to use these tools in the context of the oil market. 2

3 The Demand Curve for Oil Demand curve a function that shows the quantity demanded at different prices. Quantity demanded the quantity that buyers are willing and able to buy at a particular price. Let s look at a hypothetical demand curve for oil. 3

4 The Demand Curve for Oil Price of oil/barrel $40 Price Quantity Demanded $40 5 $20 25 $5 50 $20 $ Demand Quantity of Oil (MBD) 4

5 The Demand Curve for Oil Price of oil/barrel $40 Demand Curves are read two ways: 1. Horizontally At a given price how much are people willing to buy? 2. Vertically What are people willing to pay for a given quantity? $20 $ Demand Quantity of Oil (MBD) 5

6 Why Is the Demand Curve Downward Sloping? Oil is not equally valuable in all its uses. If the price of oil is high, it is used in only higher valued uses. Air Force One Commuting If the price of oil is low, it can be used also in lower valued uses. Manufacture rubber duckies Sight seeing 6

7 Why Is the Demand Curve Downward Price of oil/barrel Sloping? $40 Higher valued uses $20 $ Lower valued uses Demand Quantity of Oil (MBD) Law of Demand: price quantity demanded 7

8 Consumer Surplus Consumer surplus The consumer s gains from exchange, or, The difference between the maximum price the consumer is willing to pay and the market price. Total consumer surplus Measured by the area below the demand curve and above the market price. Let s use the demand curve for oil to show these concepts. 8

9 Consumer Surplus Price of oil/barrel $80 Suppose the market price = $20 $60 $40 President s consumer surplus Delta Airlines consumer surplus Total Consumer Surplus Frank s (retiree) consumer surplus $ Demand Quantity of Oil (MBD) If the demand curve is linear, measuring consumer surplus is easy. 9

10 Consumer Surplus Price of oil/barrel $80 Suppose the market price = $20 $60 $40 President s consumer surplus Delta Airlines consumer surplus Total Consumer Surplus Frank s (retiree) consumer surplus $20 Demand Quantity of Oil (MBD) If the demand curve is linear, measuring consumer surplus is easy. 10

11 Consumer Surplus Price of oil/barrel $80 $60 $40 $ Demand Quantity of Oil (MBD) 11

12 Try it! Your roommate just bought an ipad for $600. She would have been willing to pay $1,000 for a machine that could make her life so much more worthwhile. How much consumer surplus does your roommate enjoy from the ipad? a) $600 b) $400 c) $1600 d) $1400 To next Try it!

13 Try it! If the price is $2010, what is the consumer surplus? a) $3,588,000 b) $1,794,000 c) $6,000,000 d) $3,000,000 To next Try it!

14 What Shifts the Demand Curve? Increase in demand - shifts the demand curve to the right. At the same price people are willing to buy more. At the same quantity, people are willing to pay a higher price. Decrease in demand shifts the demand curve to the left. At the same price people are willing to buy less. At the same quantity, people are willing to pay a lower price. Both of these can be shown in the following diagrams. 14

15 Shifting the Demand Curve Price of oil/barrel An Increase in Demand $50 Willing to pay a higher price for same quantity. Willing to buy more at the same price. $25 New Demand Old Demand Quantity of Oil (MBD) 15

16 Shifting the Demand Curve Price of oil/barrel An Decrease in Demand Willing to buy less at the same price. $40 Willing to pay a lower price for the same quantity $ New Demand Old Demand Quantity of Oil (MBD) 16

17 What Shifts the Demand Curve? Important Demand Shifters 1. Income Normal goods Inferior goods 2. Population 3. Price of substitutes 4. Price of complements 5. Expectations 6. Tastes Let s look at each of these in turn. 17

18 Demand Shifter: Income Normal good demand when income Example: As income increases in India, many people will buy their first car. This increases the demand for oil. Inferior good demand when income Example: As college students graduate, and their incomes increase they eat less ramen noodles. Let s illustrate each of these with the demand curve. 18

19 Demand Shifter: Population Increase in population number of consumers demand. Demographic changes some subpopulations increase faster than others. Examples The average age gets older. (e.g. the U.S.) The average age gets younger. (many developing countries) Result: as average income grows, the demand for some categories of goods increases faster. 19

20 Demand Shifter: Price of Substitutes Substitute goods those than can be used as alternatives for the other. Decrease in the price of a substitute demand for a good. Examples: price of natural gas demand for petroleum. price of coffee demand for tea. price of Toyota cars demand for Ford cars. 20

21 Demand Shifter: Price Complements Complements goods that are used together Decrease in the price of a complement demand for a good. Examples: price of computer software demand for computers. price of cars demand for gasoline. price of hamburger demand for hamburger buns. 21

22 Try it! When the price of petroleum goes up, the demand for natural gas, the demand for coal, and the demand for solar power. a) increases; increases; increases b) increases; increases; decreases c) decreases; decreases; increases d) decreases; decreases; decreases To next Try it!

23 Demand Shifter: Expectations Expectation of the future price of a good will shift the demand curve for that good. Expected higher price demand. Expected lower price demand. Examples: Trouble in the Middle East higher expected price of oil current demand for oil. News of a spring freeze in Florida higher expected price of oranges current demand for oranges. 23

24 Demand Shifter: Tastes Changes in tastes shift demand curves all of the time. Examples Fad diets that advocate eating mostly protein demand for beef. People desire to have a lower carbon footprint demand for hybrid cars. Social stigma for wearing real animal fur demand for fur coats. 24

25 What Shifts the Demand Curve? A change in quantity demanded is NOT the same as a change in demand. Quantity demanded changes only when the price of a good changes. It is a movement along a fixed demand curve. Demand changes only when a non-price factor (demand shifter) changes. It is a shift in the entire demand curve. A change in Quantity Demanded A change in Demand

26 Try it! When the price of a good increases the quantity demanded. When the price of a good decreases the quantity demanded. a) rises; rises b) rises; falls c) falls; rises d) falls; falls To next Try it!

27 The Supply Curve for Oil Supply curve a function that shows the quantity supplied at different prices. Quantity Supplied the amount of a good that sellers are willing and able to sell at a particular price. The next diagram shows a hypothetical supply curve. 27

28 The Supply Curve for Oil Price of oil/barrel Supply $40 $20 $ Price Quantity Supplied $40 44 $20 30 $5 10 Quantity of Oil (MBD) 28

29 The Supply Curve for Oil Price of oil/barrel Supply $40 $20 $ Supply Curves are read two ways: 1. Horizontally At a given price, quantity sellers are willing to sell. 2. Vertically Minimum price that sellers must get to produce a given quantity. Quantity of Oil (MBD) 29

30 Supply Curves Why is the supply curve upward sloping? The cost of producing a good is not equal across all suppliers. At a low price, a good is produced and sold only by the lowest cost suppliers. At a high price, a good is also produced and sold by higher cost suppliers. 30

31 The Supply Curve for Oil Why is the supply curve for oil upward sloping? Not all oil costs the same to lift to the surface. Saudi Arabia - $2.00 per barrel Iran & Iraq - $2.00 plus a bit more Nigeria and Russia - $5 to $7 per barrel Alaska - $10 per barrel North Sea - $12 per barrel. Canada s tar sands - $22.50 per barrel U.S. - $27.50 per barrel Oklahoma oil shale - $40 Let s see what this looks like in a supply curve. 31

32 Why Is the Supply Curve for Oil Upward Sloping? Price of oil/barrel $60 Supply 40 Higher-cost oil Oil shale becomes profitable here 20 0 Lowest-cost oil Quantity of Oil (MBD) Law of Supply: price quantity supplied 32

33 Producer Surplus Producer surplus The producer s gain from exchange The difference between the minimum price the seller is willing to accept and the market price. Total producer surplus Measured by the area above the supply curve and below the market price. Let s use the supply curve for oil to show these concepts. 33

34 Producer Surplus Price of oil/barrel $60 Total producer surplus at a price of $40 Supply Quantity of Oil (MBD) 34

35 Try it! Using the following diagram, calculate total producer surplus if the price of oil is $50 per barrel. a) 0 b) $45 c) $1,350 d) $2,700 To next Try it!

36 What Shifts the Supply Curve? Increase in Supply - shifts the supply curve to the right. At the same price producers are willing to sell more. At the same quantity, producers are willing to accept a lower price Decrease in supply shifts the supply curve to the left. At the same price sellers will offer less. At the same quantity, sellers demand a higher price. Both of these can be shown in the following diagrams. 36

37 What Shifts the Supply Curve? Price of oil/barrel $60 Increase in supply Old supply New supply Willing to accept a lower price for the same quantity Greater quantity supplied at the same price Quantity of Oil (MBD) 37

38 What Shifts the Supply Curve? Price of oil/barrel $60 New supply Old supply Decrease in supply Higher price required for the same quantity Smaller quantity supplied at the same price Quantity of Oil (MBD) 38

39 What Shifts the Supply Curve? General rule: Cost changes shift the supply curve cost supply curve shifts left (higher P) cost supply curve shifts right (lower P) Important Supply Shifters 1. Technological innovations and changes in the prices of inputs 2. Taxes and subsidies 3. Expectations 4. Entry and exit from the industry 5. Changes in opportunity costs Let s look at these supply shifters in turn. 39

40 Supply Shifter: Technological Innovations and Changes in Price of Inputs Improvement in technology Results in lower cost to produce the same output. Example: sidewise drilling. Changes in prices of inputs Increased labor costs Higher wages Higher payroll taxes Higher cost of mandatory health insurance. Increased capital and materials costs Higher interest rates Higher energy costs 40

41 Supply Shifter: Taxes and Subsidies Taxes on commodities and services Higher tax is considered an increase in cost. Subsidy Same as a negative tax Considered a decrease in cost It is easier to see this if we use a diagram. 41

42 Effect of a Tax on the Supply Curve of Oil Price of oil/barrel $50 Sellers require a $10 higher price to sell the same quantity New supply $10 Old supply Tax = $10/barrel 40 0 = Quantity of Oil (MBD) Note: A subsidy of $10 per barrel would shift the supply curve down. 42

43 Taxes and Subsidies Taxes and subsidies affect profits and therefore supply. A 10% yacht tax reduced the supply of yachts 53% in the early 1990s. 43

44 Supply Shifter: Expectations What sellers think the price of their product will be in the future can have a dramatic effect on current supply. Examples War in Middle East expected prices of oil. Frost in Florida expected price of orange juice. Favorable rains in mid-west expected price of wheat Higher expected prices Decreased supply Lower expected prices Increased supply 44

45 Supply Shifter: Expectations Higher expected future prices Price of oil/barrel $50 Supply today with higher expected future price Supply today 40 Into storage Lower quantity at the same price Quantity of Oil (MBD) 45

46 Supply Shifter: Entry or Exit of Producers This one s easy: producers increase supply NAFTA resulted in Canadian firms entering the U.S. lumber market When patents expire more firms enter an industry Net entry into a market Increased supply Net exit from a market Decreased supply Let s look at each of the examples in turn. 46

47 Supply Shifter: Entry or Exit of Producers Entry Increases Supply Price Domestic Supply Greater Quantity Supplied at the Same Price Domestic Supply Plus Canadian Imports Lower Price for the Same Quantity Supplied 47 Quantity

48 Supply Shifter: Entry or Exit of Producers Patent On a Medicine Expires Price/dose $2.75 Old supply New supply 1.50 Entry Higher quantity at the same price // Quantity of Doses (millions)

49 Supply Shifter: Opportunity Costs Opportunity cost applied to supply Suppose producers can produce alternative products price of the alternative opportunity cost of producing the good. Example A farmer producing soybeans could also grow wheat. An increase in the price of wheat opportunity cost of soy beans opportunity cost supply

50 Supply Shifter: Opportunity Costs Effect of an increase in the price of wheat Price of soybeans/bushel $7 5 Higher price required to sell the same quantity Supply with higher opportunity costs Lower quantity at the same price Supply with low opportunity costs // 2,000 2,800 Quantity of soybeans (millions of bushels)

51 Try it! Technological innovations in chip making have driven down the costs of producing computers. What happens to the supply curve for computers? Why? B ACK TO

52 Try it! The U.S. subsidizes making ethanol as a fuel made from corn. What effect does this subsidy have on the supply curve for ethanol? B ACK TO

53 Takeaway A demand curve shows the quantity demanded at different prices. A supply curve shows the quantity supplied at different prices. You should be able to define and show how consumer surplus and producer surplus are measured. You should know what shifts the demand and supply curves and which direction.

54 End of Chapter 3 Second Edition

55 Chapter 4 Equilibrium: How Supply Second Edition and Demand Determine Prices

56 Chapter Outline Equilibrium and the adjustment process Gains from trade are maximized at the equilibrium price and quantity Does the model work? Evidence from the laboratory X Shifting demand and supply curves Terminology: Demand compared to quantity demanded and supply compared to quantity supplied Understanding the price of oil 56

57 Equilibrium and the Adjustment Process Definitions Surplus situation in which quantity supplied is greater than quantity demanded Sellers will offer lower prices Shortage situation in which quantity demanded is greater than quantity supplied Buyers will offer higher prices Equilibrium price price at which quantity demanded equals quantity supplied 57

58 Market Equilibrium There is ONLY ONE PRICE where Qs = Qd This is equilibrium price and quantity No shortages No surpluses FREE MARKETS ALWAYS MOVE TOWARD EQUILIBRIUM PRICE

59 Equilibrium and the Adjustment Process Price is Determined by Supply and Demand Price of Oil per Barrel Supply Curve Equilibrium Price $30 Demand Curve 65 Equilibrium Quantity Quantity of Oil (MBD)

60 Equilibrium and the Adjustment Process Price of Oil per barrel $80 P = $80 surplus Supply Equilibrium price $70 Price is driven Demand // Equilibrium quantity Quantity of Oil (MBD) 60

61 Equilibrium and the Adjustment Process Price of Oil per barrel Supply Equilibrium price $70 Price is driven $50 P = $50 shortage Demand = // Equilibrium quantity Quantity of Oil (MBD) 61

62 Try it! At a price of $3, quantity supplied is and quantity demanded is, leading to a. a) 6; 2; surplus of 4 units b) 2; 4; surplus of 2 units c) 2; 6; shortage of 8 units d) 4; 2; shortage of 2 units To next Try it!

63 Gains from Trade are Maximized at the Equilibrium Price and Quantity What this means 1. The supply of goods is bought by buyers with the highest willingness to pay. 2. The supply of goods are sold by the buyers with the lowest costs. 3. Between buyers and sellers, there are no unexploited gains from trade or any wasteful trades. Let s us the market model to show this. 63

64 Unexploited Gains From Trade Price of Oil per barrel Equilibrium price $90 70 Suppose quantity is 50: less than the equilibrium quantity Supply At Q = 50: Willingness to pay equals P = $90 Willingness to sell equals P = $50 50 = // 50 Unexploited Gaines from trade Equilibrium quantity Demand Quantity of Oil (MBD) 64

65 Unexploited Gains From Trade Price of Oil per barrel Equilibrium price $90 70 Suppose quantity is 90: greater than the equilibrium quantity Supply At Q = 90: Willingness to sell at P = $90 Willingness to pay at P = $50 50 = // 50 Unexploited Gaines from trade Equilibrium quantity Demand Quantity of Oil (MBD) 65

66 Free Market Maximized Gaines From Trade Price of Oil per barrel Equilibrium price $ Suppose quantity is Equal to the equilibrium quantity Supply At Q = 70: Q d = Q s At P = $70 P buyers willing to pay = Psellers willing to accept Conclusion: No unexploited gains from trade Demand = // Equilibrium quantity Quantity of Oil (MBD) 66

67 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 Equilibrium Price $30 Consumer Surplus Producer Surplus Sellers Non-Buyers 65 Equilibrium Quantity Demand Curve Quantity of Oil (MBD)

68 Equilibrium and Total Surplus Equilibrium in a free market yields two important results: Goods must be produced at the lowest possible cost. Goods must satisfy the highest valued demands. These results indicate that total surplus (both of the consumer and producer) is maximized in free markets.

69 Shifting Demand and Supply Curves Another way to test the model is to examine its predictions about what happens when the demand and supply curves shift. Key to learning Do: Focus on how to use the model Do not: try to memorize results of every possible scenario Do: memorize the shifters Let s take the model for a few test drives. 69

70 Shifting Demand and Supply Curves: Market for Laptops Effect of P of computer chips Price of laptops Original Supply New Supply P a P b a b price of chips cost of laptops Demand = // Quantity Q a Q b of laptops 70

71 Shifting Demand and Supply Curves: Market for Software Effect of P of laptops Price of software Original Supply P b P a a b price of laptops demand for software New Demand = // Q a Q b Original demand Quantity of software 71

72 Shifting Supply and Demand Curves: Higher Expected Prices Expectations about future prices affect us often. Let s look at the effect of a hurricane approaching the Gulf states Many oil refineries located in these states are often shut down during hurricanes. Electrical service is often interrupted for days if not weeks. What happens to the prices of some goods before the hurricane arrives? 72

73 Shifting Demand and Supply Curves: Market for Gasoline Effect of higher expected prices Price of gasoline Original Supply P b P a a b Approaching hurricane expected future price. New Demand = // Q a Q b Original demand Quantity of gasoline 73

74 Shifting Demand and Supply Curves: Market for Generators Effect of higher expected prices Price of generators Original Supply P b P a a b Approaching hurricane expected future price. New Demand = // Q a Q b Original demand Quantity of generators 74

75 Try it! Flooding in Iowa destroys some of the corn and soybean crop. What will happen to the price and quantity for each of these crops? To next Try it!

76 Try it! With the increase in gasoline prices, demand has shifted away from large cars and SUVs and toward hybrid cars like the Prius. Draw a graph showing the supply and demand for hybrid cars before and after the increase in the price of gasoline. What do you predict will happen to the price of hybrids as the price of gasoline rises? To next Try it!

77 Terminology: Demand Compared to Change in demand Quantity Demanded Refers to a shift in the demand curve Caused by a change in one of the shifters of the demand curve Change in quantity demanded Refers to a movement along the same demand curve Caused by a change in the price This can be illustrated with our model. 77

78 Terminology: Demand Compared to Quantity Demanded P Change in demand P Change in quantity demanded S S 1 S 2 P E2 P E1 P E1 D 2 P E2 D 1 D Q Q Q E1 Q E2 Q E1 Q E2 Note: the change in quantity demanded results from a change in supply. 78

79 Terminology: Supply Compared to Quantity Change in supply Supplied Refers to a shift in the supply curve Caused by a change in one of the shifters of the supply curve Change in quantity supplied Refers to a movement along the same supply curve Caused by a change in the price 79

80 Terminology: Supply Compared to Quantity Supplied P Change in supply P Change in quantity supplied S 1 S S 2 P E2 P E1 P E1 P E2 D 2 D D 1 Q E1 Q E2 Q Q E1 Q E2 Q Note: the change in quantity supplied results from a change in demand. 80

81 Understanding the Price of Oil The supply and demand model can be used to understand the behavior of oil prices since Let s turn to the following diagram. 81

82 Understanding the Price of Oil 82

83 Takeaway Your understanding of this chapter should include the following: 1. Market competition brings about an equilibrium in which quantity demand equals quantity supplied. 2. Only one price/quantity combination is a market equilibrium and you should be able to identify this equilibrium in a diagram. 3. You should understand and be able to explain the incentives that enforce the market equilibrium. What happens when the price is above the equilibrium price? Why? What happens when the price is below the equilibrium price? Why? 83

84 Try it! If garden gnomes regain widespread popularity, what will happen? a) Equilibrium Price and Quantity both fall. b) Equilibrium Price and Quantity both rise. c) Equilibrium Price falls and Quantity rises. d) Equilibrium Price rises and Quantity falls. To next Try it!

85 Try it! To next Try it!

86 Try it! #1: New machine is invented that lowers the cost of harvesting oranges.

87 Try it! #2: The FDA announces health benefits to eating oranges.

88 Try it! #2: The income of consumers falls and some orange growers quit the business and turn their orange groves into housing developments..

89 End of Chapter 4 Second Edition

90 Chapter 7 Second Edition The Price System: Signals, Speculation, and Prediction

91 Chapter Outline Markets link the world Markets link to each other Solving the great economic problem A price is a signal wrapped up in an incentive speculation signal watching prediction markets 91

92 Introduction Prices Convey important information Create incentives In other words, prices integrate markets and motivate entrepreneurs We will see how the price system enables societies to mobilize knowledge and resources toward common ends All without central planning 92

93 Markets Link the World Just where did that rose you gave or received last Valentine s Day come from? Likely Grown in Kenya Flown to the largest flower auction in Holland Loaded onto cooled aircraft Becomes a gift of love in Stillwater, Oklahoma All this in 72 hours. 93

94 Markets Link to Each Other Shifts of supply and demand in one market affect the entire world market Let s see how the market for Oil and flowers are linked. Example Prior to 1970s roses were grown in American greenhouses. Higher oil prices in the 1970s costs of growing roses in greenhouses It became cheaper to grow flowers in warm countries and ship them to colder countries Flower production moved from California to Kenya 94

95 Markets Link to Each Other The price of oil rose. Brazil shifted sugar cane into ethanol production (rather than table sugar). As a result, table sugar got more expensive. Thus, one way that we economize on oil is by eating fewer donuts! 95

96 Try it! Sawdust is used for bedding milk cows. What did the end of the housing boom in 2007 do to the price of milk? 96

97 From Oil to Candy Bars and Brick Driveways The price of oil affects how driveways are built. 42-gallon barrel of oil is refined into gasoline and other products Asphalt is what is left after the other products High price of gasoline will cause refiners to production of gasoline and production of asphalt price of asphalt price of asphalt use of concrete, cobblestone, and brick 97

98 Solving the Great Economic Problem Great Economic Problem limited resources, unlimited wants Commodities (Oil) are not equally valuable in all uses. If the supply of oil, oil should shift to higher valued uses. How? Central planner lacks information and incentives There is a better way. 98

99 Solving the Great Economic Problem Price system Each user compares the values of commodities in alternative uses. Each user has an incentive to give up a commodity if it has a lower value than in alternative uses. In the free market, the price of the good (asphalt) is equal to its opportunity cost. Let s use our model to show how the market allocates goods to their highest value uses 99

100 Solving the Great Economic Problem Price of oil per barrel High Valued uses Satisfied demands Supply Market price Unsatisfied demands Any use of oil valued less than the market price will not get oil Low Valued uses Market Quantity Demand Quantity of oil (MBD) 100

101 Solving the Great Economic Problem How does the market solve the problem created by a decrease in supply? Price of oil per barrel New Market price High Valued uses Satisfied demands New Supply Old Supply Additional unsatisfied demands Market price Unsatisfied demands New market Quantity Low Valued uses Demand Quantity of oil Market Quantity (MBD) 101

102 SEE THE INVISIBLE HAND Hayek saw the invisible hand the marvel is that in a case like that of the 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 are made to use the material or its products more sparingly; i.e., they move in the right direction - Nobel Laureate Friedrich Hayek 102

103 A Price is a Signal Wrapped Up in an Incentive How is order produced from freedom of choice? When the price of oil rises, all users are encouraged to economize By using less, or, Substituting to a lower cost alternative. It is a signal To suppliers to invest more in exploration. To look for alternative sources of energy. 103

104 A Price is a Signal Wrapped Up in an Incentive Politicians and consumers sometime fail to understand the signaling role of prices. Example: After a hurricane, prices of ice, generators, and chainsaws skyrocket Consumers complain of price gouging Politicians call for price controls. This is a bad rap on the market because it is just doing its job: signaling for more resources to come to the rescue! 104

105 A Price is a Signal Wrapped Up in an Incentive Losses are also a signal Businesses that fail to produce goods people want at low prices will fail Resources will go to firms that are able to do this Entrepreneurs with the best ideas may succeed. Others will fail. Result: In a successful economy there will be many unsuccessful firms. 105

106 Try it! Imagine that whenever the supply of oil rose or fell, the government sent text messages to every user of oil asking them to use more or less oil as the case warranted. Suppose that the messaging system worked very well. Is such a messaging system likely to allocate resources as well as prices? Why or why not? What is the difference between the message system and the price system? To next Try it!

107 Speculation Speculation is the attempt to profit from future price changes. 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 smooth prices fluctuations. 107

108 Speculation Tends Smoothens Prices and Increases Welfare Prices without speculation Price Price Supply Supply Price in future Today s price Production today Demand Q Production future Demand Q 108

109 Speculation Tends Smoothens Prices and Increases Welfare Prices with speculation Price with speculation Price Today s Price no speculation Supply Into storage Consumption = Production minus storage Supply Production today Price in future Loss in value Gain in value Q Price Supply Supply Out of storage Result: Stable price Welfare Q Production future Consumption = Production plus inventory 109

110 Speculation Why Do Speculators Have an Image Problem? They raise prices today but lower prices in the future Everyone sees the price increase No one sees that the future price is lower than it would have been Why is society better off with speculation? Oil is moved from when it is lower valued to when it is higher valued. Speculators don t always guess correctly, but They use their own money. They have a huge incentive to be right. Bad speculators go bankrupt. 110

111 Takeaway Markets are linked Geographically Through time Across different goods The market acts like a giant computer that arranges limited resources over space, time, and across different goods to satisfy as many of our wants as possible. Prices are the signals that coordinate this economic activity. 111

112 Takeaway Free market prices reflect information. Prices in futures markets can signal War in the Middle East Cold weather in Florida Who will win the next election Prediction markets are being created to help businesses, governments, and scientists predict future events. 112

113 End of Chapter 7 Second Edition