Unit9_Feb2015.pdf

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9MARKET DYNAMICS

HOW MARKETS CHANGE WHEN SUPPLY OR DEMAND CHANGES, AND HOW PRICES SEND MESSAGES THAT REFLECT THE SCARCITY OF RESOURCES.You will learn:

How changes in market conditions lead to shifts in demand or supply, and adjustment to a new equilibrium price and quantity.

That market prices can act as messages (both to individuals and between markets) about the relative scarcity of goods.

The distinction between a short-run and long-run equilibrium.

How prices are determined in financial markets, and how they change from minute to minute.

How price bubbles can occur.

Why some prices dont change, and some markets do not clear.

February 2015 beta

See www.core-econ.org for the full interactive version of The Economy by The CORE Project. Guide yourself through key concepts with clickable figures, test your understanding with multiple choice

questions, look up key terms in the glossary, read full mathematical derivations in the Leibniz supplements, watch economists explain their work in Economists in Action and much more.

Photo: Alexander Bustos Concha

coreecon | Curriculum Open-access Resources in Economics 2

history students know that the defeat of the southern Confederate states in the American civil war ended slavery in the production of cotton and other crops in that region. There is also an economics lesson in this story.

At the wars outbreak, on 12 April 1861, President Abraham Lincoln ordered the US Navy to blockade the ports of the Confederate states. These states had declared themselves independent of the US so as to preserve the institution of slavery.

As a result of the naval blockade, the export of US-grown raw cotton to the textile mills of Lancashire in England came to a virtual halt, eliminating three-quarters of the supply of this critical raw material. Sailing at night, a few blockade-running ships evaded Lincolns patrols, but 1,000 were destroyed or captured.

We saw in Unit 8 that the price of a good is determined by the interaction of the supply and demand curves. In this unit, we will see how prices change when supply or demand changes, In the case of raw cotton, the tiny quantities reaching England through the blockade were a dramatic reduction in supply. There was large excess demandthat is to say, at the prevailing price, the quantity of raw cotton demanded exceeded the available supply. As a result some sellers realised they could profit by raising the price. Eventually, cotton sold at prices six times higher than before the war, keeping the lucky blockade-runners in business.

Mill owners responded. For them, the price rise was increase in marginal costs. They cut production to half the pre-war level, throwing hundreds of thousands of people out of work. Some firms failed and left the industry due to the reduction in their profits. Mill owners looked to India to find an alternative to US cotton, greatly increasing the demand for cotton there. The excess demand in the markets for Indian cotton gave some sellers an opportunity to profit by raising prices, which resulted in increases in prices of Indian cotton, which quickly rose almost to match the price of US cotton.

Responding to the higher income now obtainable from growing cotton, Indian farmers abandoned other crops and grew cotton instead. The same occurred wherever cotton could be grown, including Brazil. In Egypt, farmers who rushed to expand production of cotton in response to the higher prices began employing slaves, captured (like the American slaves that Lincoln was fighting to free), in sub-Saharan Africa.

There was a problem. The only source of cotton that could come close to making up the shortfall from the US was in India. But Indian cotton differed from American cotton, and required an entirely different kind of processing. Within months of the shift to Indian cotton new machinery was developed for ginning and carding it.

As the demand for this new equipment soared, Dobson & Barlow, a large firm making textile machinery for which we have detailed sales records, saw its profits take off. It responded with increased production of these new machines and other equipment.

UNIT 9 | MARKET DYNAMICS 3

No mill could afford to be left behind in the rush to retool, because if it didnt, it could not use the new raw material. The result was such an extensive investment of capital that it amounted almost to the creation of a new industry.

The lesson: Lincoln ordered the blockade. But in what followed, the farmers and sellers who increased the price of cotton were not responding to orders. Neither were the mill owners who cut back the output of textiles and laid off the mill workers, nor were the mill owners desperately searching for new sources of raw material. The mill owners who ordered new machinery and set off a boom in investment and new jobs that resulted were not responding to orders from anyone.

All of these decisions took place over a matter of months, by millions of people, most of whom were total strangers to one another, each seeking to make the best of a totally new economic situation.

Though nobody ordered the decisions, economically they made sense. American cotton was now scarcer, and people responded, from the cotton fields of Maharashtra in India to the Nile delta, to Brazil and the Lancashire mills.

To understand how the change in the price of cotton transformed the world cotton and textile production system, think about the prices determined by a market as messages. The increase in the price of US cotton shouted: find other sources, and find new technologies appropriate for their use. Similarly, when the price of petrol rises the message to the car driver is: take the train. It is passed on to the railway operator: there are profits to be made by running more train services. When the price of electricity goes up, the firm or the family is being told: think about installing photo-voltaic cells on the roof.

In many caseslike the chain of events that began at Lincolns desk on 12 April 1861the messages make sense not only for individual firms and families but also for society: if something has become more expensive then it is likely that more people are demanding it, or the cost of producing it has risen, or both. By finding an alternative, the individual is saving money and in so doing conserving societys resources. This is because (as in Unit 8) under some conditions, prices provide an accurate measure of the scarcity of a good or service.

The amazing thing about prices determined by markets is that the messages they convey are not decided and sent by one person. The message is the result of the interaction of sometimes millions of peoplemost of them total strangers to one anothergoverned by supply and demand. Partly as a result, when conditions changea cheaper way of producing bread, for examplenobody has to change the message (put bread instead of potatoes on the table tonight). A price change results from a change in firms marginal costs. The reduced price of bread says it all.

In planned economies, which operated in the Soviet Union and other central and eastern European countries before the 1990s (we discussed them in Unit 1), messages about how things would be produced are sent deliberately by government experts


who are responsible for the decisions about what is produced and at what price it is sold. The same is true, as we saw in Unit 6, in large firms like General Motors, where managers (and not prices) determine who is to carry out which function. The economist Friedrich Hayek (see below) contrasted the decentralised signalling of information about relative scarcity by market prices with the inefficiency of central planning.

FRIEDRICH HAYEK

The Great Depression of the 1930s ravaged the capitalist economies of Europe and North America, throwing a quarter of the workforce out of work in the US. During the same period the centrally planned economy of the Soviet Union continued to grow rapidly under a succession of five-year plans. Even the arch-opponent of socialism, Joseph Schumpeter, had conceded: Can socialism work? Of course it can... There is nothing wrong with the pure theory of socialism.

Friedrich Hayek (1899-1992) did not think so. Born in Vienna, he was an Austrian (later British) economist and philosopher who believed that the government should play a minimal role in the running of society. He was against any efforts to redistribute income in the name of social justice. He was also an opponent of the policies advocated by John Maynard Keynes designed to moderate the instability of the economy and the insecurity of employment.

Hayeks book Road to Serfdom was written against the backdrop of the second world war, where economic planning was being used both by German and Japanese fascist regimes and, on the Allied side, by the Soviet communist authorities and British and American governments. He argued that well-intentioned planning would inevitably lead to a totalitarian outcome.

PAST ECONOMISTS


In Unit 8 we introduced the concept of market equilibrium: a situation in which the actions of the buyers and sellers of a good have no tendency to change its price, or the quantity traded. When a market reaches equilibrium the price and quantity will remain unchanged unless there is a change in the conditions of supply or demand. If the market is perfectly competitive, we know that at the equilibrium price the quantity demanded by buyers is exactly equal to the quantity supplied by sellersthe market clears.

This unit is concerned with how, and why, prices and quantities change. If there is a change in market conditions, will we see prices and quantities adjusting in a way that tends to restore equilibrium? Does the change in price reflect a change in the scarcity of the goods or services? Is a change in the price conveying information that will signal a change in the way resources in the economy are allocated? Will the result be efficient or fair? We will look at examples in which prices change rapidly, such as financial markets, and others where quantities change more than prices. Lastly we will investigate some cases in which the prevailing price in a market does not equalise demand and supply. How can this happen, and what are the implications for efficiency and fairness?

His key idea, one that revolutionised how economists think about markets, is that prices are messages: they convey valuable information about how scarce a good is, information that is available only if prices are free to be determined by supply and demand, rather than by the decision of a planner.

The advantage of capitalism, to Hayek, is that it provides the right information to the right people. In 1945 he wrote in The Use of Knowledge in Society:

Which of these systems [central planning or competition] is likely to be more efficient depends on which of them we can expect [to make] fuller use of the existing knowledge. And this, in turn, depends on whether we are more likely to succeed in putting at the disposal of a single central authority all the knowledge which ought to be used but which is initially dispersed among many different individuals, or in conveying to the individuals such additional information as they need in order to enable them to fit their plans in with those of others.


9.1 FLEXIBLE PRICES: CHANGES IN SUPPLY AND DEMAND

quinoa (pronounced keenwa) is a cereal crop grown on the altiplano, a high, barren plateau in the Andes of South America. It is a traditional staple food in Peru and Bolivia. In recent years, as its nutritional properties have become known, there has been a huge increase in demand from richer health-conscious consumers in Europe and North America. Figure 1 shows how the market has changed. You can see in Figures 1a and 1b that between 2001 and 2011 the price trebled, and production almost doubled. Figure 1c indicates the strength of the increase in demand: spending on imports of quinoa rose from just $2.4m to $43.7m in 10 years.

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Figure 1b. Quinoa producer prices.

Source: Reyes, J. 2013. Quinoa: the little cereal that could. World Bank Group blog. Underlying data from the Food and Agricultural Organization of the United Nations (FAOSTAT) database.

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Figure 1a. The market for quinoa.



For the producer countries these changes are a mixed blessing: while their staple food has become expensive for poor consumers, farmerswho are amongst the poorestare benefiting from the boom in export sales. Other countries are now investigating whether quinoa can be grown in different climates, and France and the US have become substantial producers.

How can we explain the rapid increase in the price of quinoa? In this section, and the section that follows, we analyse the effects of changes in demand and supply in a competitive market, starting with the simple examples of markets from Unit 8, before returning to the real-world case of quinoa.

Recall that in the market for the second-hand textbook in Unit 8, demand comes from new students enrolling on the course, and supply from students in the previous year. In Figure 2 the orange and purple lines represent supply and demand for the book while the number of students enrolling remains stable at 40 per year. The equilibrium price is $8, and 24 books are sold, as shown by point A in Figure 2. What would happen if, one year, the course became more popular?

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Figure 1c. Global import demand for quinoa.



INTERACT

Follow figures click-by-click in the full interactive version at www.core-econ.org.

This would lead to an increase in the demand for books. At each possible price there are more students wanting to buy, so the demand curve shifts to the right, as shown by the brown line in Figure 2.

There is a new equilibrium with a price of $10, at which 32 books are sold. How does the market adjust to this point? At the original price of $8, there would be more buyers than sellers: that is, excess demand. As they become aware of the changed market conditions, some sellers may raise their prices. Some students who would not have sold their books at $8 now want to sell: the quantity supplied increases along the supply curve until the market clears at P = $10. There is a new equilibrium at point B, with a price of $10, at which 32 books are sold. Notice, however, that not all the students who would have bought at $8 purchase the book at the new equilibrium. Some of them no longer want to buy at $10. These are the students with a willingness to pay shown by the part of the demand curve between $8 and $10.

Although we have described how the market might adjust, the model of supply and demand that we are using focuses on the equilibria; it does not tell us exactly what happens in the process of moving from one perfectly competitive equilibrium to another. But it is plausible to suppose that some sellers would raise their prices before others. While the market istemporarilyout of equilibrium they are not constrained to be price takers: excess demand allows them to raise their prices without losing customers.

When using terms such as increase in demand its important to be careful. When we say this, we mean that demand is higher at each possible price: that is, the demand curve has shifted. In response to the shift there is a change in the price and this leads to an increase in the quantity supplied. In the diagram this change is a movement along the supply curve. The supply curve has not shifted (the number of sellers and their reserve prices have not changed), so we would not call this an increase in supply.

As an example of an increase in supply, think again about the market for bread in one city that we studied in Unit 8. Remember that the supply curve represents the marginal cost of producing bread. Suppose that bakeries discover a new technique that allows each worker to make bread more quickly. This will lead to a fall in the marginal cost of a loaf at each level of output. In other words, the marginal cost curve of each bakery shifts down.


Figure 3 shows what happens. The citys bakeries start out at point A, producing 5,000 loaves and selling them for 2 each. The supply curve then shifts because of the fall in marginal cost. You can think of this in two ways. You could say that the supply curve shifts down, because at each level of output, the marginal cost and therefore the supply price is lower. Alternatively you could say that the supply curve shifts to the right: since costs have fallen, the amount that bakeries will supply at each price is greateran increase in supply.

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Figure 3. An increase in the supply of bread (fall in MC).

So the effect of the improvement in the technology of breadmaking is an increase in market supply; at the original price there is more bread than buyers want (excess supply). The bakeries respond to the excess supply by lowering their prices and the market reaches a new equilibrium at point B where more bread is sold. The demand curve has not shifted, but the fall in price has led to an increase in the quantity demanded, along the demand curve. LEIBNIZ 18 shows you how to model shifts in supply and demand using calculus.

LEIBNIZ

For mathematical derivations of key concepts, download the Leibniz boxes from www.core-econ.org.


TEST YOUR UNDERSTANDING

Test yourself using multiple choice questions in the full interactive version at www.core-econ.org.

DISCUSS 1: BREAD, PRICES, SHOCKS AND REVOLUTION

Historians have usually attributed the wave of revolutions across Europe in 1848 to long-term socioeconomic factors and a surge of radical ideas. But a poor wheat harvest in 1845 lead to food shortages and sharp price risesprice shocksin many European countries over the next three years. Economic historians Helge Berger and Mark Spoerer investigated whether these short-term economic factors contributed to the sudden social and political changes that took place.

Explain, using supply and demand curves, how a poor wheat harvest could lead to price rises and food shortages.

The table below shows the average price of wheat in European countries between 1838 and 1845, measured relative to the price of silver for comparison across countries, and also the peak price reached during the period of food shortage. There are three groups of countries: those where violent revolutions took place, those in which there was substantial constitutional change in 1848 without widespread violence, and those where no revolution occurred.

1. Find a way to present the data to show that the size of the price shock (that is, the sudden change in prices), rather than the level of prices, is associated with the likelihood of revolution. Do you think this is a plausible explanation for revolution?

2. In April 2011 it was suggested that similar factors may have played a part in the Arab Spring that began in late 2010 in the Middle East and North Africa: LINK. What do you think of this hypothesis?


AVE. PRICE 1838-45 MAX. PRICE 1845-48Violent revolution 1848

AUSTRIA 52.9 10.40BADEN 77.0 136.6BAVARIA 70.0 127.3BOHEMIA 61.5 101.2FRANCE 93.8 149.2HAMBURG 67.1 108.7HESSE-DARMSTADT 76.7 119.7HUNGARY 39.0 92.3LOMBARDY 88.3 119.1MECKLENBURG -SCHWERIN 72.9 110.9

PAPAL STATES 74.0 105.1PRUSSIA 71.2 110.7SAXONY 73.3 125.2SWITZERLAND 87.9 146.7WRTTEMBERG 75.9 128.7

AVE. PRICE 1838-45 MAX. PRICE 1845-48Immediate constitutional change 1848

BELGIUM 93.8 140.1BREMEN 76.1 109.5BRUNSWICK 62.3 100.3DENMARK 66.3 81.5NETHERLANDS 82.6 136.0OLDENBURG 52.1 79.3

AVE. PRICE 1838-45 MAX. PRICE 1845-48No revolution 1848

ENGLAND 115.3 134.7FINLAND 73.6 73.7NORWAY 89.3 119.7RUSSIA 50.7 44.1SPAIN 105.3 141.3SWEDEN 75.8 81.4

Source: Berger, H. and Spoerer, M. 2001. Economic crises and the European revolutions of 1848. The Journal of Economic History, 61(02), pp. 293-326.


9.2 ENTRY TO THE MARKET

another reason for a change in supply in a market is the entry of more firms, or the exit of existing firms. So far in our analysis of the bread market we have just assumed that there are 50 bakeries. But, as we discussed in Unit 8, if the profits of the bakeries were above normal profits then other firms might want to invest in the baking business. Conversely, if profitability fellperhaps as a result of a fall in demandeconomic profits could become negative, causing some bakeries to close down.

Lets start again from the original equilibrium in the bread market, in which 5,000 loaves are produced, and sold at 2 each. There are 50 bakeries, and we will assume they all have the same costs: the isocost and marginal cost curves are shown in Figure 4. Remember that isoprofit curves slope down where the marginal cost is less than the price, because making one more loaf would increase profit unless the price went down, and similarly they slope up where the marginal cost is above the price. Since the market is competitive, each bakery is producing at the point on its own marginal cost curve, where price equals 2, making 100 loaves. As in Unit 8, the lightest blue isoprofit curve shows points at which economic profits are zero (price equals marginal cost, and the firm is earning normal profits). You can see that, when price is equal to 2 and quantity is equal to 100, the bakery is above this curve at point Aso it is making a positive economic profit.

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Figure 4. Isoprofit curves and marginal cost curve for the bakery.


Since there is an opportunity for making greater than normal profit by selling bread in this city, other bakeries may decide to enter the market. There will be some costs of entryof acquiring and equipping the premises, for examplebut provided these are not too high (or if premises and equipment can be easily sold if the venture doesnt work out) it will be worthwhile to do so.

When more bakeries have entered, more bread will be supplied at each level of the market price. Although the reason for the supply increase is different, the effect on the market equilibrium is the same: a fall in price and a rise in bread sales. Figure 5 shows the effects on equilibrium of more firms entering the market. The bakeries once again start off at point A, selling 5,000 loaves of bread for 2. The entrance of new firms shifts out the supply curve. There is more bread for sale at each price. As before there is excess supply, so the market adjusts to the new equilibrium at point B with a lower price and higher bread sales.

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Figure 5. An increase in the supply of bread (more firms enter).

The entry of new firms is unlikely to be welcomed by the existing bakeries. Their costs have not changed, but the market price has fallen to 1.75, so they must be making less profit. Looking again at Figure 4, you can see that they will be on a lower isoprofit curve, producing less output than before. However, they are still above the lightest blue curve, making positive economic profitsperhaps more firms can be expected to enter the market in future.

The original bread market equilibrium at point A in Figure 5 is described as a short-run equilibrium. Short-run is used to indicate that we are holding something constant. In this case, we mean that point A is the competitive equilibrium while the number of firms in the market remains constant. In the longer run, firms may leave or enter the market, leading to a change in market supply. Closing down or opening


new firms takes time, so this cannot happen instantaneously. In general we expect more firms to enter if profits are high. Similarly, if a fall in demand leads to losses, firms eventually leave.

In the long run we would expect the number of firms in the market to be such that no more than normal profits could be made by entering the market. Profits to be made in the bread market would be no higher than the profits potential bakery owners could make by using their assets elsewhere. And, if any bakery owners could do better by putting their premises to a different use (or by selling them and investing in a different business) we would expect them to do so. Although no-one would be earning more than normal profits, no-one should be earning less than normal profits either.

So firms would continue to enter, increasing supply and lowering the market price, until the price of a loaf of bread was equal to the average cost of producing it (including the opportunity cost of capital).

In our model, in which we are assuming that all bakeries have the same cost functions, the long run equilibrium will be reached when the price is exactly 1.52 and each bakery is producing 66 loaves. This is point C in Figure 4, at which the marginal cost curve cuts the average cost curve. When this point is reached the price of bread is equal to both the marginal and the average cost, and every bakerys economic profit is zero.

We can work out how many bakeries there will be in the long-run equilibrium in this market. We know that the long-run equilibrium price must be 1.52, because that is where the marginal and average costs are equal. From the demand curve in Figure 5 we can deduce that at this price the quantity of bread sold will be 6,500 loaves. Because each bakery is producing 66 loaves, we can divide 6,500 by 66 to find that there will be 98 bakeries in the market.

DISCUSS 2: THE MARKET FOR QUINOA

What can we say about the market for quinoa? The changes shown in Figure 1 can be analysed using the tools we have developed in the last two sections, as shifts in demand and supply.

Initially there seems to have been increase in demand. What happened next?

Using graphs of supply and demand curves, try to explain what happened:


1. Suppose there was an unexpected increase in demand for quinoa in the early 2000s. What would you expect to happen to the price and quantity initially?

2. Assuming that demand continued to rise over the next few years, how do you think farmers responded?

3. Why did the price stay constant until 2007?4. How could you account for the rapid price rise in 2008 and 2009?5. Would you expect the price to fall eventually to its original level?

The graphs in Figure 1 are taken from a World Bank blog that tells you more about quinoa: LINK.

9.3 CHANGING SUPPLY AND DEMAND IN FINANCIAL MARKETS

prices in some markets are constantly changing. The graph in Figure 6 shows how News Corps share price on the Nasdaq stock exchange fluctuated over one day in May 2014 and, in the lower panel, the number of shares traded at each point. Soon after the market opened at 9.30am the price was $16.66 per share. As investors bought and sold shares through the day, the price reached a low point of $16.45 at both 10am and 2pm. By the time the market closed, with the price at $16.54, nearly 556,000 shares had been traded.

Remember from Unit 6 that owning a share in a firm (also known as common stock) gives the shareholder a right to receive a certain proportion (depending on how many shares there are in total) of a firms profitsits earnings after payment of interest and taxes. A portion of the profits are paid out to shareholders as dividends, while the rest is reinvested in the firm to maintain and expand its ability to generate future profits. The price at which shareholders are willing to buy or sell depends on what they believe about the companys future profitability. In addition, since they may want to sell their shares in future, they need to think about how the price might changewhich depends on what other people believe about future profits.


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Figure 6. News Corps share price and volume traded, 7 May 2014.

Source: Bloomberg L. P., accessed 28 May 2014.

In the market for shares in News Corp, each of the existing shareholders has a reserve price at which the shareholder would be willing to sell. Others are in the market to buy, as long as they can find an acceptable price. Figure 7 shows demand and supply curves for the potential buyers and sellers in a particular time periodsay an hour. The curves show the hourly volume of shares that would be demanded and supplied at each price.

Initially the market is in equilibrium at A: 6,000 shares are sold per hour, at a price of $16.50. If there is some good news about the future profitability of News Corp, this will shift both the supply and the demand curves simultaneously. There will be more buyers at each price, but the number of willing sellers decreases. Both effects will raise the pricewhich is why we see large changes in share prices, even when the volume of trade doesnt alter much. The new market equilibrium is at B; the price has risen from $16.50 to $16.65. In this illustration demand changes more than supply, so volume rises too. Unlike markets for ordinary goods and services, there can be large changes in the prices of financial assets like shares when very few trades occur.


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Figure 7. Good news about profitability.

In practice stock markets dont operate in fixed time periods such as an hour. Trade takes place continuously and prices are always changing, as we saw in Figure 6. To understand how prices change we need to understand a trading mechanism known as a continuous double auction.

This is how the process works. Anyone wishing to buy can submit a price and quantity combination known as a limit order. For instance, a limit order to buy 100 shares in News Corp (NWS) at a price of $16.50 per share indicates that the buyer commits to buying 100 shares, as long as they can be obtained at a price no greater than $16.50 per share. Similarly, a limit sell order indicates a commitment to sell a given quantity of shares, as long as the price is no less than the amount specified.

When a limit buy order is placed, one of two things can happen. If a previously placed limit sell order exists that has not yet been filled, and it offers the required number of shares at a price that is at (or below) the amount indicated by the buyer, a trade occurs. If there is no such order available, then the limit order is placed in an order book, and becomes available to trade against new sell orders that arrive.

Orders to buy are referred to as bids, and orders to sell as asks. The order book lists bids in decreasing order of price, and asks in increasing order. The top of the book for shares in NWS at around midday on 8 May 2014 looked like Figure 8.


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16.56 400 16.59 500

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16.53 600 16.62 500

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Figure 8. Bid and ask prices for News Corp (NWS) shares.

Source: Yahoo! Finance, accessed 8 May 2014.

Given this situation, a buy order for 100 shares at $16.57 would remain unfilled and would enter the book at the top of the bid column. However, a bid for 600 shares at $16.60 would be filled immediately, since it can be matched against existing limit sell orders. 500 shares would trade at $16.59 apiece, and 100 shares would trade at $16.60. Whenever a buy order is immediately filled, trade occurs at the best possible price for the buyerthe ask price; similarly if a sell order is placed and immediately filled from existing orders, trade occurs at the best possible price for the sellerthe bid price.

DISCUSS 3: THE NEWS CORP ORDER BOOK

Consider the order book for NWS in Figure 8. Determine which transactions (if any) will occur at what prices, and how the book will change, if the following orders arrive in sequence: a limit buy order for 650 shares at $16.59, followed by a limit sell order for 600 shares at $16.55.


We can now see how prices in such a market change over time. If someone receives negative news about NWS, for example a rumour that an important member of the board is about to resign, and believes that this information has not yet been incorporated into the price, that person may place a large sell order at a price below $16.56, which will immediately trade against existing bids. As these trades occur, bids are removed from the order book and the price of the stock declines. Similarly, orders to buy at prices above the lowest ask will trade against existing sell orders, and transactions will occur at successively increasing prices.

Since the price is fluctuating, it is not easy to think of this market as being in equilibrium. But it is nevertheless the case that the price is always adjusting to reconcile supply and demand and hence clear the market. In that sense it is always in equilibriumit is just that the equilibrium keeps changing.

DISCUSS 4

Use the data from the NWS order book in Figure 8 to plot supply and demand curves for shares. Explain why the two curves do not intersect.

9.4 BUBBLES

the example of shares in News Corp demonstrates the flexibility of stock prices. This flexibility is common in markets for other assets such as bonds, currencies under floating exchange rates, and commodities such as gold, crude oil and corn.

When the trading process works smoothly, new information about the underlying value of an asset is quickly and reliably expressed in markets. Changes in beliefs about a firms future earnings growth or volatility result in virtually instantaneous adjustments in its share price. Both good and bad news about patents or lawsuits, the illness or departure of important personnel, earnings surprises, or mergers and acquisitions can all result in active tradingand swift price movements.


The fact that price movements often reflect important information about the financial health of a firm means that traders who do not have this information can try to deduce it from price movements. Trading strategies like this include momentum trading and can be potentially destabilising, resulting in asset price bubbles and the sudden price declines that typically follow bubbles, called crashes.

The term bubble refers to a sustained and significant departure of an asset price from some notion of its intrinsic or fundamental value. The fundamental value of a share in a firm, for example, is the value of receiving the expected flow of dividends. We show how to calculate this in EINSTEIN 1. But, since for most assets there is no consensus about how such values should be assessed in real time, there is always debate about whether we are experiencing an asset price bubble.

EINSTEIN 1

Calculating the present value of an asset: You may be wondering how it is possible to work out the price you would be willing to pay for a share that you expect to deliver dividends in the future. For example, suppose you are considering investing in an asset that will pay $100 in one years time, and no other dividends. You probably wouldnt pay $100 without considering alternative investments. Suppose, for example, that the best alternative you can find is to invest $100 now in a savings account at 3% annual interest. Then you would receive $100 x 1.03 = $103 in a years timea better use of your initial $100.

But following this line of reasoning, if you invested $100/1.03 = $97.09 in the savings account, you would have $100 in a years time. So, if the current interest rate is 3%, owning an asset consisting of $100 in a years time is equivalent to having $97.09 now. We say that the present value of this asset is $97.09. Given the alternatives available to you, you would be willing to pay at most $97.09 to buy it.

In principle you can use this method to work out the present value of any asset that delivers payments in the futurejust work out the present value of each expected payment, which depends on the rate of return on alternative investments over the same time period, and add them together. The more difficult problem in evaluating an asset is to work out what you expect the dividends to be.

To get a sense of the extent of volatility in asset prices, consider Figure 9, which shows the value of the Nasdaq Composite Index between 1995 and 2004. This index is an average of prices for a set of stocks, with companies weighted in proportion to their market capitalisation. The Nasdaq stocks include many fast-growing and hard-to-value companies in technology sectors.


Jan

95

Jan

96

Jan

97

Jan

98

Jan

99

Jan

00

Jan

01

Jan

02

Jan

03

Jan

04

6,000

5,000

4,000

3,000

2,000

1,000

0

Dai

ly c

losi

ng v

alue

Figure 9. The tech bubble: Nasdaq Composite Index (1995-2004).

Source: Yahoo! Finance, accessed 14 January 2014.

The index began the period at less than 750 and had risen in five years to more than 5,000. The index increased more than six-fold between 1995 and 2000 with a remarkable annualised rate of return of around 45% (find out how to calculate this in EINSTEIN 2). It then lost two-thirds of its value in less than a year, and eventually bottomed out at around 1,100, almost 80% below its peak. The episode has come to be called the tech bubble.

EINSTEIN 2

Calculating compound annual growth rates (CAGRs) and indices: In only five years the Nasdaq Composite Index rose from 750 to 5,000. We can calculate the average annual growth of the Nasdaq over this period by calculating a compound annual growth rate. This measure takes into account the fact that this years growth builds on last years growth. For example, if a stock was priced at $10 and then rose by 10% over the next year, it would end the year at $11; a gain of $1. If that stock then rose 10% again over the next year, it would rise to $12.10; a gain of $1.10. We can see that the same growth rate gives a bigger price gain over the second year because the stock started at a higher price. The compound annual growth rate for the stock over the two years is 10%, but it has risen 21% from its original price.


The formula for calculating a compound annual growth rate (CAGR) is:

CAGR = (final value/initial value)(1/n) - 1

where n is the number of years over which the growth has taken place. In our example, the number of years is five.

Hence the compound annual growth rate of the Nasdaq between 1995 and 2000 is:

CAGR = (5000/750)(1/5) - 1 = 46.14%

We can also use some simple maths to create an index. An index typically allocates a value of 100 to one year in a series, and then shows how each of the other years in the series compares to that year. For example, if we rebase the Nasdaq stock index at 100 in 1995 then we can see how other years compared. A value of 200 in the index would indicate the Nasdaq had doubled from 750 to 1,500.

Rebasing a series is simple. First you choose the reference year and allocate it a value of 100. Then for each other year in the series you use this calculation:

(value of series this year/value of series in reference year) x 100.

In our example, we have two data points: 750 in 1995 and 5,000 in 2000. We set 1995 as the reference year. The value of the index in the year 2000 is therefore:

(5000/750) x 100 = 666.66

From this we can easily see that the Nasdaq rose over six-fold between 1995 and 2000.

Both the CAGR and indices can be easily calculated from a set of data in a spreadsheet program on a computer.


WHEN ECONOMISTS DISAGREE

DO BUBBLES EXIST?

Looking at the price movements in Figure 9 (and Figure 12, below), one gets the impression that asset prices can be subject to wild swings that bear little relation to the stream of income that might reasonably be expected from holding them.

But do bubbles really exist, or are they an illusion based only on hindsight? In other words, is it possible to know that a market is experiencing a bubble before it crashes? Perhaps surprisingly, some of the most prominent economists working with financial market data disagree on this question. They include Eugene Fama and Robert Shiller, two of the three recipients of the 2013 Nobel prize.

Fama denies that the term bubble has any useful meaning at all:

These words have become popular. I dont think they have any meaning Its easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.

This is an expression of the efficient markets hypothesis (EMH), which claims that all generally available information is incorporated into prices virtually instantaneously, making future prices impossible to predict. The logic of this argument was explained in 2009, in the middle of the financial crisis, by Robert Lucasanother Nobel laureate who is firmly in Famas camp:

One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Famas efficient-market hypothesis If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier.


While the logic of this argument is compelling, it is not watertight. Even if most market participants share a belief that asset prices are too high relative to their intrinsic values, and expect a crash to occur at some point in the future, they may be uncertain about exactly when the crash will occur and how much further prices might rise in the interim. Put differently, the crash will occur when there is coordinated selling of the asset, and this coordination cannot be attained by the actions of any individual investor or trader. In a reply to Lucas, Markus Brunnermeier explains this position as follows:

Of course, as Bob Lucas points out, when it is commonly known among all investors that a bubble will burst next week, then they will prick it already today. However, in practice each individual investor does not know when other investors will start trading against the bubble. This uncertainty makes each individual investor nervous about whether he can be out of (or short) the market sufficiently long until the bubble finally bursts. Consequently, each investor is reluctant to lean against the wind. Indeed, investors may in fact prefer to ride a bubble for a long time such that price corrections only occur after a long delay, and often abruptly. Empirical research on stock price predictability supports this view. Furthermore, since funding frictions limit arbitrage activity, the fact that you cant make money does not imply that the price is right.

This way of thinking suggests a radically different approach for the future financial architecture. Central banks and financial regulators have to be vigilant and look out for bubbles, and should help investors to synchronise their effort to lean against asset price bubbles. As the current episode has shown, it is not sufficient to clean up after the bubble bursts, but essential to lean against the formation of the bubble in the first place.

Shiller has argued that relatively simple and publicly observable statistics, such as the ratio of stock prices to earnings per share, can be used to identify bubbles in real time. Buying assets that are cheap based on this criterion, and selling those that are dear, can result in losses in the short-run but with long-term gains that, in Shillers view, exceed the returns that one would make by simply investing in a diversified basket of securities with similar risk attributes.

In collaboration with Barclays Bank, Shiller has launched a product called an exchange traded note (ETN) that can be used to invest in accordance with his theory. This asset is linked to the value of the cyclically adjusted price-to-earnings (CAPE) ratio, which Shiller believes is predictive of future prices over long periods. So this is one economist who has put his money where his mouth is.


So there are two quite different interpretations of the tech bubble, associated with Fama and Shiller respectively. Famas view is that the asset prices throughout the episode were based on the best information available at the time and fluctuated because information about the prospects of the companies was changing sharply. Shillers view, in contrast, is that the prices in the late 1990s had been driven up simply by expectations that the price would rise farther still. He called this irrational exuberance among investors.

To see how irrational exuberance might work, look at Figure 10. Initially the price of a share is $50 on the darkest red demand curve. When potential traders and investors receive good news about expected future profitability, the demand curve shifts to the right, and the price increases to $60. (For simplicity we assume that the supply curve doesnt move). But now suppose that potential buyers, observing the price rise, treat it as further good news. Individuals might believe that the price has risen because other people have received news that they themselves hadnt heard, and adjust their own expectations upwards. Or they may think there is an opportunity for speculation: to buy the stock now because they will be able to sell to other buyers at a profit later. Either way, demand increases again. The demand curve shifts up simply because the price has been increasing, and the price rises again to $70. This further rise may lead to another shift in demand, continuing the process.

Shar

e pr

ice,

$

Volume of trade

80

70

60

50

00

Response to further price rise

Response to initial price rise

Initial good news

Supply curveDemand curve 4Demand curve 3

Demand curve 2Demand curve 1

Figure 10. The beginning of a bubble.

This can be described as a bubble if the price rises significantly beyond the fundamental value of the stockthe value of profits that could reasonably be expected by a well-informed observer of the firm.


The bubble bursts when potential traders perceive a danger that the price will fall. Then demand falls sharply, and those who hold shares rush to sell. Figure 11 shows what happens. At the top of the bubble the shares trade at $80. Both the supply and demand curves shift when the bubble bursts, and the price collapses from $80 to $50leaving those who owned shares when the price was $80 with large losses. LEIBNIZ 19 shows you how to model algebraically the emergence of a bubble on a stock market.

Shar

e pr

ice,

$

Volume of trade

80

50

00

Supply curve

New supply curve

Demand curve

New supply curve

Fall in demand

Increasedsupply

Figure 11. The collapse of the share price.

An interesting contemporary example of a possible bubble may be found in the market for the virtual currency called Bitcoin (LINK). Bitcoin was introduced by a group of software developers in 2009. Where it is accepted, it can be transferred from one person to another as payment for goods and services.

It is unlike other currencies in that it is not controlled by a single entity, such as a central bank, but instead is mined by individuals who are willing to lend their computing power to verify and record Bitcoin transactions in the public ledger. At the start of 2013 a bitcoin could be purchased for about $13. At its peak on 4 December 2013 the same asset was trading for more than $1,200. It then lost more than half its value in two weeks, before recovering to about $800 by the end of 2013. These price swings are shown in Figure 12.


1,400

1,200

1,000

800

600

400

200

0

Bit

coin

pri

ce ($

)

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Figure 12. The value of Bitcoin during 2013.

Source: Bitcoincharts.com, accessed 14 January 2014.

If the price of an asset has been driven up by irrational exuberance, there should be opportunities for those who are well informed about the value to profit from their superior information. So if the rise in the Nasdaq index was indeed a bubble, why did those who identified it fail to profit by placing gigantic bets on a major price decline? As it happens, many large investors did place such bets, including some well-known fund managers on Wall Street. The manner in which these bets were placed on the bubble bursting was by selling short, or shorting: borrowing stock and immediately selling it, with the intention of buying it back (to return to the owner) after the price crashes. This is an extremely risky strategy, since it requires accuracy in timing the crashif prices continue to rise, the losses can become unsustainable.

Bitcoin brings no intrinsic benefit to the holder; its fundamental value comes from being able to use it to purchase goods and services where it is accepted (these places are, in 2014, few and far between). As with other assets there is also the possibility of selling it to someone else at a future date. Belief in the remote possibility that it will emerge as a widely accepted global currency sustains its price. More importantly, the price is also sustained by the difficulty of betting on a decline in value, and because the investors who bet on an increase in 2013 made extravagant gains. Even if it were possible to borrow and sell the asset (that is, to sell short), and a group of well-funded individuals were certain that its price would eventually collapse to zero, placing big bets on a crash would carry large risks. Even if they were eventually proved right, they may suffer heavy losses if they got the timing wrong.

In fact, many of those buying the asset may also be convinced of an eventual crash, but hoping to exit the market before it happens. This was the case during the tech bubble when Stanley Druckenmiller, manager of the $8bn Quantum Fund, held


shares in technology companies that he knew were overvalued. After prices collapsed and inflicted significant losses on the fund, he used a baseball metaphor to describe his error. We thought it was the eighth inning, and it was the ninth, he explained, I overplayed my hand.

DISCUSS 5: MARKETS FOR GEMS

This article describes how the worldwide markets for opals, sapphires, and emeralds are affected by discoveries of new sources of gems: LINK.

1. Explain, using supply and demand analysis, why Australian dealers were unhappy about the discovery of opals in Ethiopia.

2. What determines the willingness to pay for gems? Why do Madagascan sapphires command lower prices than Asian ones?

3. Explain why the reputation of gems from particular sources might matter to a consumer. Shouldnt you judge how much you are willing to pay for a stone by how much you like it yourself?

4. Do you think that the high reputation of gems from particular origins necessarily reflects true differences in quality? Could we see bubbles in markets for gems?

9.5 MARKETS WITH POSTED PRICES

while the prices of securities and commodities can change in milliseconds in response to shifting demand and supply, many of the goods and services we buy are traded in markets with posted prices that change only occasionally. From grocery stores to auto dealerships to online retailers, items are available for purchase at a listed price to anyone who wants to make a purchase.

Newspapers change their prices rarelythey may stay constant even when market conditions change. While News Corps share price fluctuated from minute to minute, the price of its London-based newspaper The Times maintained a constant price of 1 over a period of 4 years from 2010 until 2014. Yet its daily circulation fell from 508,000 to 384,000 during that period as consumers switched from print newspapers to digital media.


The market for The Times is not perfectly competitive: it is a differentiated product, so the producer has some discretion over the price that it sets. We can analyse the market for a newspaper as we did for other differentiated products in Unit 7. The marginal cost of one newspaper, which includes printing and distribution costs, does not change very much with circulation. So in Figure 13 we show the marginal cost as constanta horizontal line. The cost of producing the content of the paper is a fixed cost, independent of circulation, and this may be quite high. The lightest blue isoprofit line corresponds to economic profits of exactly zero: it shows what the price needs to be at each level of circulation for the newspaper to just cover its fixed costs as well as its marginal costs. Lets begin with the light red demand curve: we can see that the newspaper maximises profits when it sells 113,000 newspapers. This is where the demand curve is just tangent to the darkest blue isoprofit curve. The newspaper sets its profit-maximising price at 1.10.

Pric

e,

65,000 113,000

B A Isoprofit curve: high profitsOriginal demand curveIsoprofit curve: low profits

New demand curve

Zero economic profit (AC curve)Marginal cost curve

1.101.05

Quantity of newspapers

Figure 13. A fall in demand for newspapers.

Now suppose that there is a fall in demand. At each level of the price there are fewer potential customers, so the demand curve shifts inwards, as shown by the dark red demand curve. On the new demand curve profits are maximised at point B. This diagram illustrates a case in which the profit-maximising price on the new demand curve has hardly changed at allthe new price of 1.05 is only slightly lower than the original price, although the quantity of newspapers sold is much smaller than before, and the firm is now on a lower isoprofit curve.

Why does the price change so little? We know that producers of differentiated products set a price above the level of marginal cost, as the newspaper owner has done here. The difference between the price and the marginal cost is the profit margin on each unit. When the quantity falls from 113,000 to 65,000, the marginal cost stays the same, and in Figure 13 the profit margin stays almost the same too.


This will not always happen: in general the profit margin depends on the elasticity of demand. It can rise, or fall, or stay the same, depending on what happens to the elasticity when the demand curve shifts. But this example illustrates a plausible case in which demand falls by approximately the same proportion at each price, so the demand curve gets steeper; since the lower isoprofit curves are also steeper, the price stays approximately the same, as we calculate in EINSTEIN 3. So for price-setting firms there can be large changes in quantity without much change in price, especially when marginal costs are flat. And if we also take into account the possible costs for a firm of adjusting pricesof changing its price lists and advertising, for examplewe can begin to explain why prices of many goods and services seem to be inflexible when demand changes.

EINSTEIN 3

In Unit 7 we found a formula for the firms markup of the price above marginal cost:

(P-MC)/P = 1/elasticity

where the elasticity depends on the slope of the demand curve:

elasticity = P/Q Q/P = P/Q 1/slope

So the profit margin is:

P-MC = Q slope

In the example illustrated in Figure 8, when demand for newspapers falls, Q decreases at each price level, but the slope rises, so Q slope stays approximately constant. This means that the profit margin stays approximately the same, despite the fall in Q.

Many posted-price markets involve large fixed costs of setup and operation, and sellers therefore welcome increases in demand: they respond by raising output rather than prices. The newspaper illustrated in Figure 13 makes higher profit when its output is higher, at 113,000, because the cost per newspaper is lower than at 65,000.

Even for manufactured goods with increasing marginal costs of production, the immediate effect of a change in demand will be on inventories, not on prices. If demand rises, stored stock declines faster than expected, and shops order more


goods to replenish this stock. In many markets with posted prices there is a great deal of productive slack. This means factories can run longer or extra shifts, hiring additional labour or paying overtime if necessary.

For services with posted prices there are no inventories, but the immediate effect of changes in demand is on capacity utilisation rather than prices. A typical restaurant, for instance, has posted prices on a menu, and these do not change with fluctuations in demand. Instead, the number of empty tables, or the length of waiting times, rises and falls depending on customer interest.

When we looked at financial markets we saw that, when conditions change, prices adjust rapidly to clear the market. The perfectly competitive model of Unit 8 seems to apply, despite constantly changing conditions. In posted-price markets firms behave like the price-setting firms in Unit 7, and the market behaves differently: equilibrium is restoredinitially at leastthrough quantity rather than price adjustments. In the long run, if the change proves to be permanent, suppliers may decide to adjust prices too.

9.6 RATIONING, QUEUING AND SECONDARY MARKETS

in each of the examples we have discussed so far, the market clears: adjustments of price or quantity take place to equalise supply and demand. Now we look at some cases where markets dont clear, but remain in a state of excess supply or excess demand.

Tickets for the 2013 world tour by Beyonc sold out in 15 minutes for the Auckland show in New Zealand, in 12 minutes for three UK venues, and in less than a minute for Washington DC in the US. When American singer Billy Joel announced a surprise concert in his native Long Island, New York in October 2013, all available tickets were snapped up in minutes. In both cases its safe to say that there were many disappointed buyers who would have paid well above the ticket price: at the price chosen by the concert organisers, demand exceeded supply.

We see excess demand for tickets for sporting events, too. The London organising committee for the 2012 Olympic Games received 22 million applications for 7 million tickets. Figure 14 is a stylised representation of the situation for one Olympic event. The number of available tickets, 40,000, is fixed by the capacity of the stadium. The ticket price at which supply and demand are equal is 225. The organising committee do not choose this price, but a lower price of 100; at this price 70,000 tickets are demanded. There is excess demand of 30,000 tickets.


Tick

et p

rice

,

Number of tickets, thousands

225

100

00

Supply curve

Demand curve

Economicrent

Excess demand

40 70

Figure 14. Excess demand for tickets.

Some of those who succeed in obtaining tickets for a popular event may be tempted to sell them rather than use them. In Figure 14, a ticket bought for 100 could be sold for at least 225, making the seller a profit of 125.

The money received by someone behaving like this (the 125), is an example of an economic rent. Recall from Unit 2 that this is a payment received by an individual above the next best alternative, which in this case would be to hold on to the ticket and attend the concert, for which he or she was willing to pay 100. So a person who valued attending the event at 100, and sold a ticket for 225, received an economic rent of 125. The other 100 compensates this person for not seeing the event.

The potential for rents may create a parallel or secondary market. In the case of tickets for concerts and sporting events, part of the initial demand comes from scalpers: people who plan to resell at a profit. Tickets appear almost instantly on peer-to-peer trading platforms such as eBay, Craigslist and StubHub, listed at prices that may be multiples of what was originally paid. In the last few days of the 2014 Winter Olympics in Sochi, tickets for the Olympic Park with a face value of 200 roubles were sold outside the Park for up to 4,000 roubles. (Event organisers may try to prevent this practice; in Sochi the security officers were supposed to intervene.)

Prices in the secondary market equate demand and supply, and allocations are accordingly made to those with the greatest willingness to pay. The assumption that this market-clearing price will be much higher than the listed price is responsible, in part, for the initial frenzied demand for tickets. Nevertheless, some individuals who buy at the lower prices hold on to their tickets, and attend an event that they would otherwise be unable to afford.


In the case of the London Olympics, the organising committee set the price and the tickets were allocated by lottery. This is an example of goods being rationed, rather than allocated by price. The organisers could have chosen a much higher price (225 for the event in Figure 14), which would have cleared the market. But that would have meant that people willing to pay less than 225 would not have seen the event. By allocating the tickets through a lottery some people with a lesser willingness to pay (perhaps because they had limited incomes) would also get to see the Games. There was much public debate about the process, and some anger, but IOC president Jacques Rogge defended it as open, transparent and fair.

We might argue that the initial allocation of tickets was Pareto inefficientthat they were not allocated to the people who valued them most. That argument is supported by the fact that some people who bought the tickets at 100 later sold them at higher prices to those willing to pay more. Scalping Olympic tickets was widely criticisedbut note that the sale of the ticket was mutually beneficial to the seller and the buyer.

But although there was some public criticism of the Olympic ticket prices, it suggested the prices were too high, not too low. It seems that in this case people were more concerned with fairness than efficiency: they did not want to give priority to those most willingor ableto pay. The Olympic organising committee was required to serve the public interest rather than maximise profit. It could have charged 225 to do this, but felt constrained by conditions of fairness not to do so.

Why do concert promoters not increase their revenue by setting a market-clearing price? One reason is that performers have an interest in maintaining their popularity with the public, as this affects their other commercial interests including advertising contracts.

There are other cases where the producer of a good chooses to operate with persistent excess demand. The New York restaurant Momofuku Ko offers a 16-course tasting menu at lunch for $175, and has just 12 seats. Online reservations may be made 10 days in advance, open at 10am daily, and typically sell out in three seconds. In 2008 the proprietor David Chang sold a reservation at a charity auction for $2,780. Even taking into account the willingness of individuals to pay more for an item when the proceeds go to charity, this suggests substantial excess demand for reservationsbut he has not raised the price.

DISCUSS 6: THE PRICE OF A TICKET

Explain why the seller of a good in fixed supply (such as concert tickets or restaurant reservations) might set a price that is known to be too low to clear the market.


When goods are allocated via a market-clearing price, they go to the buyers with highest willingness to pay. But when they are rationed, the rationing process decides who gets the goods. In the Olympic lottery the successful buyers were a random subgroup of everyone who wished to buy. At Momofuku Ko they are the people who are ready to book at exactly the right moment 10 days ahead. In popular restaurants where tables are allocated to those at the head of the queue each evening, they are people who are willing to sacrifice time to get there early and wait. In this case, and for Momofuku Ko, buyers indicate how much they value the good by paying in a non-monetary way.

9.7 MARKETS WITH CONTROLLED PRICES

in december 2013,on a cold and snowy Saturday in New York City, demand for taxi services rose appreciably. The familiar metered yellow and green cabs, which operate at a fixed rate (subject to minor adjustments for peak and night-time hours), were hard to find. Those looking for taxis were accordingly rationed, or faced long waiting times.

But there was an alternative availableanother example of a secondary market: an on-demand, app-based taxi service called Uber (LINK), which at the beginning of 2014 operated in 67 cities in 25 countries. This recent entrant in the local transportation market uses a secret algorithm that responds rapidly to changing demand and supply conditions. Standard cab fares do not change with the weather, but Ubers prices can change substantially. On this December night Ubers surge-pricing algorithm resulted in fares that were more than eight times the base rate charged by the yellow and green cabs. This spike in pricing choked off some demand and also led to some increased supply, as drivers who would have clocked off remained on the road and were joined by others.

DISCUSS 7: WHY NOT RAISE THE PRICE?

Discuss the following: A sharp increase in cab fares led to severe criticism of Uber on social media, but a sharp increase in the price of gold has no such effect.


City authorities often regulate taxi fares as part of their transport policy, for example to maintain safety standards, and minimise congestion. In some countries local or national government also controls housing rents. Sometimes this is to protect tenants, who may have little bargaining power in their relationships with landlords, or sometimes because urban rents would be too high for key groups of workers.

Figure 15 shows a situation in which local government might decide to control the housing rent in a city. Note that here we mean rent in the everyday sense of a payment from tenant to landlord for use of the accommodation. Initially the market is in equilibrium on the dark red demand curve, with 8,000 tenancies at rent of 500the market clears. Now suppose that there is an increase in demand for tenancies, to the light red demand curve. The supply of housing for rent is inelastic, at least in the short run: since it would take time to build new houses, the only way that more can be supplied in the short run is if some owner-occupiers decide to become landlords and live elsewhere themselves. So the new market clearing rent, 830, is much higher.

Hou

sing

ren

t,

Economicrent

Number of tenancies

1,100

500

012,000

830

Supply curve

Demand curveNew demand curve

New supply curve

Excessdemand

Marketclearing rent

Controlled rent

Figure 15. Housing rents and economic rents.

Suppose that the city authorities are concerned that this rise would be unaffordable for many families, so they impose a rent ceiling at 500. The controlled price of 500 is below the market-clearing price of 830; the supply of housing for rent remains at 8,000, and there is excess demand for tenancies.

In this situation tenancies are not allocated to those with highest willingness to pay. The supply of tenancies is effectively restricted to 8,000 by rent control, and there are 8,000 people willing to pay more than 1,100. But the 8,000 people lucky enough to obtain tenancies may be anywhere on the light red demand curve above 500. The


rent control policy puts more weight on maintaining a rent that is seen to be fair, and affordable by existing tenants who might otherwise be forced to move out, than it does on Pareto efficiency.

The scarcity of rental accommodation gives rise to a potential economic rent: if it were legal (which it usually isnt) some tenants could sublet their accommodation, obtaining an economic rent of 600 (the difference between 1,100 and 500).

If the increase in demand proves to be permanent, the long run solution for the city authorities may be policies that encourage house-building, shifting out the supply curve so that more tenancies are available at a reasonable rent.

9.8 CONCLUSION

the capitalist economy combines both the decentralised decision-making of the market, illustrated by the chain of events triggered by the American civil war and rise in the price of cotton, with the centralised decision-making process in large firms. The decision by the owners and managers of Dobson & Barlow to develop new machinery for textile mills suitable for Indian cotton was not implemented through price messages, but by orders to the companys engineers and mechanics to undertake the work.

The balance of these two systemsdecentralised and centralisedin a capitalist economy shifts over time, as we saw in Unit 6, as firms decide to outsource production or to take on the production of parts previously acquired by purchase. Where massive changes in the use of a societys resources need to happen quickly, such as in wartime, virtually all economies resort to planningas the UK and the US did in the second world war. But for the normal changes in an economy the use of prices as messages works well as illustrated by the case of cotton prices.

Sometimes suppliers or regulators choose to override price messages, leading to persistent excess supply or demand, as we have seen in the cases of concert tickets and housing rents. And when suppliers have power to set prices they may initially respond to market conditions by adjusting quantity rather than price. But many market prices are free to change when conditions of supply or demand change, and markets represent a flexible way to inform members of an economy of the relative scarcity of goods, giving them a reason (their own desire to save or make money) to respond in a way that makes better use of an economys productive capacity.


DISCUSS 8: COTTON PRICES AND THE AMERICAN CIVIL WAR

Use the methods introduced above and Units 2, 3, 6 ,7 and 8 to represent:

1. The increase in the price of US raw cotton (show the market for US raw cotton, a market with many producers and buyers).

2. The increase in the price of Indian cotton (show the market for Indian raw cotton; a market with many producers and buyers).

3. The reduction in textile output in an English textile mill (show a single firm in a competitive product market).

4. The increase in cotton output by Indian, Egyptian and Brazilian farmers (show an individual farmers production function).

5. The introduction of new carding and ginning machinery appropriate for processing Indian cotton (show the isoquants and the isocost lines from Unit 2 and assume the cost of labour and coal remain unchanged).

In each case indicate which curve(s) in the relevant figures shifted and explain the result.

But not all prices send the right message. We have already seen how the wrong messages are sent when bubbles develop. In the next unit we describe the conditions under which markets send the right messages, and the reasons why they sometimes fail to do so.


UNIT 9 KEY POINTS

1. In a competitive market with flexible prices, shifts of demand or supply are followed by an adjustment of the price to reach a new market-clearing equilibrium.

2. In markets for financial assets, supply and demand shift as traders receive new information. The price adjusts in a continuous double action to reconcile supply and demand.

3. A bubble occurs if the price of an asset deviates from its expected fundamental value, which could happen if traders expectations were influenced by price changes.

4. In markets where price-setting firms post prices, quantities rather than prices may adjust in response to changes in demand.

5. Firms or governments may choose to set a price that does not clear the market, giving rise to excess demand or supply, and potential economic rents.

6. Prices determined by markets are messages about the scarcity of goods and services, which respond to changes in economic circumstances and motivate all participants to change their decisions to reflect the new conditions.


UNIT 9: READ MORE

INTRODUCTION

The use of knowledge in societyYou can read Hayeks article here: LINK.Hayek, F. A. 1945. The use of knowledge in society. The American economic review, pp. 519-530.

The knowledge problem as a rhetorical clubHis ideas continue to provoke arguments today: LINK.Giberson, M. 2010. Knowledge Problem: I cringe when I see Hayeks knowledge problem wielded as a rhetorical club, April 4.

Keynes and HayekHayek opposed Keynes but, in some areas, they agreed: LINK.The Economist. 2014. Free Exchange: Keynes and Hayek, prophets for today, 14 March.

9.4 BUBBLES

Still think you can beat the market?Tim Harford discusses the hypothesis that financial markets incorporate new information into share prices so quickly that you cant beat the market: LINK.Harford, T. 2012. Still think you can beat the market? timharford.com, 24 November.

BubblesYou can know more about Eugene Famas view on crises and bubbles from this frank interview published in the New Yorker: LINK.Cassidy, J. 2010. The New Yorker: Interview with Eugene Fama, January 13.Economist Markus Brunnermeir discusses the intellectual legacy of the economist Robert Lucas: LINK.Brunnermeir, M. 2009. Free Exchange: Lucas Roundtable: Mind the Frictions. The Economist, 9 August.Economists have been under severe criticism for failing to predict and prevent the last financial crisis. Nobel laureate Robert Lucas elaborates on Famas EMH: LINK.Lucas, R. 2009. In Defence of the Dismal Science. The Economist, 6 August.


Was tulipmania irrational?A famous example of a bubble is the Dutch tulipmania of 1637: LINK.The Economist. 2013. Was tulipmania irrational? 4 October.For a more detailed analysis, including the data on tulip prices: LINK.Garber, P. M. 1989. Tulipmania. Journal of Political Economy, pp. 535-560.

Myopic rationality in a maniaAnother historical example of a bubble is the railway mania in the 1840s:Campbell, G. 2012. Myopic rationality in a Mania. Explorations in economic history, 49(1), pp. 75-91.

An introduction to volatility and financial crisesAn introduction by Joseph Stiglitz: LINK.Stiglitz, J. E. 1990. Symposium on bubbles. The Journal of Economic Perspectives, Vol 4(2), pp. 13-18

Irrational ExuberanceRobert Shillers book. Chapter 1 is available here: LINK.Shiller, R. J. 2005. Irrational Exuberance. New York: Random House.

Manias, panics and crashesKindleberger, C. 1996. Manias, panics and crashes: a history of financial crises. Hoboken: Wiley.

9.7 MARKETS WITH CONTROLLED PRICES

Rent controlThis brief economic analysis of the recent introduction of rent controls in Paris points out the counter-productive effects: LINK.Bosvieux, J. (translated Waine, O.). 2012. Rent control: a miracle solution to the housing crisis? Metropolitics, 21 November.Richard Arnott argues that economists should rethink their traditional opposition: LINK.Arnott, R. 1995. Time for revisionism on rent control? Journal of Economic Perspectives, 9(1), pp. 99-120.


MORE

Economic crises and the European revolutions of 1848: LINK.Berger, H. and Spoerer, M. 2001. Economic crises and the European revolutions of 1848. The Journal of Economic History, 61(02), pp. 293-326.Paul Masons article compares the data in 1848 and 2011: LINK.Mason, P. 2011. Idle Scrawl: Revolutions and the price of bread: 1848 and now. April 21, BBC blogs.

Varieties of capitalismDavid Soskice and Peter Hall discuss interactions within firms and markets, distinguishing between liberal market economies and coordinated market economies: LINK.Hall, P. A., and Soskice, D. 2001. An introduction to varieties of capitalism. In Varieties of capitalism: The institutional foundations of comparative advantage, 1, pp. 21-27.

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