Personal Finance
Scott Wentland
[email protected]
434-395-2160
Longwood University
201 High Street
Farmville, VA 23901
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Markets, Information, and
Incentives
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Markets - Information & Incentives
• Market prices provide information and
incentives
– Prices guide the behavior of consumers and
producers
– Also create incentives of workers, employers,
savors, investors, and anyone else who participates
in markets
• Why is this important?
– Efficiency and order, without intention
• Adam Smith called this the “invisible hand”
• F. A. Hayek called this “spontaneous order”
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Last Lecture…
• Buyers
– Buyers always want the lowest price they can
get from something
• Sellers
– Sellers always want the highest price they can
get for something
• What happens when they get together?
– They agree to exchange
• End up somewhere in between
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Exchange
• The nature of exchange
– Buyers and sellers agree on a mutually beneficial price
– Always a win-win (ex ante)
• How do we know it is a win-win?
– Exchange is voluntary
– If the buyer didn’t benefit (on net), s/he wouldn’t buy
– If the seller didn’t benefit (on net), s/he wouldn’t sell
• Do you really have to buy an iPhone?
– Yes? You value iPhone > iPhone’s price
– No? It wasn’t worth it to you…
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Exchange Example
• Another Example:
– Seller (me): I can produce a barrel of oil for $10
– Buyer (you): You want a barrel of oil, and are willing
to pay up to $60
• Result: we agree to a price so that we both win
– Suppose we agree on a price of, say, $30
• I win because I get $30 for something that cost me
$10
– PRODUCER SURPLUS (Profit) = $20
• You win because you get something you value for
$60 for only $30
– CONSUMER SURPLUS = $30
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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
Equilibrium
Price
$30
Non-Sellers
Consumer
Surplus
Producer
Surplus
Sellers
Non-Buyers
Demand Curve
65
Equilibrium Quantity
Quantity of Oil
(MBD)
7
Other Conclusions
• Markets are efficient
– Lowest cost producers are the sellers
– Highest value consumers are the buyers
– No more mutually advantageous trades can take
place
– Producer surplus (profit) and consumer surplus are
maximized
• This is all done voluntarily, because people
just want to better themselves
– Both buyers and sellers are self-interested
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Equilibrium: How do we get there?
• Up to this point:
– Buyers and sellers get together in markets
– Negotiate price…an equilibrium emerges
– Presto! Efficiency!
• The story is a bit more complicated…
– How markets work  more interesting than just
the outcome or equilibrium
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Equilibrium: How do we get there?
• Supply and demand helps us understand how
markets work
– Helps show us how prices emerge, not just that
markets are efficient
• What if a market is not in equilibrium? How
does it get there?
– How do buyers and sellers figure out how to get to
the right price?
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Price: Too High?
• What happens if the price is too high?
– At prices greater than the equilibrium price:
Quantity Supplied > Quantity Demanded
• Economists refer to this as Excess Supply or
Surplus.
– Note that prices convey information
• The high price gives buyers an incentive to cut back
– Law of demand: buyers want less when price is high
• The high price gives sellers an incentive to produce more
– Law of supply: sellers want to sell more at a higher price
– Result: surplus
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Excess Supply
Price per
Barrel
$50
Excess Supply Drives Prices Down
Supply Curve
Surplus
$30
Equilibrium
Price
Demand Curve
Quantity of Oil (MBD)
32
100
65
Equilibrium Quantity
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Prices, Information, & Incentives
• In this situation sellers must reduce their
prices to induce buyers to purchase all of
this extra product.
– The lower price gives buyers an incentive to buy
more and sellers to produce less
– As prices fall, the surplus disappears
• When there’s no surplus, and S = D  equilibrium
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Prices, Information, & Incentives
• How do sellers know the price is too high and
they are out of equilibrium?
• Quantities convey information too
 check your shelves
– With a surplus on the market, sellers know to lower
price
• The lower price will attract more buyers
– If the price was too high, the market was wrong,
temporarily
• Why temporarily?
• What if they lower the price too much?
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Prices, Information, & Incentives
• What happens if the price is too low?
– At prices less than the equilibrium price
Quantity Supplied < Quantity Demanded
• Economists refer to this as Excess Demand or
Shortage.
– Again, prices convey information!
• The low price gives buyers an incentive to buy more
– Law of demand: buyers want more when price is low
• The low price gives sellers an incentive to produce less
– Law of supply: sellers want to sell less at a low price
– Result: shortage
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Excess Demand
Price per
Barrel
Excess Demand Drives Prices Up
Supply Curve
Equilibrium
$30
Price
$15
Shortage
Demand Curve
24
65
95
Equilibrium Quantity
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Quantity of Oil
(MBD)
Prices, Information, & Incentives
• How do sellers know the price is too low and they
are out of equilibrium?
• Quantities convey information too
 Are there lines? Back orders?
– With a market shortage, sellers know to raise price
• Sellers would always like to charge more…a shortage
tells them that they can, and they will still have
customers!
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Prices, Information, & Incentives
• Prices guide behavior in markets
– Buyers know to economize when the price is too high
– Sellers know to make more when the price is high
• And, vice versa
• Prices are important and create order out of chaos
– Buyers and sellers are guided by self-interest to reach
efficient outcomes
– No one tells them to reach an equilibrium, they go to it
spontaneously…order emerges out of buyers and
sellers reacting to prices
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Spontaneous Order
• Markets create order, from the bottom up
– Order emerges in markets through individuals
acting out of self-interest
• The result: a more efficient allocation of societal
resources than any (centrally planned) design could
possibly achieve
• Why?
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Spontaneous Order
• Markets create order, from the bottom up
– Why?
• Without prices and markets, people don’t have a good
incentive to take care of shortages and surpluses
• Centrally planned, communist countries: plagued by
shortages (of good things) and surplus (less useful
things)
– Prices are information, coming from market
participants  impossible for government to know
all!
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Self Interest & the Invisible Hand
• The economist F.A. Hayek focused on prices
as information and incentives
• Adam Smith had a similar idea, but focused on
the motivation of buyers/sellers:
– "It is not from the benevolence of the butcher, the
brewer or the baker, that we expect our dinner, but
from their regard to their own self interest. We
address ourselves, not to their humanity but to
their self-love, and never talk to them of our own
necessities but of their advantages.“
– Adam Smith, The Wealth of Nations
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Invisible Hand
• Prices guide actions of individuals
– Prices emerge from individuals participating in
markets
• In a free market, no central authority “sets” prices
– “[one’s] own gain is led by an invisible hand to
promote an end which was no part of his intention.
Nor is it always the worse for society that it was no
part of it. By pursuing his own interest [an individual]
frequently promotes that of the society more
effectually than when he really intends to promote it. I
have never known much good done by those who
affected to trade for the [common] good.“
– Adam Smith, The Wealth of Nations
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Tampering with the market
• Can we do better?
– What if we don’t like the market outcome?
– What if we don’t think self-interested individuals
should be left to their own device?
• Example
– Some people don’t get paid enough
• The market wage (determined by supply and demand) is
very low for some jobs
• Solution: minimum wage (a type of “price floor”)
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Price Floors
Wage
($)
Labor surplus
Minimum wage
(floor)
Supply
(Unemployment)
Conclusion: the
greater the
difference
between the
minimum wage
and the market
wage, the greater
is unemployment
Market wage
Demand
Quantity demanded
at minimum wage
Market
employment
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Quantity supplied
at minimum wage
Quantity
Tampering with the market
• Can we do better?
– What if we don’t like the market outcome?
– What if we don’t think self-interested individuals
should be left to their own device?
• Example
– Some stuff is too expensive  sellers “gouge”
• The market price might seem to high
• Solution: price ceiling  government mandated ceiling
on price…the market cannot charge higher than the set
price
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How Price Ceilings Affect Market Outcomes
Example: rent in
NYC is “too
high” The price
($1000) is above
the ceiling and
therefore illegal.
The ceiling
is a binding
constraint
on the price,
causes a shortage.
P
S
$1000
Price
ceiling
$500
shortage
D
250
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400
Q
Tampering with the market
• Sometimes we don’t like the market outcome
– Policies that interfere with market forces often
have unintended consequences
– Is all market interference bad?
• No. But policymakers need to be very careful about the
effects of various policies
• Have to weigh unintended consequences against other
social goals
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Tampering with the market
• Studying markets is like studying physics
– Is gravity bad? Is motion good?  nonsense
– Like gravity, market forces simply exist.
• How can we make market forces work for us?
• Understanding how markets work (through
supply and demand) helps us understand the
world we live in
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Thank You
http://en.wikipedia.org/wiki/Supply_and_demand
http://en.wikipedia.org/wiki/Invisible_hand
http://en.wikipedia.org/wiki/Spontaneous_order
http://en.wikipedia.org/wiki/Price_ceiling
http://en.wikipedia.org/wiki/Price_floor
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