Why Markets? Lecture Notes Johan Stennek 1 2 3 4 How where - - PowerPoint PPT Presentation

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Why Markets? Lecture Notes Johan Stennek 1 2 3 4 How where all those people aligned to produce this meal? 5 But, lets start from the beginning. .why dont we simply eat what we produce 6 Love of variety we want a liAle

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Why Markets?

Lecture Notes 


Johan Stennek

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How where all those people aligned to produce this meal?

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But, lets start from the beginning…. ….why don’t we simply eat what we produce

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Love of variety

we want a liAle of this and a liAle of that

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In 1913, Henry Fords invented the moving assembly line

  • Building of T-Ford divided into 84 steps
  • ProducLon Lme dropped from 12 hours to 1.5
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Returns to specializa<on

Do what we are good at and learn

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Love of variety Returns to specializa<on

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Fundamental Economic Problem:

  • 1. Exchange - Under what condiLons do we gain?
  • 2. CoordinaLon - How do we know that
  • somebody else produces what we wish to eat
  • somebody else wishes to eat what we produce

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Why Markets?

  • Why Exchange?

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Why Markets?

  • Purpose: understand why
  • 1. Love of variety
  • 2. Returns to specializaLon
  • How?

– Build a model – Model = an “imaginary economy” – Do imaginary experiments

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➡︎ Exchange

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Model 1

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Why Markets?

  • Simplifying assumpLons

– Two people: Anderson & Peterson – Two goods: Apples & Pears – Resource constraint

  • Work 1500 hours per year
  • No disuLlity of working

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Why Markets?

  • Love of variety

– People derive uLlity from consuming fruit – But only in pairs (= fruit salad)

  • 1 apple + 2 pears is as good as 1 apple + 1 pear
  • To enjoy a 2nd pear, I need a 2nd apple

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Why Markets?

– Perfect complements ≠ Love of variety

  • Extreme caricature
  • Makes model easy to analyze without a lot of math
  • QualitaLve conclusions do not hinge on this

simplificaLon

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Why Markets?

  • Returns to specializaLon

– Maximum producLon per hour: – Absolute advantage

  • Anderson – apples
  • Peterson – pears

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Apples Pears Anderson 2 1 Peterson 1 2

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Why Markets?

  • QuesLon 1

– How many apples and pears would Anderson and Peterson produce and eat, if they could not exchange fruit with one another? (3 minutes) – Recall

  • 1500 hours per year
  • Eat fruit in pairs
  • Anderson produces 2 apples or 1 pear per hour
  • Peterson 1 2

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Why Markets?

  • Answer 1

– Anderson always produces the same number of apples and pears in order to consume even pairs – He has to work 1.5 hours to produce one pair – Since he works 1500 hours, he will produce and eat 1000 apples and 1000 pears – Also Peterson will produce and eat the same number of apples and pears.

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Why Markets?

  • QuesLon 2: Someone suggests Anderson

should give an apple to Peterson for some amount of pears

– How many pears would Anderson at least require from Peterson in exchange for one apple? – How many pears would Peterson at most be prepared to give Anderson in return for one apple? – (5 minutes)

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Why Markets?

  • Anderson

– Producing one more apple takes ½ hour – Must produce ½ pear less – Anderson requires at least ½ pear in exchange for an apple

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Why Markets?

  • Peterson

– Producing one apple less frees 1 hour – Can produce 2 pear more – Peterson is willing to give 2 pears in exchange for an apple

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Why Markets?

  • Answer 2

– Anderson demands ½ pear in return for 1 apple – Peterson willing to give 2 pears in return for 1 apple

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Why Markets?

  • QuesLon 3

– Anderson and Peterson agree (for some unexplained reason) to trade the fruit one for

  • ne.

– How many apples and pears will Anderson and Peterson produce and eat? – How many fruits will they trade? – (3 minutes)

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Why Markets?

  • Answer 3

– Let Anderson and Peterson specialize completely – Anderson spends all Lme producing apples; In total 3000 apples – Peterson spends all Lme producing pears; In total 3000 pears – Exchanging 1500 apples and pears, both people will be able to eat 1500 fruit-pairs

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Why Markets?

  • QuesLon 4

– Compare the two outcomes.

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Why Markets?

  • Answer 4

– Without exchange: Each eat 1000 fruit pairs – With exchange: Each eat 1500 fruit pairs

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GDP increased by 50%

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Why Markets?

  • Causes of Growth?

– Technical progress?

  • No!

– Investments?

  • No!

– Economic organizaLon?

  • Yes!

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GDP increased by 50%

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Model 1b

The coordinaLon problems

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Why Markets?

  • QuesLon 5

– What happens if Anderson specializes in apples, but Peterson produces both apples and pears?

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Why Markets?

  • Answer 5 (Exchange aper producLon)

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Why Markets?

  • Answer 5 (Exchange aper producLon)

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Why Markets?

  • Answer 5 (Exchange aper producLon)

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Why Markets?

  • Answer 5

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Specializing in the wrong acLvity is a dominated strategy!

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Why Markets?

  • Answer 5

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Both specializing according to advantage => Pareto- dominaLng outcome.

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Why Markets?

  • Answer 5

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BUT: Specializing according to advantage is risky – Requires coordina0on

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Why Markets?

  • QuesLon for the break: What would you do?

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Why Markets?

  • There is no right answer
  • In fact, Keynes argued:

– SomeLmes….

  • people confident they will be able to sell what they produce
  • when everyone confident, expectaLons confirmed
  • Boom

– Other Lmes…

  • people lack confidence and thus don’t take risks
  • when everyone lacks confidence, expectaLons confirmed
  • Recession

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Animal Spirits

– John Maynard Keynes: An essenLal ingredients of economic prosperity is confidence. – Animal spirit is a parLcular sort of confidence, "naive

  • pLmism”

– For entrepreneurs in parLcular, "the thought of ulLmate loss which open overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectaLon of death". – John Maynard Keynes used the term to describe the gloom and despondence that led to the Great Depression and the changing psychology that accompanied recovery.

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Why Prices?

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Why Prices?

  • CoordinaLon problem 1

– SpecializaLon vs Self-sufficiency

  • CoordinaLon problem 2

– If I wish to specialize, how do I know what to produce, given that I don’t know other people’s produc6vi6es and preferences

  • Answer 2

– Prices

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Why Prices?

  • Assume

– Price of apple = price of pear = € 1 – All people believe they can sell and buy as much as they wish at these prices

  • Analysis
  • 1. Maximize income by choosing what to produce
  • 2. Maximize uLlity by choosing what to eat

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Why Prices?

  • Maximize Anderson’s income

– Producing apples => €2/per hour – Producing pears => €1/per hour – Thus specialize in apples => produce 3000 => – Income = €3000

  • Maximize Peterson’s income

– Specialize in pears => produce 3000 => – Income = €3000

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Why Prices?

  • Maximize Anderson’s uLlity

– Income = €3000 – Buy 1500 pears and 1500 apples

  • Maximize Peterson’s uLlity

– Income = €3000 – Buy 1500 pears and 1500 apples

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Total producLon = total consumpLon Everyone can realize their plans at the same Lme!

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Why Prices?

  • Prices => CoordinaLon

– Same outcome as with agreement – But, need not know other people’s producLviLes and preferences

  • CondiLons
  • 1. Prices correctly set, for some reason
  • 2. People believe they can buy and sell as much as

they wish at these prices

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Example when it didn’t work

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Johnny Carson American TV-host (“The Tonight Show”) & comedian

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Example when it didn’t work

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December of 1973

You know what’s disappearing from the supermarket shelves?

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Example when it didn’t work

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December of 1973

Toilet paper….

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Example when it didn’t work

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December of 1973

There’s an acute shortage

  • f toilet paper in the

United States!

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Example when it didn’t work

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Americans went out and bought up all toilet paper they could find

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Example when it didn’t work

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Supermarkets tried to raLon it, but without success. By noon the next day, all the naLon’s supermarkets were sold out.

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Example when it didn’t work

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Sorry – it was a joke

Aper several days of toilet paper shortages due to this hysteria,

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Example when it didn’t work

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But shelves were almost always empty => => whenever some would come in, people would buy it all and hoard it This toilet paper shortage lasted three weeks.

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Example when it didn’t work

  • Expressed differently

If people expect shortage or price increases, demand today increases … a form of speculaLon demand … … which may create shortage and price increases increasing demand even further …. … creaLng a vicious circle

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Example when it didn’t work

  • Conclusion:

– If people don’t trust that prices are in equilibrium (i.e. believe they can buy as much as they wish) – The price system may fail to coordinate

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Example when it didn’t work

– hAp://youtu.be/UZLjUEBuUQY

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Example when it didn’t work

  • Related (more common?) phenomena

– Price regulaLon => small excess demand => people start to hoard => big excess demand (common in Soviet Union) – Bubbles in asset markets (with flexible prices)

  • People expect a price to increase
  • Increase their demand (speculaLon)
  • Causes price to increase, confirming beliefs
  • May cause expectaLons for further price increases …

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Why Markets? Model 2

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Why Markets?

  • Returns to specializaLon

– Suddenly Anderson becomes 4 Lmes more producLve than before – Maximum producLon per hour: – Anderson has absolute advantage in both fruits

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Apples Pears Anderson 8 4 Peterson 1 2

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Why Markets?

  • QuesLon

– Does Anderson have any reason to trade with Peterson?

  • Answer

– Lets do the same analysis as last Lme

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  • QuesLon 1

– How many apples and pears would Anderson and Peterson produce and eat, if they could not exchange fruit with one another? (2 min) – Recall

  • 1500 hours per year
  • Eat fruit in pairs
  • Anderson produces 8 apples or 4 pear per hour
  • Peterson 1 2

Why Markets?

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Why Markets?

  • Answer 1

– Anderson has to work 1.5 hours to produce 4 fruit pairs – Since he works 1500 hours, he will produce and eat 4000 apples and 4000 pears – Peterson will produce and eat 1000 apples and pears

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Why Markets?

  • QuesLon 2

– How many pears would Peterson at most be prepared to give Anderson in return for one apple? – How many pears would Anderson at least require from Peterson in exchange for one apple? – (4 min)

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Why Markets?

  • Anderson

– Producing one more apple takes 1/8 hour – Must produce ½ = (1/8 * 4) pears less – Anderson requires at least ½ pear in exchange for an apple

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Why Markets?

  • Peterson

– Producing one apple less frees 1 hour – Can produce 2 pear more – Peterson is willing to give 2 pears in exchange for an apple

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Why Markets?

  • Answer 2

– Anderson demands ½ pear in return for 1 apple – Peterson willing to give 2 pears in return for 1 apple

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Why Markets?

  • QuesLon 2 – follow up

– What is the cost of producing a pear

  • for Anderson?
  • for Peterson?

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Why Markets?

  • Answer 2 – follow up

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Produc<vity Apples Pears Anderson 8 4 Peterson 1 2 Cost of producing a pear Time spent Pears foregone Anderson 15 minutes 1/2 Peterson 30 minutes 2 = 1/4 hour = 1/2 hour

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Why Markets?

  • Answer 2 – follow up

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Produc<vity Apples Pears Anderson 8 4 Peterson 1 2 Cost of producing a pear Time spent Pears foregone Anderson 15 minutes 1/2 Peterson 30 minutes 2 = 1/4 hour = 1/2 hour Q: More costly for Peterson to produce pears?

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Why Markets?

  • Answer 2 – follow up

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Produc<vity Apples Pears Anderson 8 4 Peterson 1 2 Cost of producing a pear Time spent Apples foregone Anderson 15 minutes 2 Peterson 30 minutes 1/2

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Why Markets?

  • Answer 2 – follow up

– Anderson is more producLve in producing pears – His cost in terms of resources (Lme) is lower – Anderson’s cost in terms of apples is larger – His opportunity cost is larger

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Cost of producing a pear Time spent Apples foregone Anderson 15 minutes 2 Peterson 30 minutes 1/2

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Why Markets?

  • DefiniLon: Opportunity Cost

– The cost of an acLvity (here: pears) in terms of the value of the best alternaLve that is not chosen (here: apples, rather than Lme).

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Why Markets?

  • QuesLon 3

– Anderson and Peterson agree (for some unexplained reason) to trade the fruit one for

  • ne.

– How many fruits will they trade? – Expressed differently, how many apples and pears will Anderson and Peterson produce and eat?

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Why Markets?

  • Answer 3

– Peterson can consume 1500 fruit pairs – Anderson can consume 4500 fruit pairs – DO CALCULATIONS!!!

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Why Markets?

  • Result: “Law of ComparaLve Advantage”

– Two individuals (or firms, countries) will both gain from exchange – if they have different rela0ve producLviLes (i.e. resource costs) for producing the same goods – even if one individual is more producLve in the producLon of all goods (absolute advantage) – assuming both wish to consume a variety of goods

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Why Markets?

  • ApplicaLons

– Firms - specialize in “core competencies” – Countries - specialize in producing goods requiring inputs that they have in abundance – Household members… – Football players…

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Why Markets?

  • How is this outcome achieved by prices?

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Produc<vity Apples Pears Anderson 8 4 Peterson 1 2

Wages adjust to reflect workers’ maximum producLviLes wAnderson= 8; wPeterson= 2

Cost of producing a pear Time spent € Anderson 15 minutes Peterson 30 minutes

1 4 ⋅8 = 2

1 2 ⋅2 = 1

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Why Money?

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Why Money?

  • Problem with barter

– Presumes double coincidence of wants

  • You have what I want
  • You want what I have

– But this is rare

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Why Money?

  • SoluLon

– Commodity money

  • Ex: gold
  • Everyone likes, transportable, storable,

– Fiat money

  • Ex: paper - no intrinsic value
  • Requires trust

– I am willing to give people goods in exchange for paper, – trusLng that others give me what I want in exchange for paper

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Why Money?

– Read in lecture notes

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