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CHAPTER 7Modern Principles of Economics:The Price System: Signals, Speculation, and PredictionFacts and Tools a. “uppose LJou’d like to do fiǀe diffeƌeŶt thiŶgs, eaĐh of ǁhiĐh ƌeƋuiƌes edžaĐtlLJ oŶe oƌaŶge. Coŵplete the following table, ranking your highest-valued orange-related activity (1) to your...

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CHAPTER 7 Modern Principles of Economics:

The Price System: Signals, Speculation, and Prediction Facts and Tools 1. a. Suppose you’d like to do five different things, each of which requires exactly one orange. Complete the following table, ranking your highest-valued orange-related activity (1) to your lowest-valued activity (5).

b. Suppose the price per orange is high enough that you buy only four. What activity do you not do? c. How low would the price of oranges have to fall for you to purchase five oranges? What does the price at which you would just purchase the fifth orange tell us about the value you receive from the fifth-ranked activity? Solution 1. a. Any order is fine, though watch out for the student that prioritizes throwing the orange at someone they don’t like. b. Whatever activity the student ranked at number 5. c. The price at which the student would just purchase the fifth orange is the value (or just slightly below the value) of the fifth-ranked activity. 2. The supply and demand for copper change constantly. New sources are discovered, mines collapse, workers go on strike, products that use it wane in and out of popularity, weather affects shipping conditions, and so on. a. Suppose you learned that growing political instability in Chile (the largest producer of copper) will greatly reduce the productivity of its mines in two years. Ignoring all other factors, which curve (demand or supply) will shift which way in the market for copper two years from now? b. Will the price rise or fall as a result of this curve shift? c. Given your answer in part b, would a reasonable person buy copper to store for later? Why or why not? Ignore storage costs. d. As a result of many people imitating your choice in part c, what happens to the current price of copper?

e. Does the action in parts c and d encourage people to use more copper today or less copper today? Solution 2. a. Supply would decrease, that is, it will shift to the left (up). b. The price will rise. c. A reasonable person would buy and store copper now if the price was going to rise in the future. d. The current price would be higher. e. The high price encourages people to begin to conserve copper today. 3. In this chapter, we noted that successful economies are more likely to have many failing firms. If a nation’s government instead made it impossible for inefficient firms to fail by giving them loans, cash grants, and other bailouts to stay in business, why is that nation likely to be poor? (Hint: Steven Davis and John Haltiwanger. 1999. “Gross Job Flows.” In Handbook of Labor Economics, [Amsterdam: North– Holland] found that in the United States, 60% of the increase in U.S. manufacturing efficiency was caused by people moving from weak firms to strong firms.) Solution 3. If the most inefficient firms are kept from failing, then many people are spending their days producing less than they would at a more efficient firm. Less production implies that, on average, people will have less to consume. Thus, the country produces less output for any given level of investment of resources. 4. For you, personally, what is your opportunity cost of doing this homework? Solution 4. Any activity the student could reasonably be doing in place of doing homework and is believable as their next-best option would be appropriate, for example, watching a movie. 5. Suppose you are bidding on a used car and someone else bids above the highest amount that you are willing to pay. What can you say for sure about that person’s monetary value of the good compared to yours? Solution 5. That person’s monetary value of the used car is higher than yours. 6. Sometimes speculators get it wrong. In the months before the Persian Gulf War, speculators drove up the price of oil: The average price in October 1990 was $36 per barrel, more than double its price in 1988. Oil speculators, like many people around the world, expected the Gulf War to last for months, disrupting the oil supply throughout the Gulf region. Thus, speculators either bought oil on the open market (almost always at the high speculative price) or they already owned oil and just kept it in storage. Either way, their plan was the same: to sell it in the future, when prices might even be higher. As it turned out, the war was swift: After one month of massive aerial bombardment of Iraqi troops and a 100-hour ground war, then-President George H. W. Bush declared a cessation of hostilities. Despite the fact that Saddam Hussein set fire to many of Kuwait’s oil fields, the price of oil plummeted to about $20 per barrel, a price at which it remained for years. a. Is buying oil for $36 a barrel and selling it for $20 per barrel a good business plan? How much profit did speculators earn, or how much money did they lose, on each barrel?

b. Why did the speculators follow this plan? c. When the speculators sold their stored oil in the months after the war, did this massive resale tend to increase the price of oil or decrease it? d. Do you think that many consumers complained about speculators or even realized that speculators were influencing the price of oil in spring 1991? Solution 6. a. This is obviously a bad business plan. Speculators lost $16 on each barrel. b. Speculators did this because they thought the price would stay high. They believed in their hunch strongly enough to bet their own money on it. c. This increase in supply reduced the price of oil after the war. d. Few consumers thought about the speculators, even though by betting wrong the speculators reduced social surplus. Oddly, it’s when speculators bet right and increase social surplus that they are more often attacked! 7. You manage a department store in Florida, and one winter day you read in the newspaper that orange juice futures have fallen dramatically in price. Should your store stock up on more sweaters than usual, or should your store stock up on more Bermuda shorts? Solution 7. Bermuda shorts. The fall in orange juice futures is a sign of a good crop, which probably means speculators are expecting warm weather. 8. Take a look at Figure 7.3. If investors in the Hollywood Stock Market were too optimistic on average, would the dots tend to cluster above the red diagonal line or below it? How can you tell? Solution 8. Below it. If they are optimistic, then predicted opening revenues must be higher than the actual opening revenues, or the X-axis value has to be bigger than the Y-axis value, which means below the 45degree line. 9. Let’s see if the forces of the market can be as efficient as a benevolent dictator. Since laptop computers are increasingly easy to build and since they allow people to use their computers wherever they like, an all-wise benevolent dictator would probably decree that most people buy laptops rather than desktop computers. This is especially true now that laptops are about as powerful as most desktops. In answering questions a–c, answer in words as well as by shifting the appropriate curves in the following figures.

a. Since it’s become much easier to build better laptop computers in recent years, laptop supply has increased. What does this do to the price of laptops? b. Laptop and desktop computers are substitutes. Now that the price of laptops has changed, what does this do to the demand for desktop computers? c. And how does that affect the quantity supplied of desktop computers? d. Now let’s look at the final result: Once it became easier to build good laptops, did “invisible hand” forces push more of society’s resources into making laptops and push resources away from making desktops? (Note: Laptop sales first outnumbered desktop sales in 2008.) Solution 9. a. The increase in supply pushes down the price of laptops. b. This reduces the demand for desktops. c. This reduces the quantity of desktops supplied. d. Yes, there are now fewer people and machines making the old, worse kind of computers.

Thinking and Problem Solving 10. Andy enters into a futures contract, allowing him to sell 5,000 troy ounces of gold at $1,000 per ounce in 36 months. After that time passes, the market price of gold is $950 per troy ounce. How much does Andy make or lose? Solution 10. Andy made $250,000—he buys gold for $950 and sells it for $1,000, repeating the process 5,000 times. 11. Circa 1200 BCE, a decreasing supply of tin due to wars and the breakdown of trade led to a drastic increase in the price of bronze in the Middle East and Greece (tin being necessary for its production). It

is around this time that blacksmiths developed iron- and steel-making techniques (as substitutes for bronze). a. How is the increasing price of bronze a signal? b. How is the increasing price an incentive? c. How do your answers in questions a and b help explain why iron and steel became more common around the same time as the increase in price? d. After the development of iron, did the supply or demand for bronze shift? Which way did it shift? Why? Solution 11. a. It tells people that bronze is getting harder to produce, and its higher price will signal consumers to conserve it more or seek substitutes. b. It rewards people who make bronze less scarce, consumers who choose to conserve bronze by seeking alternatives, and entrepreneurs who seek to supply more economically efficient bronze alternatives. Thus, the price increase encourages recycling, finding new sources of tin, reducing the need for bronze (e.g., by developing technologies to make bronze products thinner or hollow), developing substitutes, and so forth. c. An increase in the price of a resource encourages innovation to produce substitutes for that resource. d. The demand for bronze shifted to the left (down) because there was now a good substitute for bronze. 12. In 1980, University of Maryland economist Julian Simon bet Stanford entomologist Paul Ehrlich that the price of any five metals of Ehrlich’s choosing would fall over 10 years. Ehrlich believed that resources would become scarcer over time as population grew, while Simon believed that people would find good substitutes, just as earlier people developed iron as a substitute for scarce bronze. The price of all five metals that Ehrlich chose (nickel, tin, tungsten, chromium, and copper) fell over the next 10 years and Simon won the bet. Ehrlich, an honorable man, sent a check in the appropriate amount to Simon. a. What does the falling price tell us about the relative scarcity of these metals? b. What could have shifted to push these prices down: Demand or supply? And would demand have increased or decreased? And supply? Solution 12. a. The falling price indicates that the metals are relatively less scarce than what they were before. b. A falling price could have been due to a reduction in demand (caused, for example, by the development of substitutes) or supply could have increased (caused, for example, by new discoveries of these scarce resources). 13. In this chapter, we explored how prices tie all goods together. To illustrate this idea, suppose new farming techniques drastically increased the productivity of growing wheat. a. Given this change, how would the price of wheat change? b. Given your answer in question a, how would the price of cookbooks specializing in recipes using wheat flour change? c. Given your answer in question b, how would the price of paper change?

d. Given your answer in question c, how would the price of pencils change? (Hint: Are paper and pencils substitutes or complements?) e. Given your answer in question d, how would the quantity of graphite (used in pencils) consumed change? Solution 13. a. Fall, because supply would shift to the right b. Increase, because demand would shift to the right c. Increase, because demand would shift to the right d. Fall, since paper and pencils are complements and so demand would shift to the left e. Fall, because demand would shift to the left 14. The law of one price states that if it’s easy to move a good from one place to another, the price of identical goods will be the same because traders will buy low in one region and sell high in another. How is our story about the effect of speculators similar to the lesson about the law of one price? Solution 14. Like traders who move goods across regions, speculators buy low and sell high, except they buy and sell across time instead of national boundaries. 15. Let’s build on this chapter’s example of asphalt. Suppose a new invention comes along that makes it easier and much less expensive to recycle clothing: Perhaps a new device about the size of a washing machine can bleach, re-weave, and re-dye cotton fabric to closely imitate any cotton item you see in a fashion magazine. Head into the laundry room, drop in a batch of old clothes, scan in a couple of pages from Vogue, and come back in an hour. a. If you think of the “market for clothing” as “the market for new clothing,” does this shift the demand or the supply, and in which direction? b. If you think of the “market for clothing” as “the market for clothing, whether it’s new or used,” does this shift the demand or the supply, and in which direction? c. What will this do to the price of new, unrecycled clothing? d. After this invention, will society’s scarce productive resources (machines, workers, retail space) flow toward the “new clothing” sector or away from it? (Note: This question might sound fanciful but three-dimensional printers, which can create plastic or plaster prototypes of small items such as toys, cups, etc., have fallen dramatically in price. Every day, you’re getting just a little bit closer to having your own personal Star Trek replicator.) Solution 15. a. This shifts the demand for clothing to the left: a fall in demand. b. This shifts the supply of clothing to the right: a rise in supply. c. Either way, this pushes down the price of new clothing. d. The scarce resources will flow away from the new clothing sector, hopefully to other, more productive uses.

16. Robin is planning to ask Peggy to the Homecoming dance. Before he asks her, he wants to know what are the chances that she’ll say yes. Robin is a scientist so he considers two paths to estimate the probability that Peggy will say yes. I. Ask 10 of his friends, “Do you think she’ll really say yes?” II. Tell another 10 of his friends, “I’m starting a betting market. I’ll pay $10 if she says yes, $0 if she says no. I’m offering this bet only once, to the highest bidder. Start bidding against each other for a chance at $10!” a. According to the evidence in this chapter, one of these methods will work better. Which one, and why? b. If the highest bid from Group II is $1 (along with a few lower bids of $0.75, $0.50, and zero), then roughly what’s the chance that Peggy will say yes to Robin? c. If the highest bid from Group II quickly shoots up to about $9, then what’s the chance that Peggy will say yes to Robin? Solution 16. a. According to the evidence, method II, the betting market, will work better. When money is on the line, people tend to be more honest and are more willing to hurt their friends (or their boss’s) feelings. b. Assuming the highest bidder is the most accurate, about a 10% chance (1/10), though Robin might reduce that to take into account the knowledge of the lower (and more pessimistic) bidders. c. About a 90% chance (9/10), though, again, the true value might be lower. 17. A classic essay about how markets link each other is entitled “I, Pencil,” written by Leonard E. Read (his real name). It is available for free online at the Library of Economics and Liberty. As you might suspect, it is written from the point of view of a pencil. One line is particularly famous: “no single person on the face of this earth knows how to make me.” Based on what you’ve learned in this chapter about how markets link the world, how is this true? Solution 17. No one knows how to perform all of the steps in making a pencil: Growing the right kind of wood, making graphite, inventing safe, nontoxic paint, making the metal thing that holds the eraser onto the pencil, making the rubber eraser on the top. There are many steps, and no one person knows the ins and outs of more than a few of the steps, especially when it comes to the details. Yet the pencil is made anyway, illustrating how much cooperation is required and induced to produce even a simple object like a pencil.

Challenges 18. In The Fatal Conceit, economist Friedrich A. Hayek, arguing against central planning, wrote: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” In other words, people generally assume that they can plan out the best procedure for producing a good (such as the Valentine’s Day rose mentioned at the beginning of the chapter) but as we learned, that’s not true. What are some of the different roles that the price system plays in creating this order? (Hint: Key words are “links,” “signals,” and “incentives.”) Solution

18. Prices link markets: A rise in price in one market encourages people to switch their demand over to other markets, reducing the pressure on the high-priced market. Markets are like a computer because they take the information from the prices and act “as if ” they know the best use of scarce goods. Prices as signals let business owners and consumers know what is plentiful and what is scarce. And prices are incentives that get people to economize on (or produce more of the) scarce goods and to switch over to using more of the inexpensive, plentiful goods. 19. One question that economics students often ask is, “In a market with a lot of buyers and sellers, who sets the price of the good?” There are two possible correct answers to this question: “Everyone” and “No one.” Choose one of the two as your answer, and explain in one or two sentences why you are correct. Solution 19. “Everyone”: In a market with many suppliers and demanders, each person’s actions push the supply or the demand just a little bit, so everyone gets a kind of vote, everyone has some small influence. “No one”: Nobody actually plans for a given price to be the equilibrium price. All of the suppliers want a higher price, and all of the demanders want a lower price. The equilibrium price was unintended by everyone, and desired by no one. 20. This chapter emphasized the ability of an orderly system to emerge without someone explicitly designing the entire system. How does the evolution of language illustrate a type of spontaneous order? Solution 20. Like markets, no one wrote out all the rules for any given language beforehand. They emerged over time through trial and error. The one exception to this rule is Esperanto, which no one speaks. 21. Are you in favor of “price gouging” during natural disasters? Why or why not? Solution 21. This is intentionally open-ended and intentionally inflammatory. Anti-gouging arguments should at least recognize the “signal flare” effect mentioned in the chapter. If anti-gougers are giving up the “signal flare” of high prices, then they’ll have to support extra government responses to make up for the absence of entrepreneurs. Pro-gougers should note that “gouging” is a subjective term, and though “gougers” really are motivated by greed rather than benevolence, the net effect is getting more resources into disaster areas. It would take a very efficient government to ensure that water bottles go to the people who need it most: The gouging mechanism might not be any worse than having the National Guard handing out bottles on street corners. 22. What is the opportunity cost of the economics profession? Solution 22. The opportunity cost of the field of economics is the next best thing that economists could be doing with their time. If economics didn’t exist, perhaps some potential economists would go to Wall Street to become financiers, many would go to law school, many would go to engineering or physics or biochemistry. In any of these fields, they’d probably create some value. So, to tell whether the field of

economics is “worth it,” we have to compare it with the next best alternative use of all of these resources. Perhaps the world would be better off if economics disappeared, perhaps not. But by thinking in terms of opportunity cost, we sharpen our debates on the value of t...