How Markets WorkHow Markets Work

ECO 284

Dr. D. Foster

Three (Economic?) Questions:

1. What to produce?

2. How to produce?

3. For whom to produce?

We mustmust decide!

Scarcity Choices Costs

Markets are the solution . . .

What is the role of priceprice?

Serves to reward producersfor fulfilling our desires.

Forces consumers to conserve on the consumption of goods (and services, and resources . . .).

Adam SmithAdam Smith

““It is not from the It is not from the benevolencebenevolence of the of the butcher, the brewer, or the baker that butcher, the brewer, or the baker that we expect our dinner, but from their we expect our dinner, but from their

regard to their regard to their self interestself interest. .

We address ourselves, not to their We address ourselves, not to their humanity, but to their self-love, and humanity, but to their self-love, and

never talk to them of never talk to them of our necessitiesour necessities, , but of but of their advantagestheir advantages.”.”

Robert HeinleinRobert Heinlein

““Never appeal to a man’s better nature. Never appeal to a man’s better nature.

He may not have one. He may not have one.

Invoking his self interest gives you more Invoking his self interest gives you more leverage.”leverage.”

Prices are . . . a rationing devicea rationing device!

How else to ration? First come, first served? Brute force? Discrimination? Equal portions? [Marxist? NoNo!]

When a good is increasingly scarce, its price rises and we are forcedforced to reduce consumption.

Equally? Of course not!

ScenarioScenario: Kuwait falls into the Gulf.

How do supplierssuppliers react to the P=$5 ? How do consumersconsumers react to the P=$5 ?

What if we fix prices (a ceiling) at $2.50 ?

$2.50

S

DQuantity

$5.00

New S

Q2

$10.50

Q1 Q3

Is a price of $5.00 . . .Is a price of $5.00 . . .

Fair?

Outrageous?

Price gouging?

An indictment against “greedy” sellers?

Napolitano, Goddard Napolitano, Goddard condemn price gougingcondemn price gouging

By HOWARD FISCHERCapitol Media Services

08/19/2003 PHOENIX -- Gov. Janet Napolitano said she will propose legislation to make price gouging on gasoline a crime. The governor's comments came after Attorney General Terry Goddard said the prices being charged at the pump by some retailers in Maricopa County appear to be unjustified. He said that while the wholesale price of regular gasoline Monday was in the $2-a-gallon range, he has had reports of retail prices twice that high. But Goddard said nothing in state law gives him any power to do anything about it -- at least not yet. Napolitano also hinted that if the situation does not get better she might even issue orders limiting how much gasoline individuals can buy. She said that is because it appears to her that at least some of the problem is due to consumers panicking and "topping off" their tanks, hording (sic) fuel that they do not needthat they do not need and leaving none for their neighbors.

The “Entitlement” ProblemThe “Entitlement” Problem

Dairy Price SupportsDairy Price Supports

1986 - $1.3 billion to slaughter dairy cows. No effect on milk, but on beef . . .

1991 - USDA buys butter at $1/lb. to sell abroad at 60 cents/lb.

1996 - Congress approves cartel in New England to raise milk prices 21%.

1999 - Milk price calculation simplified . . .

Began during G. D. of 1930s. 1981 - cheese giveaway. 1983 - $1 billion to “retire” 10,000

dairy cows. No effect.

The Inefficiency of Price FloorsThe Inefficiency of Price Floors

Dairy Price SupportsDairy Price SupportsBasic Formula Price (BFP)

= last month's average price paid for manufacturing grade milk in Minnesota and Wisconsin

+ [current grade AA butter price X 4.27 + current non-dry milk price X 8.07 - current dry-buttermilk price X 0.42]

+ [current cheddar cheese price X 9.87 + current grade A butter price X 0.238]

- [last month's grade A butter price X 4.27 + last month's nondry-milk price X 8.07 + last month's dry-buttermilk price X 0.42]

- [last month's cheddar cheese price X 9.87 + last month's grade A butter price X 0.238]

+ (present butter fat - 3.5) X [current month's butter price X 1.38]

- [last month's price of manufacturing grade milk in Minnesota-Wisconsin X 0.028].

Dairy Price SupportsDairy Price Supports

Lessons? Plenty of them . . .Lessons? Plenty of them . . . Cost to consumers of higher prices:

Butter = 2*ROW, Cheese = 1.5*ROW, Milk=1.26*ROW

Cost to taxpayers for dairy subsidies: 0 to $2.6 billion, depending on market conditions.

Health harm - more expensive for poor and elderly to get calcium.

No incentive to innovate in U.S. dairy industry (New Zealand milk is produced at about half our cost).

Since 1930, dairy farmers declined by 95%. Oct. 2002 - State of Mass. charges Midland Farms…

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How Markets WorkHow Markets Work

ECO 284

Dr. D. Foster