Markets 101: Markets 101: The Case for MarketsThe Case for Markets

Sabina ShaikhSabina ShaikhUniversity of ChicagoUniversity of Chicago

CIS Summer Teacher CIS Summer Teacher InstituteInstitute

Understanding the Understanding the Global Economy: Global Economy:

Bringing the World Bringing the World Market into your Market into your

ClassroomClassroom

June 22, 2009June 22, 2009

Why Markets and Why Markets and Globalization?Globalization?

The Benefits of The Benefits of Competition and TradeCompetition and Trade More ChoicesMore Choices Lower Prices and Rising Lower Prices and Rising

IncomesIncomes Productivity, EfficiencyProductivity, Efficiency InnovationInnovation

But, Competition But, Competition Necessarily Creates Necessarily Creates Winners Winners andand Losers Losers

Does Economics Ignore Does Economics Ignore the Losers?the Losers?

$20

$480

$100

$100

The Study of EconomicsThe Study of Economics Resources are ScarceResources are Scarce ““There is no such thing as a free lunch”There is no such thing as a free lunch” Opportunity Cost: What did you give up to be Opportunity Cost: What did you give up to be

here today?here today? Individuals see to Maximize UtilityIndividuals see to Maximize Utility

Abstract Measure of Satisfaction Abstract Measure of Satisfaction Is it Happiness? Not exactly Is it Happiness? Not exactly

Preferences and ChoicePreferences and Choice Comparison of Benefits and CostsComparison of Benefits and Costs

Maximize BenefitsMaximize Benefits Minimize CostsMinimize Costs

Incentives Affect BehaviorIncentives Affect Behavior Economics tries to be positive not normativeEconomics tries to be positive not normative Economics has no morals?Economics has no morals?

Specialization, Advantage Specialization, Advantage and Tradeand Trade

SpecializationSpecialization Parents send kids to school instead of home Parents send kids to school instead of home

schoolingschooling You visit a doctor when you’re sickYou visit a doctor when you’re sick Pay a plumber to fix a leakPay a plumber to fix a leak

Absolute Advantage and Comparative Absolute Advantage and Comparative Advantage in ProductionAdvantage in Production

Specialization by Comparative Advantage Specialization by Comparative Advantage can lead to mutually-beneficial tradescan lead to mutually-beneficial trades

Gains from Trade ExampleGains from Trade Example

Competitive MarketsCompetitive Markets Demand for Goods and ServicesDemand for Goods and Services

Price and Value (Marginal Benefit)Price and Value (Marginal Benefit) Marginal Benefit is DiminishingMarginal Benefit is Diminishing

Supply of Goods and ServicesSupply of Goods and Services Price and Marginal CostPrice and Marginal Cost Marginal Cost is IncreasingMarginal Cost is Increasing

Invisible Hand and Market EquilibriumInvisible Hand and Market Equilibrium Assumptions of a Competitive MarketAssumptions of a Competitive Market

Price Takers Price Takers No Market PowerNo Market Power No Government InterventionNo Government Intervention ““Perfect” InformationPerfect” Information No Externalities or Public GoodsNo Externalities or Public Goods Homogenous GoodsHomogenous Goods

The Graphical MarketThe Graphical Market

P

Demand = Marginal Benefit

Supply = Marginal Cost

QQ*

P*

Supplynew

Pnew

Qnew

Equilibrium will change with shifts in Supply or DemandEquilibrium will change with shifts in Supply or Demand Supply Shifts: Input prices, technology, weatherSupply Shifts: Input prices, technology, weather Demand Shifts: Income, tastes, prices of other goodsDemand Shifts: Income, tastes, prices of other goods

Demandnew

Qnew

Market Impacts: Global Market Impacts: Global Food PricesFood Prices

Could we have predicted these impacts?Could we have predicted these impacts? Could we have predicted the magnitude of these Could we have predicted the magnitude of these

impacts? impacts?

Qcorn

P

S

D

Subsidy to Subsidy to Ethanol Blenders Ethanol Blenders Increases the Increases the Demand for Corn: Demand for Corn: Price of Corn Price of Corn goes upgoes up

Dnew

Qsoy

S

D

P

Higher Price of Corn Higher Price of Corn increases the demand increases the demand for land for corn. Land for land for corn. Land diverted from other diverted from other crops. Supply of Soy crops. Supply of Soy decreases. Price of Soy decreases. Price of Soy goes up. goes up. (Same happened to (Same happened to CRP land)CRP land)

Snew

Qmilk

S

D

PSnew

Higher Price of Corn Higher Price of Corn increases the costs of increases the costs of feeding dairy cows feeding dairy cows raising the price of raising the price of milk. milk. (Think about the (Think about the substitution effects substitution effects here)here)

CORN SOY MILK

Measuring Market Impacts: Measuring Market Impacts:

Elasticity and Welfare Elasticity and Welfare MeasurementMeasurementP S

QQ*

P*

D

The slope of the curves represent the elasticity of demand or supply to price. Elasticity measures how much demand or supply change for a 1% change in

price? Elasticity can also be used for income or prices of substitutes or complements

Consumer Surplus measures the extra value to the consumer: Value – Expenditure

Producer Surplus measures the extra value to the producer: Price – Cost

Together the two comprise the total market value or the net benefit.

Efficiency requires that this net benefit be maximized.

Sources of Market Sources of Market FailureFailure

In an In an otherwise efficient competitive otherwise efficient competitive marketmarket, the following can induce market , the following can induce market failure:failure:

Government InterventionGovernment Intervention Price or Quantity ControlsPrice or Quantity Controls

Price Ceilings, Price Floors, QuotasPrice Ceilings, Price Floors, Quotas International Trade: Tariffs, Quotas, Protectionist International Trade: Tariffs, Quotas, Protectionist

MeasuresMeasures Subsidies and Taxes Subsidies and Taxes

Market Power: Loss of CompetitionMarket Power: Loss of Competition ““Imperfect” InformationImperfect” Information Externalities and Public GoodsExternalities and Public Goods

Government Intervention as Government Intervention as Market Failure: Minimum Market Failure: Minimum

Wage Wage

35 80 100 115 Qlabor

Plabor=WageS

D

Pmin=6

P*=5

At the minimum wage, there is a surplus of labor: the Quantity of labor supplied exceeds the Quantity demanded. This is an inefficient market condition or market failure.

Government Intervention as Government Intervention as Market Failure: Minimum Market Failure: Minimum

WageWage

Qgoods

S

D

Pnew

P*

Qnew Q*

The increased cost of labor shifts the supply curve (which is also the cost of production curve). Consumer prices go up. This is the market impact.

Snew

So, the theory says that minimum wages can lead to unemployment and less affordable consumer goods.

Another Example: Rent Another Example: Rent ControlsControls

Krugman and Wells, 2006

Externalities as Market Externalities as Market Failure: Why Regulate Failure: Why Regulate

Greenhouse Gases?Greenhouse Gases? Consider the market for coal-based electric Consider the market for coal-based electric

powerpower What are the costs and benefits of generating What are the costs and benefits of generating

electricity to the power company?electricity to the power company? What are the costs and benefits of purchasing What are the costs and benefits of purchasing

electricity to the consumer?electricity to the consumer? Who bears the costs of pollution?Who bears the costs of pollution? How to “internalize” this externality?How to “internalize” this externality? An important note: the externality arises from An important note: the externality arises from

the market for electric power. The power the market for electric power. The power company would not be able to sell electricity company would not be able to sell electricity at current prices without the consumers.at current prices without the consumers.

Market-Based Solutions to Market Market-Based Solutions to Market FailureFailure

The Role of IncentivesThe Role of Incentives People respond to changes in pricePeople respond to changes in price Can we appeal to conscience?Can we appeal to conscience?

Government InterventionGovernment Intervention Wait! Wasn’t this a source of market failure?Wait! Wasn’t this a source of market failure? Yes. Remember how we predicted the market Yes. Remember how we predicted the market

impacts from minimum wage, price supports, etc.impacts from minimum wage, price supports, etc. We can use this to restore market efficiency as We can use this to restore market efficiency as

well.well. Incentives: Price and Quantity InstrumentsIncentives: Price and Quantity Instruments

Property Rights and the Coase TheoremProperty Rights and the Coase Theorem Ronald Coase (1960):Ronald Coase (1960): The Problem of Social Cost The Problem of Social Cost As long as property rights are established, As long as property rights are established,

mutually-beneficial transactions exist even in the mutually-beneficial transactions exist even in the presence of externalities.presence of externalities.

Simple Coase Theorem Simple Coase Theorem ExampleExample

One bedrooms = $800/month, two bedrooms = $1400. One bedrooms = $800/month, two bedrooms = $1400. Sally smokes causing Jim costs of $150/month.Sally smokes causing Jim costs of $150/month.Can they still live together?Can they still live together?

OptionsOptions Cost ($)Cost ($) Net Gain ($)Net Gain ($)SallySally JimJim SallySally JimJim

Live AloneLive Alone 800800 800800 00 00Live TogetherLive Together 700700 700+150700+150 100100 -50-50

Sally is willing to pay X<100 since she will still have a positive gain from sharing. Sally is willing to pay X<100 since she will still have a positive gain from sharing. Jim is willing to accept X>50 since then he will have a positive gain from sharing.Jim is willing to accept X>50 since then he will have a positive gain from sharing.Take $75 as an example.Take $75 as an example.

OptionsOptions Cost ($)Cost ($) Net Gain ($)Net Gain ($)SallySally JimJim SallySally JimJim

Live AloneLive Alone 800800 800800 00 00Live TogetherLive Together 700+75 700+75700+75 700+75 2525 2525

Internalizing the Internalizing the Externality from CO2: Externality from CO2: A A

Market for CarbonMarket for Carbon?? Recall the coal-based electric power example.Recall the coal-based electric power example. Now, given the market failure from the Now, given the market failure from the

externality, suppose that we implement a market-externality, suppose that we implement a market-based solutionbased solution

Carbon Tax Vs Cap and TradeCarbon Tax Vs Cap and Trade Substitution EffectsSubstitution Effects

Supply Response: Wind, Solar, Carbon CaptureSupply Response: Wind, Solar, Carbon Capture Demand Response: Energy Efficiency Demand Response: Energy Efficiency

We should be able to predict these. A market We should be able to predict these. A market could work but there’s a good chance an could work but there’s a good chance an inefficient market will be established.inefficient market will be established.

Economics does not always make good politics.Economics does not always make good politics. Does the Coase Theorem work for pollution?Does the Coase Theorem work for pollution?

Examples from Global Examples from Global MarketsMarkets

U.S. Auto Companies (U.S. Auto Companies (Naked EconomicsNaked Economics)) Increased competition from Japanese automakers in Increased competition from Japanese automakers in

1980’s1980’s US auto company responseUS auto company response

Market Solution: Make more fuel-efficient cars to compete Market Solution: Make more fuel-efficient cars to compete OROR

Political Solution: Lobby the government for tariffs and Political Solution: Lobby the government for tariffs and quotas and avoid fuel economy lawsquotas and avoid fuel economy laws

This could have been a success story for globalizationThis could have been a success story for globalization EthanolEthanol

The Impact of Corn for FuelThe Impact of Corn for Fuel Sugarcane and Tariffs: Positive? Negative?Sugarcane and Tariffs: Positive? Negative?

The Kyoto ProtocolThe Kyoto Protocol China and India exempt from Emissions Reductions. China and India exempt from Emissions Reductions.

Why? Why? Marginal Costs of Environmental Protection: Marginal Costs of Environmental Protection:

Specialization and TradeSpecialization and Trade Income Elasticity of Environmental ProtectionIncome Elasticity of Environmental Protection

Recommended Recommended ReferencesReferences

Naked EconomicsNaked Economics by Charlie by Charlie WheelanWheelan

The EconomistThe Economist The New York TimesThe New York Times: Freakonomics, : Freakonomics,

EconomixEconomix Textbook: Krugman and Wells, Textbook: Krugman and Wells,

EconomicsEconomics www.theclimatecommunity.comwww.theclimatecommunity.com