Supply and Demand: A Process of Coordination (Chapter 5) PDF

5 Supply and Demand: A Process of Coordination Learning Objectives Describe the market as a process that coordinates the plans...

5 Supply and Demand: A Process of Coordination Learning Objectives Describe the market as a process that coordinates the plans of millions of people involved in the production of a single good. Analyze markets using the supply and demand model. Distinguish between shortages and surpluses, and explain the way free-market prices adjust to generate market-clearing outcomes. Describe how free-market prices transmit scarce information. Explain how money reduces transaction costs. Analyze the role that interest rates play in coordinating ­economic activity. S pecialization is what distinguishes every wealthy society the world has ever known. As Adam Smith observed when reflecting on the economic growth that had occurred in Britain during the eighteenth century: It is the great multiplication of the productions of all the ­different arts, in consequence of the division of labour, which occasions, in a well-governed society, that universal opulence which extends itself to the lowest ranks of the people. 96 DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 96 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services  A society becomes wealthy when its members acquire the abil- ity to specialize effectively, to “divide” their labor, as Smith put it. 97 How does the division of labor—specialization—arise? ­Chapter 1 posed that as a central question of economics. In Supply and Chapter 2 we began answering that question when we explored demand: the incentives to specialize and exchange and the increase in ­opportunities or wealth that specialization generates. We called that A process of the “law of comparative advantage.” But how exactly do the people coordination in a wealthy, highly specialized commercial society encourage one another to take those interconnected actions that wind up produc- ing the incredible array of goods and services that they enjoy? The basic problem is massive ignorance. Specialists, by their very nature, don’t know how to do everything. (Can you name Knowledge and information one person, specialist or otherwise, who does know how to do ­everything, or at least can productively order everybody to pro- are scarce goods—for duce goods and services efficiently?) The fact is, people do have everybody. some skills and abilities and they remain genuinely ignorant of countless other skills and abilities. Consider this incredible ­example, one thoroughly rooted in the real world: Probably no single person anywhere in the world knows how to produce something as simple as an ordinary no. 2 pencil. That sounds crazy at first, but go outside the box and think about it. Lots of specialists know how to assemble a pencil once the wood, graphite, rubber, paint, glue, tin ferrule, appropriate tools, and machinery are all in the pencil factory. But specialists in pencil assembly don’t know how to produce those essential inputs. That’s not their own comparative advantage. Consider the wood itself. It took loggers to fell the trees. And the loggers depend on specialized, high-tech equipment, as well as coffee, meals, clothing, health care, and countless other goods and ser- vices to do their job adequately. The logging equipment is made, in part, from steel. So steelworkers had a hand in the making of pencils, too, whether they know it or not. The steel is made from iron ore—which was probably mined in Michigan’s Upper Peninsula, and sent first by rail on the Lake Superior & Ishpem- ing Railroad and the CN Railroad, and then by hundreds of ships down Lakes Superior and Michigan to ports all around the Great Lakes. Who made the trains, the tracks, the ships, the varieties of food that fed the crews (let alone the clothing, toiletries, and so on)? Who contributed to producing the fuel, the ports, or the so- phisticated communications systems that guided the ships? The answer is countless other specialists, people pursuing their com- parative advantage, acting on their limited knowledge and skills, and cooperating with still other specialized input providers. Imagine the number of different people, from different races, colors, and creeds, with different opinions, skills, and goals, within the country and abroad, whose goods and services contributed to the production of a simple no. 2 pencil. All those people cannot How is it all coordinated? DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 97 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services 98 possibly know one another, they may not even speak the same language, yet no. 2 pencils get produced. And we consumers ­generally know where to find them, cheap. Chapter Five The miracle of the market, as some have quite properly de- scribed it, is that millions of people who don’t even know of one another’s existence, manage to cooperate and produce not only no. 2 pencils, but also innumerable other goods of much greater complexity, and to do so in ways that make them readily and abundantly available. And people are encouraged to cooper- ate not by obeying the orders of some comprehensive, national economic plan issued in part, say, from a government Writing Implement Bureau. The government’s role is much more limited. Recall what Adam Smith said, “in a well-governed society.” The government plays an important role in all of this, especially in monitoring and enforcing private property rights and contracts— the overall rules of the game—that allow for these countless ­exchanges to take place. People often tend to take this orderly, nonchaotic network of exchanges for granted (“What do you mean you’re out of ­pencils?”). Surely a market system is much more complex than the smooth flow of traffic (also taken for granted) that we dis- cussed in Chapter 1. While the orderly nature of markets might appear miraculous, it is not, however, mysterious. What are the key signals, the traffic lights, if you will, that help people in a commercial society coordinate their varied production and con- sumption plans? The answer is prices. Millions of people receive important information and signals, as well as incentives to act on those signals, from prices formed in the market. Market prices Market prices convey emerge through the interplay of supply and demand, which we useful information. introduced separately in Chapters 3 and 4. In this chapter we put supply and demand together and describe the principles of the market process itself. The Market Is a Process of Plan Coordination Many people often think of “the market” as a place or forum, such as a baseball card and collectible show at Gateway Center in St. Louis, or a cattle auction at the fairgrounds in Kansas City, or the New York Stock Exchange in the Wall Street district. But all of these are really elements of markets that stretch across regions, around the globe, and even into cyberspace. Formal markets might have emerged with town fairs during the Middle Ages, but it makes little economic sense to view markets as mere places or forums today. Journalists and those in the financial community use many mixed metaphors to describe markets, often making it sound as if DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 98 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services a market is a person. How many times have we heard some expert on the evening news or the financial channels say that Wall Street 99 was “excited” or “nervous” about the latest economic data, or that the stock market “hopes” or “expects” that Ben Bernanke at the Supply and Federal Reserve will engage in yet another round of quantitative demand: easing? Perhaps someday when the conditions are right, one of those experts will report that “the stock market has awakened A process of bloated, with terrible cramps and a bad headache, and has called coordination in sick today.” Although that kind of statement might make the news more interesting, the economic way of thinking recognizes that individuals have hopes, expectations, cramps, and head- aches; markets don’t. Even economists themselves use misleading metaphors. They often refer to market systems as “automatic” or “self-adjusting,” giving the impression that markets function without the interven- tion of human beings! Many economists make it sound as if the market is some kind of mechanical thing, like a thermostat. That’s wrong. Market systems are entirely composed of demanders and suppliers, who are real human beings pursuing the projects that interest them, economizing on the basis of the relative scarcities that they confront, and negotiating arrangements to secure what they want from others by offering others what they in turn want to obtain. It is best to avoid these common but misleading interpreta- tions of markets. The market is not a person, place, or thing. The market is a process of plan coordination among sellers and buyers. When economists use the terms supply and demand, they are re- ally talking about these kinds of continual, ongoing negotiations among individuals. The Basic Process We’re now ready to consider, with the help of a graph, the sup- ply and demand process. Let’s consider the market for relatively inexpensive acoustic guitars, the kinds bought by beginning and intermediate pickers throughout the country. Figure 5–1 depicts the market. Notice the downward-sloping market demand curve. That reflects an essential point from Chapter 3—the law of demand. People would plan to purchase more guitars as the relative price falls, and plan to purchase fewer guitars as the relative price ­increases. The quantity demanded increases or decreases, not the overall demand curve, when only the price of guitars changes. Next, notice the upward-sloping supply curve. Recall from Chap- ter 4 that supply curves generally slope upward, which reflects the increasing marginal opportunity costs of producing more guitars. Making more acoustic guitars requires many specialized resources, from specific grades of spruce and mahogany to the DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 99 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services 100 Chapter Five Surplus S $700 PRICE 500 300 Shortage D 0 800 1,000 1,200 QUANTITY OF ACOUSTIC GUITARS Figure 5–1 Supply and demand in the acoustic guitar market The market clears at $500. A surplus of 400 guitars exists at the $700 price, and a shortage of 400 guitars occurs at the $300 price. highly skilled labor of the workers. For guitar producers to obtain spruce and mahogany, they must bid those resources away from other productive uses, such as Christmas trees, fine cabinets, in- cense holders, and the many other goods that people desire that can also be made from those materials. Higher prices for the gui- tars will induce producers to make more guitars. Full market coordination: X Notice where the supply and demand curves intersect. There, marks the spot. the market price is $500 per guitar and the market output is 1,000 guitars. At the $500 price, note that the quantity demanded is 1,000 guitars, which is exactly equal to the quantity supplied. In this event, the plans of guitar buyers are fully coordinated with the plans of guitar producers. In a free market, of course, producers can charge any price they wish, and consumers can offer any price they wish. So let’s suppose that the market price were substantially higher than $500. Say it’s $700. If guitar producers plan to receive $700 per guitar, how would they respond? The upward-sloping supply curve helps illustrate the answer. At $700, the quantity supplied would increase well beyond 1,000 guitars, to 1,200. (Supply doesn’t increase—only the quantity supplied!) But never forget that the market is made up of two sides, sellers and buyers. While sellers would increase output at the higher price, how would ­potential buyers respond? The demand curve helps illustrate that answer: At the $700 price, people would reduce their planned DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 100 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services purchases of guitars. Quantity demanded (not overall demand!) would decrease to only 800 guitars. 101 Who would be able to fulfill their plans, and whose plans would become frustrated? Consumers, as a whole, would be able Supply and to purchase all the guitars they wish at $700 apiece (the quantity demand: demanded is 800), but producers would find that they have over- produced. They made and planned to sell 1,200 guitars (the quan- A process of tity supplied). That’s a difference of 400 guitars, guitars that are coordination undesirably piling up in the manufacturers’ inventories. Here, the market is not fully coordinated. A surplus of guitars has emerged. A surplus occurs when the quantity supplied is greater than the Surplus: Qd < Qs quantity demanded. In our example, there is a surplus of 400 gui- (frustrated sellers). tars. Sellers often become aware of a surplus—aware of their own errors — by the unplanned piling up of their inventories. They simply aren’t selling as much as they had counted on. How can producers unload their unplanned inventories of guitars? Perhaps they can point guns to the heads of terrified people and force them to purchase the remaining guitars for $700 apiece. But that goes against the rules of the free market. Perhaps one manufacturer can sell more guitars by burning down another Sellers compete with sellers. competitor’s guitar-making facilities. But that, too, breaks the rules of the game. Perhaps they can seek legislation requiring children to learn how to play guitars, which might improve de- mand and sales. That is an effort of manipulating and changing the rules of the game in their favor, but that takes quite a lot of time and political maneuvering and is a costly activity. What they can do, and what generally happens in free markets, is that pro- ducers will cut their own prices. Indeed, we would predict that the market price of guitars Question: Does “surplus” mean would fall from $700 to $500. As the price falls, potential buyers no more scarcity for this good? would be more receptive: The quantity demanded (not the overall demand!) would increase from 800 to 1,000 guitars. At the same time, quantity supplied (not the overall supply!) would decrease from 1,200 to 1,000. Then the surplus would disappear: The plans of both buyers and sellers would fully mesh; the market would become fully coordinated at the $500 price. Sellers would have no further incentive to compete against other sellers by lowering their prices. Finally, consider the opposite case. Suppose the current market price were well below $500. At a price of $300 per guitar, people would eagerly plan to purchase a total of 1,200 guitars (the quantity demanded), but producers would produce and plan to sell only 800 guitars (the quantity supplied). While the plans of the producers would be achieved, many customers would be frustrated as they try to purchase a guitar, but find them sold out. Here we have a shortage, which is the opposite of a surplus. Shortage: Qd > Qs A shortage occurs when the quantity demanded is greater than the quantity supplied. Customers might sense a shortage by facing (frustrated buyers). ­unusually long lines or finding items out of stock. Sellers might DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 101 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services 102 have to unexpectedly dip into their planned inventories, discover- ing that they are selling more than they originally expected. What can a frustrated buyer do? Breaking into the shop and Chapter Five stealing is a violation of the law. So is putting sand in the gas tank of another customer who might race out before you to pur- Buyers compete with buyers. chase the last remaining guitar in stock. People are, however, free to offer a higher price for a guitar. If consumers begin bidding up the price of guitars, how will sellers respond? By producing more guitars. As the market price rises from $300 to $500, notice that the quantity supplied will increase, from 800 to 1,000 guitars. At the same time, the increased price will reduce quantity demanded Substitutes for everything! from 1,200 to 1,000 guitars. Whether people actually begin to bid the price up, or sellers find that they can substitute for the consumer bidding process by raising their own prices and selling more guitars, there are tendencies for the market price to rise and the overall shortage to disappear. Competition, Cooperation, and Market Clearing People often argue that buyers compete with sellers in the market economy. Is this true? Back in Chapter 2 Brown and Jones coop- erated with each other by exchanging stouts and lagers. Does the exchange for money alter that cooperative relationship between two trading parties? No. If you voluntarily purchase a guitar for $20, $200, $500, or whatever, you and the seller have found a way to cooperate with each other—that’s the essence of mutually beneficial exchange, whether the exchange takes place through money or barter. Money facilitates the ability to induce these acts of cooperation. Competition does, of course, occur, and like cooperation, com- petition is rampant throughout the market process. Rather than Sellers cooperate with competition between buyer and seller, however, buyers tend to com- buyers. pete with other buyers, and sellers tend to compete with other sellers. Consider the case of a shortage. Frustrated guitar shoppers compete with one another by offering higher money prices or by demonstrating their own willingness to pay the higher posted price. The bidding process eliminates the shortage. The sellers of guitars would like, of course, the highest prices they can receive, and will eagerly try to accommodate buyers who are offering more money. In the opposite case of a surplus, sellers compete among themselves by trying to attract customers and move ­excess inventories. It is not a rivalry between buyer and seller; it’s a rivalry between guitar sellers. The rivalry works itself out not through violence and mayhem—as long as the rules of the game are respected and enforced!—but by price reductions. ­“Every other shop is charging $700 for this guitar. Because I see you love this guitar, I’ll give you a break. $595. And I’ll even throw in DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 102 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services free strings.” The seller is finding a way to compete against other sellers and cooperate with you. The competitor who was only of- 103 fering free strings with her $700 guitar will soon find that’s not enough. She will soon lower her price as well. (When you shop Supply and for a car, is the seller intent on competing with you or the dealer demand: down the street? You want a low price, but do you fear the seller, or do you fear that your offer may be too low, and the car may be A process of sold to a buyer who offered $750 more than you did?) coordination Therefore, the price tends to rise during times of shortages and fall during times of surpluses. The competitive bidding ­process runs its course once the shortage or surplus is alleviated. In our example, that ends at the $500 price. Individual buyers will have no incentive to increase their bids without the short- age. ­Individual sellers will have no incentive to lower their price without the surplus. Economists typically refer to that price as an equilibrium price, as the “forces” of supply and demand have worked themselves out, and there is no further tendency for the price to change. But again, that sounds a bit too mechanical, as if the market were a thing. The authors instead prefer the term market-clearing price. To say that the market is clear is to say there is neither a shortage nor a surplus, The plans of buyers have Market clearing: Qd = Qs become fully coordinated with the plans of sellers. (plans of buyers and sellers The economic way of thinking emerged in part to explain the phenomenon of market clearing. It’s not only the market for gui- are fully coordinated). tars that tends to clear. Free markets for any good or service show a tendency to clear. The “laws” or principles of supply and demand help us explain why and how markets generally tend to clear, how people with limited information nevertheless find ways to accom- plish many of their plans. One final but crucial point. A commercial society doesn’t require expert economists to clear markets. It instead requires that there are effective rules of the game that allow people to buy, sell, and trade their property—to coordinate their own plans—as they best see fit. Economists are useful in explaining how mar- ket processes coordinate people’s plans and generate wealth and economic growth, something that a lot of people still don’t un- derstand. People often fail to see that market clearing is an unin- tended consequence of the specific choices that individuals make. Guitar buyers couldn’t care less about the overall state of the market. They want guitars at an acceptable price. They can’t pos- sibly know everything there is to know about the state of the gui- tar industry. Same for guitar sellers. They pursue their own goals, too, geared toward making a living and a profit. The tendency for market clearing is not planned and engineered by economists, government agencies, nor even producers or consumers. Markets tend to clear as an unintended consequence of people competi- tively bidding and cooperatively exchanging, following their own projects, plans, and goals, with inescapably limited information and knowledge. No need for experts! DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 103 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services  104 Changing Market Conditions And now for a little further practice. Our discussion centered Chapter Five around the tendency for the market to clear with given supply and demand curves. But, as you learned in Chapters 3 and 4, demand and supply curves themselves can shift. Let’s practice a couple of those shifts. Suppose, for example, the price of spruce fell, with other P prices (for skilled labor, mahogany, and other materials) un- S1 changed. Your first challenge is to decide whether this would af- fect the supply or the demand curve. Lower spruce prices would $500 S2 tend to reduce the marginal opportunity costs of making guitars. More guitars would be produced as a result. And, recall that the supply curve is derived from the “height” of those marginal costs. 400 Lower marginal costs mean a rightward shift of the supply curve. As more guitars come on the market, and the overall supply in- D creases, the price would fall from $500 to $400. (What would hap- Q of guitars pen if supply increased, but the price stayed at $500? A surplus would emerge. Sellers would compete by lowering their prices P S until the surplus is eliminated.) A new market-clearing price would emerge, at $400 per guitar. (Notice that the demand curve $600 for guitars has not changed. The quantity demanded increased as the price fell from $500 to $400.) 500 Consider a different example. What if the price of electric gui- tars were to increase? How would this initially affect the market D2 for acoustics? Electric and acoustic guitars are generally consid- ered good substitutes. People who planned to buy electric guitars D1 would revise their plans in light of the higher price. Some would Q of guitars switch to acoustic guitars instead, while a couple of others would consider trombones, accordions, or other things to purchase with their money. Nevertheless, this raises the overall demand for acoustic guitars. We could depict that with a rightward shift of the demand curve in the market for acoustic guitars. A new ­market-clearing price would emerge, at $600 per acoustic guitar. Learning from Free-Market Prices No one blames the thermometer for low temperatures, or seri- ously proposes to warm up the house on a cold day by holding a candle under the furnace thermostat. That’s because they have a more-or-less correct understanding of how those things work. People do, however, often blame high prices for the scarcity of certain goods, and act as if scarcity could be eliminated by ­enforcing price controls. We will discuss price controls in the next chapter. For now, let it be understood that scarcity is a relationship ­between desirability and availability, or between demand and supply. DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 104 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services A good is scarce whenever people cannot obtain as much of it as they would like without being required to sacrifice something else 105 of value. Market prices inform us of relative scarcities. But don’t confuse scarcity with rarity. Something is rare if it is available in Supply and a relatively small quantity. Eight-track cassette tapes, therefore, demand: are rarer than compact discs. Desirability is not a component of rarity. Who really wants eight tracks anymore? The demand just A process of isn’t there. Old eight tracks sell for a buck or two at urban flea coordination markets. The same music on compact discs fetches much higher prices. People are willing to sacrifice more cash for the disc. It is therefore more scarce than an eight track. (If you still can’t see it, consider this. Suppose one of the authors—Prychitko—autographs a baseball. It will be much rarer than an Alex Rodriguez ball, be- cause there would be only one in existence, whereas A-Rod has For Sale: A-Rod autographed signed hundreds, if not more. But nobody wants to pay as much baseball, $600. for a Prychitko as for Rodriguez. In fact, Prychitko’s signature probably reduces the value of the ball close to zero. It is therefore For Sale: Dave Prychitko nowhere near as scarce as a Rodriquez.) autographed baseball, Now it follows immediately, as Chapter 3 insisted, that if 50 cents. a good is scarce, some selection process, criteria of some kind, must be established for discriminating among claimants to de- termine who will get how much. The criterion could be age, elo- quence, swiftness, public esteem, willingness to pay money, or almost anything else. In commercial society it’s most commonly on the basis of willingness to pay money. But sometimes we use other criteria. For example, Harvard University each year has many more applicants than it can place in the freshman class, so Harvard discriminates on the basis of high school grades, test scores, recommendations, relationship to important alumni, and other criteria. Joe College is the most popular man on campus, and has young women clamoring for his favor. He must therefore direct his attentions. Whether he employs the criterion of beauty, intelli- gence, geniality, or something else, he must and will discriminate in some fashion. Once Harvard announces its criteria for discrimination, fresh- man applicants will compete to meet them. If the women eager to date Joe College believe that beauty is his main criterion, they will compete with one another to seem more beautiful. Competition is obviously not confined to capitalist societies, Scarcity makes competition or to societies that use money. Competition results from scarcity, inevitable. and can be eliminated only with the elimination of scarcity—it ­occurs when people strive to meet the criteria that are being used to determine who gets what. The criteria that are used make a difference, sometimes a huge and important difference. If a society coordinates economic plans on the basis of willingness to pay money, members of that society will strive to make money. If it uses physical strength as a primary criterion, members of the society will do bodybuilding DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 105 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services 106 exercises. If it coordinates on the basis of people’s ability to play brass instruments, members will try to learn how to play bugles. If the better colleges and universities use high school grades as an Chapter Five important criterion for selection, high school students will com- pete for grades. They might be competing for grades to acquire other goods as well (status among classmates, compliments from teachers, use of the family car, or the old man’s credit card), but the discriminatory criteria used by these schools will certainly ­encourage students to compete for higher grades. Central Planning and the Knowledge Problem The economic task for a society is to secure coordination among people in using what is available to obtain what is wanted. Ef- fective plan coordination among large numbers of people who barely know each other requires that the terms of exchange be clear, simple, and standardized, so that transaction costs can be kept down. We live in a world of people with highly diverse skills, in- terests, values, and preferences; where resources have many ­different potential uses, and opportunity costs vary infinitely; where continual change and constant discovery are the features of everyday life. Imagine an alternative economic system of socialist central planning, in which all the means of production— resources, machinery, factories, and so on—are not owned pri- vately, but by society as a whole, with decisions about the best uses of these scarce goods deposited in the hands of a group of expert economists, sociologists, chemists, and so on, who would form a central planning board and decide what to produce, how to produce, and for whom to produce. The entire socialist econ- omy would be run like a huge state post office. Markets would be abolished. So, too, would the use of money. What information and signals would central planners use to effectively and efficiently pro- duce and distribute the massive array of goods and services desired by millions of citizens? After all, the engineers on the planning committee could ­announce that it is physically possible to make buses out of gold, to make train tracks out of platinum, and to make wedding rings out of tin. In a free-market system, bus producers, railroad builders, and jewelers are both politically and economically free to make these goods in this way. So why don’t they commonly do that in a market economy? Because it would be ridiculously unprofitable to do so. The market prices of those resources, compared to the prices people are will- ing to pay for the final goods, help inform producers that these will likely generate losses in advance of actually undertaking the DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 106 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services activity. That’s what monetary calculation is all about. Those same prices emerge by millions of people’s daily acts of voluntary 107 exchange and negotiation in the market process. But socialist central planning abolishes that process. What signals and infor- Supply and mation will be readily available to the planners? They might enjoy demand: reams of engineering principles and equations, huge warehouses stockpiled with material resources, an eager and fit-for-work pop- A process of ulation, and sophisticated computer systems tracking all the data, coordination but will the data be economically useful? The data show that tin Economic calculation wedding rings are remarkably rare. Should more be produced? informs people of the relative Or less? At what cost? Just how scarce are tin wedding rings? Plati- num provides less friction than steel, but does that inform plan- scarcity of goods and ners that platinum is best used to make railroad tracks? What services. are all the alternative uses of platinum and the associated costs of using platinum for medical equipment, railroad tracks, or what- A socialist economy abolishes ever? Indeed, what are the associated costs of producing a rail- road track when those materials and workers could be devoted to economic calculation and the producing hospitals, toasters, pencils, and countless other scarce information that it provides. goods and services? Without money and market pricing, planners cannot effectively engage in economic calculation. The demise of central planning in China, and in the former USSR and its client states illustrated what economic theory has long suggested: Central economic planners, even if they are bril- liant and loving people, don’t even begin to know enough to man- age effectively the day-to-day business of a commercial society. The issue is not getting better people to plan our way to economic growth; it’s getting more effective institutions and rules of the game that encourage people to discover their own compara- tive advantage, and make the most effective use of their limited knowledge, information, and resources. Lack of market pricing also creates significant transaction costs and failures of cooperation among suppliers and demand- ers. As the system of central economic planning in the USSR disintegrated, news reports regularly told about unharvested food rotting in rural areas, while grocery store shelves stood empty in the cities. How could a thing like this occur? Why didn’t someone transport that food to the cities where it was so much in demand? Collapse of the system of bureaucratic control does not provide an adequate explanation. People should be able to move food out of the fields and into the hands of hungry people without explicit orders from above. Or so one would suppose. But think more carefully and con- cretely. Who owned the food that was going to waste? Who had authority to harvest it? Who owned harvesting equipment? Who could authorize the use of the equipment? Who owned trucks to transport the food to the cities? Who had fuel for the trucks? How was the food to be distributed once it arrived in the cities? The mere fact that food is going to waste in the fields while people are hungry in the cities is not enough to get food actually moving DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 107 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services 108 from farms to urban pantries. The right people must first acquire the appropriate information and incentives. Transaction costs explain that “wasteful” situation. The word Chapter Five wasteful is set within quotation marks because it’s not at all clear that what happened really was wasteful. It’s not wasteful to let food rot rather than consume it if the costs of getting the food to consumers exceed the value of the food. And that was apparently the case. Transaction costs are just as real, and no less important than the costs of harvesting and transporting. Property Rights and Institutions Such a situation would be much less likely to develop in the United States, where fields, food, farm machinery, trucks, ware- houses, and retail stores are privately owned. The rules of the game are different. Under a system of clearly defined property rights, people with information about the situation would have strong incentives to acquire control of whatever resources were needed to move the food from where it had no use to where it did. And within a system that allows for free exchange among property owners, the necessary resources will quickly and at low cost come together under the control of those who can put them to valuable uses. Contrast the frustrating situation in the former USSR with the way that people, tractors, construction equipment, and every- thing else needed for emergency relief and reconstruction moves into hurricane-torn regions in the U.S. The crucial difference is the well-established system of clearly defined property rights in the United States, along with the extensive freedom that people Clearly defined property have to trade those rights as they choose. This has produced over rights the years a vast network of institutions—profit and not-for- profit—in the United States that keeps transaction costs low The ability to exchange for almost all the exchanges in which people engage with any rights ­frequency or regularity. (The thoughtful reader will shrewdly note that people frequently and regularly engage in particular transac- tions only because the transaction costs are low.) Think again about how easy it usually is to obtain the precise pizza on which your hungry heart is set. The many transactions that make your pizza possible—that constructed the pizzeria, grew the peppers, shipped the olives, milked the cows, and ar- ranged the requisite lines of credit for all these activities—all had to be negotiated. These negotiations succeeded because the trans- action costs were sufficiently low. And the transaction costs were low because the transactions occurred within an extensive set of institutions that evolved over time as market participants worked to lower the costs of the transactions in which they wanted to engage. Think of specialized manufacturers, specialized Inter- net retailers, specialized providers of every kind of service; the DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 108 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services principles of financial accounting, the rules of the road, the cus- toms of the trade in varied lines of business; banks, credit report- 109 ing agencies, highly organized stock exchanges; the classified sections of daily newspapers, the telephone companies’ Yellow Supply and Pages, lists of brokers and suppliers that can be obtained on a demand: moment’s notice; the rules of the common law, police to enforce these rules, and courts to resolve disputed issues, plus private sys- A process of tems of arbitration to supplement the system of public law. coordination In those nations where central planning has failed, market systems have been evolving. Achievement of those market sys- tems faces the enormous obstacle of high transaction costs at almost every turn, precisely because many of the institutions that are crucial are still lacking. Can individual transactors (ordi- nary people) in these nations now create by design what evolved without design in long-established market economies? Can they create quickly the complex institutions that have elsewhere come into existence through a slow, evolutionary process? Can they overcome the problem of high transaction costs rapidly enough to satisfy the aspirations of their citizens, who are impatient to ­enjoy the promised rewards of a market system? The success of the reform programs in many of the nations of the former Soviet bloc depends largely on the answers to these questions. An Appendix: The Coordinating Roles of Money and Interest Money: The General Medium of Exchange Why do almost all the exchanges in a market system take place for money? Why don’t more people engage in barter, trading what they produce directly for what they want? Why do business own- ers sell goods and services for money, and workers accept pay- ment in money, even though money is of little use in itself. The answer is that money lowers transaction costs. Money is a general medium of exchange. It pervades all markets, licit and ­illicit. The advantages of using money rather than relying solely on a barter system are enormous. The cost of arranging exchanges would be far greater, and our wealth as a consequence far less, if there were no money in our society to facilitate the process. (Don’t forget, wealth is not defined as money or material things; wealth is whatever people value.) In an economic system limited to barter, people would have to spend a tremendous amount of time searching for others with whom they could make a trade. A guitar maker would have to find a farmer, toilet paper manu- facturer, logging mill owner, toolmaker, glue supplier, building contractor, among many others, each willing to accept guitars in DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 109 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services 110 return for the goods that he or she produces. All that time spent on searching would be time not available for guitar making, and the production of guitars would decline steeply. So, too, would Chapter Five the production of all those other goods whose owners must also search for the right people to barter with. Aware of the high transaction costs attached to almost ev- ery exchange, people would increasingly try to produce for themselves most of whatever they wanted. Specialization would ­decline dramatically in a society confined to barter, an exchange system without the facility of money, and everyone would be much poorer. The evolution of some kind of money system in ­almost every known society, even when conditions were extremely unfavorable to it, is eloquent testimony to the advantages of using money. Money has another important advantage. The amount of money offered in exchange can be adjusted up or down by very small or very large amounts. Imagine the guitar maker wanting one concert ticket in a pure barter economy. Can he offer only 1/10 of a guitar for the ticket and trade the remaining portions of his guitar for a six-pack, Big Mac and fries, gasoline, and the many other things he values? Or must he trade a whole guitar for, say, 10 concert tickets, and then find ways to exchange the extra tickets for the six-pack, burger, and so on? Think of the ri- diculously large transaction costs! No wonder Buddha gave it all up. But if the guitar maker sells guitars for money, he can buy a little bit more, or a little bit less of what he wants with no trouble at all. And he can raise the exchange value—the money price—of his guitars by a small amount if he senses that his customers are willing to pay more for them than before, or lower their exchange value by just a little if he thinks this would secure some sales that he wouldn’t otherwise get. The ability to make small adjustments is essential to the Two halves do not equal ­coordination of a commercial society. Consider a gallon of gaso- a whole. line. If we are to be able to fill our tanks at the station on Tuesday evening at 5:30, just the right number of people with just the right abilities and command over just the right physical resources must cooperate at just the right times, and in just the right ways to explore, drill, pump, pipe, refine, truck, and store. That intricate system is coordinated basically by means of the responses people make to adjustments in money prices. The people who regularly accomplish this spectacular feat of coordination don’t do it because they love us and know how much we want gasoline, but to further the innumerable and diverse projects in which they themselves happen to be interested. Their efforts mesh because those efforts are coordinated by the continually changing signals that money prices emit. We must insist once again that the crucial importance of money prices to the working of our society implies nothing about the character or morality of our citizens. People pay attention DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 110 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services to money prices insofar as they want to economize, that is, to get as much as possible of what they value from the resources 111 they command. Money prices help consumers establish budgets and clarify their options. Money prices help producers calculate Supply and ­expected costs and expected revenues. People don’t pay attention demand: exclusively to money prices, of course; that wouldn’t make sense. They do, however, change their behavior when prices change, A process of in order to “take advantage” of the new situation signaled by the coordination new prices. This is what causes coordination to occur and self- interested (again, not necessarily selfish) behavior to become The role of monetary ­cooperative action. calculation Money and Interest Recently a financial journalist wrote, “If Ben Bernanke at the Federal Reserve raises interest rates the price of money will go up.” Unfortunately, statements like this are entirely wrong from the perspective of the economic way of thinking. Interest is not the price of money. Nor is it a payment made to use money. Interest is paid not for using money, but for borrowing money. Borrowing is a matter of obtaining purchasing power that we have not yet earned. Borrowers, through the channels of banks, per- suade lenders to provide them with credit now, by promising to pay back the principle plus interest later. They enter a mutually agreed-upon contract. The interest rate reflects the price of credit, Interest is not “the price the terms of the deal. of money.” Think of a student loan. Why are you willing to pay inter- est? Current resources are generally more valuable than future resources because having them usually expands one’s oppor­ tunities—enabling us to do things that cause our earning capacity to increase over time, so that we might have more resources at some future date. When we see such a prospect, we want to borrow—invest in our own education in this case. And we are willing to pay, if we have to, a premium — interest — as long as the interest is less than what we expect to gain as a result of borrowing. Businesses do the same. Time Preference Interest is the difference in value between present and future goods. Many economists over the decades argued that the differ- ence between the two might be explained by the expected produc- tivity of capital. But more than that, people display a positive rate of time preference: we tend to place a higher value on present enjoy- ment than on enjoyment in the distant future. We often discount the future, if only a bit. DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 111 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services 112 Here are a couple of little tests you might use to find out whether you have a positive rate of time preference. You’re hun- gry. You have the choice of either eating an hour from now, or Chapter Five having the same meal a few hours from now. If you prefer to eat sooner rather than later, then you are displaying a positive rate of time preference. Or imagine your grandmother surprises you with a check in the mail for $100. You’re naturally thrilled by the gift. But then you notice it is dated to be cashed next month. If that disappoints you a little, if you’d prefer to be able to cash the check today, you are displaying a positive rate of time preference. It then becomes a matter of trade-offs. You might be more If you place the same value than willing to postpone a present consumption opportunity if on $1,000 now as on $1,250 you can be compensated with a larger opportunity in the future. a year from now, then you For example, you might choose to go without lunch if you can have a tastier meal for supper. Or, as a student, you might be have a 25% rate of time willing to live with a smaller income today as long as you believe preference. your degree will provide a larger flow of income in the future. Saving Creates Credit Opportunities Getting back to the financial aspect of interest. Interest is paid to induce people to give up present enjoyment of goods. After all, lenders face trade-offs, too. A promised return of interest on a loan compensates for the lender’s own opportunity cost so that she can enjoy more goods and services in the future. And that’s an important reason why households are willing to save money. They are willing to give up some present consump- tion for future consumption opportunities. While we see banks themselves lending money to their customers, the flow of savings from households actually creates the credit opportunities made available to borrowers. (We will delay an important discussion of additional credit creation through the Federal Reserve until Chapter 14.) Savings dollars that are deposited in banks, promis- ing a particular interest return to households, are then lent out by banks who charge a higher rate to the borrowers, keeping any ­difference as a potential profit opportunity. The supply of credit, provided by banks, but channelled from household savings, is an upward-sloping function of the interest rate. A higher interest rate, other things constant, encourages a larger quantity of credit supplied. The demand for credit among borrowers—households and businesses—is, like all demand curves, downward-sloping. Other things constant, people are more inclined to borrow at lower rates of interest as opposed to higher rates. The market rate of interest, say, 5% (you may think of it as the price of credit, the price of the loan) emerges where supply meets demand. This is depicted in Figure 5–2. If households were willing to save more at the prevailing rate of interest (if their rate of time preference were to fall) the entire DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 112 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services  P 113 S Supply and 5% demand: A process of coordination D Q of Credit Figure 5–2 Supply and demand in the market for credit The 5% market rate of interest is determined by saving and investment decisions. Should households wish to save more, the supply of credit will increase, the interest rate will fall, and more borrowing will occur. supply of credit curve would shift left. That would lower the mar- ket rate of interest from r1 to r2, and allow more opportunities to borrow among other households and—importantly—investors. We can think of the greater savings as giving the green light to businesses to borrow and undertake more time-sensitive and lengthier production processes, Those investments will provide households with greater consumption opportunities in the future. The Risk Factor in Interest Rates The market rate of interest of which we speak reflects the rate of time preferences, but it also includes risk premiums of various sizes. Highly credit-worthy customers generally pay lower inter- est rates compared to those with a weaker credit record. Think of it as a kind of insurance premium that the bank collects from the borrower in anticipation of losses through costs of collection and defaults. If the bank could not charge this risk premium, it would refuse to make loans to customers in higher-risk categories. Real and Nominal Interest Rates The quoted interest rates that you see in credit contracts also include one other component. They incorporate an additional amount to compensate the lender for any expected decrease in the purchasing power of money (inflation). If a lender wishes to earn 3% annually, and expects zero inflation (a constant pur- chasing power of money), then he will charge borrowers a 3% “nominal” rate of interest. (“Nominal” is the actual, quoted rate of interest spelled out in the loan, the rate that you see posted on DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 113 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services 114 the wall behind the bank tellers.) And he will “really” earn 3% as long as the terms of the loan are met. But if the lender expects a 2% rate of inflation that lowers the purchasing power of money, Chapter Five or whittles away at its value, then he would charge an inflationary premium, and raise his nominal rate to 5%. If the lender receives 5% annually during the course of a 2% inflation, then he is “re- ally” earning 3% after the inflation is taken into account. The formula for calculating the real interest rate is straightforward: The real interest rate = the nominal rate 2 the rate of inflation In our preceding example, we determined the real interest rate by subtracting the expected rate of inflation, 2%, from the nominal rate of interest, 5%, leaving us with a real rate of 3%. Once Over Lightly The coordination of decisions in a society characterized by exten- sive division of labor is a task of enormous complexity, requiring the continuous daily negotiation, renegotiation, and monitoring of millions of agreements to exchange. The market is best thought of as a process of plan coordi- nation, rather than being depicted as a person, place, or thing. Supply and demand is the process of interaction through which relative prices are determined. It is a process of mutual adjust- ment and accommodation. Markets clear when the plans of buyers are coordinated with the plans of sellers, in other words, when quantity demanded equals quantity supplied. When a price is below its market-clearing level, a shortage occurs, defined as quantity demanded exceeding quantity supplied. The market price will tend to increase, thereby reduc- ing the shortage. When a price is above its market-clearing level, a surplus occurs, defined as quantity supplied exceeding quantity demanded. The market price will tend to decrease, thereby reducing the surplus. Market clearing is an unintended outcome of buyers and sellers pursuing their own objectives. Economists are helpful in explaining how this process works; economists aren’t necessary, however, for free markets to work effectively. Exchange is a cooperative activity. Buyers and sellers cooperate with one another by agreeing to the terms of trade. Buyers compete with buyers by bidding up prices, or finding other nonmonetary ways to gain access to scarce goods, which is evident during a short- age. Sellers compete with sellers in their search for profit. During shortages they typically compete by reducing their prices. Rarity shouldn’t be confused with scarcity. Something is rare if it exists in relatively small quantities, such as a Prychitko auto- graphed baseball or a Boettke autographed tennis racket. DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 114 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services  Scarcity is a relationship between availability and desirability, or between supply and demand. A good ceases to be scarce only 115 when people can obtain all they want at a zero opportunity cost to themselves. Supply and In a world of scarcity, rules of the game, including discrimi- demand: natory criteria, must evolve or be designed to determine who gets what. Competition is the attempt to satisfy whatever discrimina- A process of tory criteria are being used. coordination Prices established in an open market process transmit impor- tant information regarding the relative scarcities of goods and services. By ­attempting officially to abolish private ownership, money, and markets, ­centrally planned economies also destroyed precisely those market signals that allow people to discover their comparative advantage and effectively ­coordinate their produc- tion and consumption plans. An effective market economy features numerous institutions that have evolved to reduce transaction costs and thus facilitate vol- untary exchange. Transaction costs are the costs of arranging con- tracts or transaction agreements between suppliers and demanders. Money is a general medium of exchange that reduces transaction costs. A corresponding system of money prices that change readily in response to changing conditions of supply and demand transmits the kind of information that allows for people to coordinate their plans efficiently in highly specialized economic systems. In its most general sense, interest represents the difference in value between present and future goods. Another way of stating this is that people display a positive rate of time preference: other things constant, an individual would prefer enjoyment of a good sooner rather than later in time. This is one reason why people are willing to pay interest to borrow money from others, to gain present command of goods. It’s also the reason why people will ask for an interest return—for they will be induced to give up some present command of goods if they can be compensated with more in the future. Market rates of interest are determined by the supply and de- mand for credit. The interest rate itself is not the price of money, but rather the terms of the loan. The specific terms will include a premium for the risk-factor of the loan, and a premium for the expected rate of inflation. The real rate of interest is calculated by subtracting that expected rate of inflation from the nominal rate of interest. Questions for Discussion 1. Here is a good question to get you thinking about supply and demand as a process of coordination. Millions of Americans change their residences each year, many moving long distances to new and strange areas. How do they all find places to live? DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 115 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services 116 (a) Who sees to it that every individual or family moving to a new state finds someone in that state willing to sell or rent them a house or apartment that suits their tastes and circumstances? Chapter Five (b) Who oversees construction planning so that those states that are growing most rapidly manage to expand their stock of housing at a rate that matches their population growth? (c) List some of the institutions that lower transaction costs for Ameri- cans who must sell a house and buy another house in order to move from one city to another. (d) During the years when the communist government of China claimed ownership of all housing in the nation, it also maintained housing- exchange stations in all the major cities. Why would transaction costs be much higher with a housing exchange than with a system of private ownership and changing prices when it comes to facilitating trades among millions of people who want to move? 2. The deputy chairman of the Russian Red Cross complained in the 1990s that food aid sent to the country by Western nations was being stolen. “Russian swindlers are the most experienced in the world,” he said. The deputy director of the Russian aid commission expressed the need for a centralized system to ensure proper distribution. Which do you think is likely to get into the mouths of hungry people faster and with less loss through spoilage: food that is distributed through government agencies and charity organizations or food that has been stolen? Why? 3. If the desire for more money is an indication of a selfish and materi- alistic attitude, as many people seem to think, why do churches and charitable organizations work so hard to acquire more of it? (If your first response is “they’re just as greedy as anyone else,” you might want to think again.) 4. Explain how, in a barter economy, a toilet paper manufacturer would have a little easier time bartering compared to a guitar maker. 5. It might take only one person to screw in a lightbulb, but how many people does it take to eventually produce lightbulbs? 6. Mastering the economic way of thinking means learning to reason in terms of supply and demand. Here are additional questions on which you can practice. Some are harder than others. You should probably begin in each case by sketching a small supply and demand graph. Then ask yourself whether the event described would affect the supply curve or the demand curve, in which direction the curve would move, and what effect that would have on the price and the quantity exchanged. Don’t be content merely to conclude that the price will rise or the price will fall. Would you expect a large or a small change in price or in the quantity exchanged? You will usually have to supply some information from your own experience. Keep in mind that the answer will often depend on the length of time you are allowing for adjustments to occur. Are you predict- ing a very short-run effect or are you thinking about the long-run effect? (a) What would happen to the market-clearing price of acoustic guitars in Figure 5–1 if (i) People turned on to some accordion craze and started losing interest in learning to play the guitar? DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 116 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services  (ii) The price of electric guitars were to fall substantially? (iii) A number of acoustic guitar makers decide to exit the market 117 and make violins instead? (b) Suppose scientists discover that eating soybeans prevents cancer and Supply and heart disease. demand: (i) What effect would you predict on the price of soybeans? (ii) What effect would you predict on the price of feed corn (which A process of can usually be grown on land suitable for growing soybeans)? coordination (c) What effect would you expect each of the following to have (or to have had) on the market for domestically grown cotton? (i) Nylon is invented. (ii) The cotton gin is invented. (iii) The boll weevil (a crop killer) becomes extinct. (iv) Foreign cotton growers bring in an exceptionally large harvest. (d) Suppose that all states adopt a serious no-fault rule to cover automo- bile accidents, so that it becomes impossible to sue for damages after an accident. (i) What effect would you predict on the cost of hiring a lawyer to draw up a will? (ii) If only one state moves to no-fault, what effect would you pre- dict on the cost of hiring lawyers to draw up wills in that state? Would you expect a larger or smaller effect than in the preced- ing question? (e) Suppose the dental hygienists of the country persuade everyone to floss at least three times each day. What effect would you predict on the price of dental floss? (f) If it takes five times as much grain to provide a nourishing diet to people who run that grain through beef cattle before eating it than it takes to provide a nourishing diet to those who eat the grain ­directly, do those who eat beef cause hunger among poor people in the world? (g) Here is a somewhat different kind of question, one for which you obviously can’t supply information from your own experience. Sup- pose you discover that consumers are currently purchasing 20 times as many widgets as they were purchasing 10 years ago. Would you expect the price of a widget to be higher or lower today than it was 10 years ago? Under what circumstances would you expect it to be higher? Under what circumstances would you expect it to be lower? (h) What effect would you predict on the price of rental housing in an area if several major new employers set up operations in the area? (i) If the city council passes an ordinance requiring all apartment own- ers in a particularly congested area to provide one off-street parking place for each apartment that they rent out, what effect would you predict on the level of rents in that area and on the number of apart- ment units being rented? (j) If the city council did not require provision of parking spaces, but simply prohibited all on-street parking on the streets in this con- gested area, what effect would you predict on the level of rents in the area and on the number of apartment units being rented? DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 117 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services 118 (k) What effect would you predict on the price of gasoline if automobile manufacturers succeeded in doubling the number of miles that driv- ers can obtain per gallon? Chapter Five (l) As colleges and universities adopt more online testing programs, what effect would this have on the price of old-fashioned no. 2 pencils? Would you expect the price change to be small or quite large? What does that say about the price elasticity of supply of no. 2 pencils? 7. “When the price of apples falls, the supply falls and the demand in- creases.” Evaluate this statement. 8. “If there is a shortage of platinum, its price will rise. The shortage will eventually disappear because the higher price will reduce demand and increase supply.” Evaluate this statement. 9. If gasoline prices continue above $4.00 a gallon, what would tend to hap- pen to the demand for eight-cylinder SUVs? What would that tend to do to the market price of those SUVs? 10. Many people believe that in the event of another oil crisis brought on by war in the Middle East or elsewhere, gasoline should be rationed by the government by the criterion of need. How would you propose that the rationing authorities determine need? 11. There are no toll charges for driving on many urban expressways during the rush hour. How is it determined who gets to drive on the roadwat? 12. Parking space is sometimes made available on college campuses at a zero price even when parking space is quite scarce. (a) What exactly does it mean that parking space is scarce? Does it mean that parking spaces are not available? (b) How is scarce parking space rationed in the absence of parking fees? (c) If a college charged all students who wanted to park on campus $200 for a yearly parking permit, would that fee effectively ration scarce parking space? (d) Suppose the college placed parking meters along all the campus streets. How could these be used to ration scarce parking space ­effectively? Keep in mind that some parking spaces will be in much greater demand than others. 13. Concert tickets are often initially sold on a first-come, first-served ba- sis. Back in the day, before there were ticket sites on the Internet, kids skipped school, camped out in overnight lines, and did who knows what else to try to obtain tickets before they sold out. (a) Who were they competing against? The performers? The manag- ers and promoters? Sponsors? The ticket agency? The concert hall? Were they competing at all? (b) Today people can purchase tickets through Internet ticket brokers and sites such as eBay. What criterion is being used there to deter- mine who gets the tickets? 14. Far fewer babies are currently offered for adoption in the United States than couples want to adopt. Would you be willing to let the available children go to the highest bidder? What consequences would you pre- dict from such a system? By what criteria are scarce babies currently ­assigned to prospective adopters? DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 118 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services 15. Federal law currently prohibits the sale of human organs for transplant purposes. At the present time, people are dying while waiting for suitable 119 organs to become available. 2012 Nobel Prize winner in economics Alvin Roth has suggested designing a barter-like market for organs. But what Supply and about outright buying and selling of organs? It seems almost certain that demand: more organs would become available if financial incentives were offered to prospective donors. Roth contends too many people find the idea A process of repugnant. Would you be in favor of allowing this? What consequences coordination would you predict? 16. Some years ago Utah annually sold 27 licenses to hunt buffalo in a 1,500-square-mile area of the state. The fee was $200 for residents and $1,000 for nonresidents. Because the state received more than a thousand applications each year, it held a drawing to decide who will get the 27 licenses. (a) Why do you suppose Utah didn’t sell the licenses to the highest bidder? (b) Do you think people who receive a license should be allowed to sell it to someone else? (c) What effects do you think a lottery system with freely transferable ­licenses would have? 17. If the supply of turkeys in a particular November turned out to be unusu- ally small, do you think a turkey shortage would result? Why or why not? 18. If you travel through the western United States in the summer, you are much more likely to encounter a shortage of camping spaces than of mo- tel rooms. Why? 19. Here’s one about competition on the supply side. In 2011, two manag- ers of a Domino’s pizza franchise in Lake City, Florida, burned down the building of a newly-established Papa John’s pizzeria a couple blocks away. They said they were tired of watching cars drive past their store and into the Papa John’s parking lot. While such violent activity is rare in the fast food industry, your authors know of another market where the elimination of one’s competitors through violence is practically a daily occurrence. Can you guess which one it is? 20. Which is more scarce, an ounce of gold or an ounce of plastic? What ­information did you use to reach your conclusion? 21. “Central planners were more effective than your free market-loving text- book authors let on. Planners in the former Soviet Union never even con- sidered making railroad tracks out of platinum or ships out of gold. They already knew that would be a waste of those scarce resources. They were informed by the world market prices for platinum and gold.” We never said ships. We said buses. But anyway, how would you respond to that statement? What does it actually say about the importance of market processes and market prices? 22. In the United States today, the largest denomination note is the $100 bill. The $500 bills no longer circulate as money. Can you explain why authorities might abolish larger-denomination notes as part of their ­effort to fight organized crime? 23. If interest rates are largely determined by the time preferences of savers and borrowers, what does it mean when we say that the Federal Reserve is raising or lowering interest rates? DESIGN SERVICES OF # 111458   Cust: Pearson   Au: Heyne  Pg. No. 119 PMS / K Title: The Economic Way of Thinking 13/e    Server: Short / Normal S4carlisle Publishing Services