How Markets WorkHow Markets Work

ECO 285 - Dr. D. Foster

Three (Economic?) Questions:

1.1. What to produce?What to produce?

2.2. How to produce?How to produce?

3.3. For whom to produce?For whom to produce?

We mustmust decide!

Scarcity Choices Costs

Consider the market for gasoline…

Supply

Demand

Price

Quantity

Pe = $3

Qe

How does this help us to answer the what, how & for

whom questions?

Markets prices = signals Serves to reward producers

for fulfilling our desires.

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

Adam SmithAdam Smith

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

regard to their self interest.

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

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

Prices … are a 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 $3.00 ?

$3.00

S

DQuantity

$5.00

New S

Q2

$10.50

Q1 Q3

In the long run, we expect that producers

will search for and find additional

supplies, Q and P.

What will be said of P=$5?

Markets don’t work! Prices are not fair! These prices are outrageous! This is an example of price gouging! This is an indictment against greedy

sellers!

Dairy Price Dairy Price SupportsSupports

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

Basic 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 Dairy Price SupportsSupports

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%.

How Markets WorkHow Markets Work

ECO 285 - Dr. D. Foster