Principles of Economics - 11. Prices, Rent-seeking, and ...

Market equilibrationAssets and asset price bubbles

Non-clearing marketsEconomic rents

Principles of Economics1

11. Prices, Rent-seeking, and Market Dynamics

Giuseppe Vittucci Marzetti2

SCORDepartment of Sociology and Social Research

University of Milano-Bicocca

A.Y. 2018-19

1These slides are based on the material made available under Creative Commons BY-NC-ND4.0 by the CORE Project©, https://www.core-econ.org/.

2Department of Sociology and Social Research, University of Milano-Bicocca, Via Bicoccadegli Arcimboldi 8, 20126, Milan, E-mail: [email protected]

Giuseppe Vittucci Marzetti Principles of Economics 1/47

https://www.core-econ.org/



Layout

1 Market equilibrationMarket equilibration through rent-seekingMarket organization and pricesShort-run and long-run equilibriaPrices, rent-seeking, and market dynamics at work: oil price

2 Assets and asset price bubblesValue of assetsStock exchange markets and continuous double auctionAsset market bubblesModeling bubbles and crashes

3 Non-clearing marketsRationing, queuing, and secondary marketsMarkets with controlled prices

4 Economic rentsThe role of economic rentsSummary




Market equilibration through rent-seekingMarket organization and pricesShort-run and long-run equilibriaPrices, rent-seeking, and market dynamics at work: oil price

Bargaining and prices in the Kerala wholesale fish market

On January 1997:

at Badagara, 11 boatloads brought to the market found the marketoversupplied, and jettisoned their catch (excess supply);at Cochabamba, (15 km from Badagara), 15 buyers left the marketunable to purchase fish at any price (excess demand).

Jensen (2007) studied 15 beachmarkets along 225 km of thenorthern Kerala coast, findingthat, once the fishermen usedmobile phones:

Differences in daily pricesamong the beach marketswere cut to 1/4.No boats jettisoned catches.Reduced waste and dealers’bargaining power raisedfishermen’s profits by 8% andconsumer prices fell by 4%.

Source: Jensen, 2007; CORE The Economy





Market equilibration through rent-seekingAn exogenous shift in supply or demand means that the price has tochange for the market to reach a new equilibrium.The market equilibrates through rent-seeking behavior on the shortside of the market:

sellers in case of excess demand ;buyers in case of excess supply.

Figure: An increase in demand in a market for hats





Disequilibrium rents

Disequilibrium rents are the economic rents that arise when amarket is not in equilibrium. Buyers and sellers:

can gain these rents by transacting at different prices.become price-makers.

This process continues until there is a new competitive equilibrium:at this point there is no excess demand or supply, and buyers andsellers are price-takers again.





How market organization can influence prices

Social interactions and market organization can both have apowerful impact on prices.

Prices ultimately come from the interests of and relationshipsbetween buyers and sellers.

Market organization determines precisely how these relationshipsinfluence prices.

Example (Gallegati, Giulioni, Kirman & Palestrini, 2011):

auctions (e.g. Ancona fish market);pairwise trading, trading between two individuals where individualrelationships and past experiences influence prices and customerloyalty might have heavy influence on prices (e.g. Marseille fishmarket).





Short-run and long-run equilibriaPoint A is the short-run equilibrium.

The number of firms (bakeries in the city) remains constant.Firms are earning rents (positive economic profits).

In the long-run equilibrium:the number of firms increases via endogenous rent-seeking;the process of entry stops when rent gets zero:

P = MC = ACProfits to be made in the market are no higher than those to bemade elsewhere by using the same resources.





Short-run and long-run elasticities

The number of firms is exogenous in the short run, but endogenousin the long run.

This means that supply is more elastic in the long run, as more firmsenter production.





Market dynamics at work: oil pricePrices reflect scarcity: if a good becomes scarcer (more costly toproduce), the supply falls and price tends to rise.For more than 60 years, oil industry analysts have been predictingdemand would outstrip supply, but...Peak oil not evident: high price has stimulated further exploration.

Figure: World oil prices (deflated, 1865-2014) and global oil consumption(1965-2014)





Oil supply and demand in the short-run

Demand:Inelastic demand because of limited substitution possibilities.

Supply:Supply curve initially low and flat, and then very steep.With traditional technology, once the well is drilled, extraction costrelatively low, but extraction faces capacity constraints: producerscan get only so many barrels per day from a well.

Market oligopolistic structure:

OPEC (Organization ofPetroleum Exporting Countries)is a cartel with a dozen membercountries that currently accountsfor about 40% of world oilproduction.OPEC sets output quotas for itsmembers.





The 1970s oil price shocks

In 1973 and 1974, OPEC countries imposed a partial oil embargo inresponse to the 1973-4 Middle East war;

In 1979-80, oil production by Iran and Iraq fell because of the supplydisruptions following the Iranian Revolution and the outbreak of theIran-Iraq war.

Leftward shift of supply.

Oil price (in 2014 USD) goes from$18 per barrel in 1973 to $56 in1974, and then to $106 in 1980.

Declines in world oil consumptionafter these price shocks are smallby comparison:

1973-1975: -2%;1979-1983: -10%.





The 2000-2008 oil price shock

Rapid economic growth in industrializing countries, especially Chinaand India, over 2000-2008.

Income elasticity of demand for oil higher in these countries than indeveloped economies.

Outward shift of demand.

The inelastic short-run supply curvefor oil accounts for:

the big increase in pricerelatively modest increase inworld oil consumption.





Recent trends in global oil prices: the financial crisis andthe shale oil revolution

Source: Data from FRED and OECD.





How the U.S. and OPEC have driven oil prices

Source: Ashkenas, Parlapiano & Fairfield, 2015.


https://www.nytimes.com/interactive/2015/09/30/business/how-the-us-and-opec-drive-oil-prices.html



Value of assetsStock exchange markets and continuous double auctionAsset market bubblesModeling bubbles and crashes

The value of assets

People buy assets for two reasons:

To benefit from owning them.To be able to sell it later.

The value of a financial asset (a security) depends on:

the size of the cash flows that it is expected to generate (dividends);the uncertainty in one’s forecasts of these cash flows.





Bonds and stocks

Bonds

Fixed stream of payments from the asset, thus price inversely relatedto the interest rate it yields.Government bonds vs. corporate bonds:

Default risk on government bonds usually negligible (e.g. US,Germany, Switzerland).Corporate bonds are not risk-free.

↑ risk of default → ↑ yield demanded by investors → ↓ bond price

Stocks (shares)

A claim on a part of assets of a firm, and hence on its profits.They offer no specific promised stream of payments, and the timeperiod over which payments will be made is not fixed.Firms expected to generate greater net earnings will have highervaluations → higher share price.Like bonds, their value also depends on interest rates in theeconomy, and on how risky the earnings are thought to be.





Systematic and idiosyncratic risk

Value of bonds and stocks depends on uncertainty over earnings.

Systematic risk (undiversifiable risk): a risk that affects all assets inthe market, so that it is not possible for investors to reduce theirexposure to the risk by holding a combination of different assets.Idiosyncratic risk (diversifiable risk): a risk that only affects a smallnumber of assets at one time.

Since traders can almost eliminate their exposure to idiosyncraticrisks by holding a diverse portfolio of assets, this risk is essentiallyirrelevant in the valuation of securities (Sharpe, 1964; Lintner, 1965).

The rate of return that investors demand for buying the shares of acompany (required rate of return, or market capitalization rate) ishigher the higher the level of its systematic risk, i.e. the correlationbetween the company’s earnings and those of the market as a whole.





Trading strategies

The fundamental value of a share is the share price based on:

anticipated future earnings;level of systematic risk.

Trading strategies:

Buy assets that are priced below their perceived fundamental value,and vice versa.Look for momentum in asset prices, buying when expecting prices torise further, and vice versa.

Both types of trading are a form of speculation, i.e. buying andselling assets in order to profit from an anticipated change in theirprice.





Stock exchange markets and continuous double auction

A stock exchange is a financial marketplace where shares and otherfinancial assets are traded (e.g. NYSE, NASDAQ, Tokyo StockExchange, Borsa italiana, . . .)In stock markets trade takes place continuously and prices arealways changing, through a trading mechanism known as acontinuous double auction.

Anyone wishing to buy can submit a price and quantity combinationknown as a limit buy order (the buyer’s reservation price).

For instance, a limit order to buy 100 shares in Apple at a price of$195 indicates that the buyer commits to buying 100 shares, as longas they can be obtained at a price no greater than $195 per share.

Similarly, a limit sell order indicates a commitment to sell a givenquantity of shares, as long as the price is no less than the amountspecified (the seller’s reservation price).Orders to buy (sell) are referred to as bids (asks).A trade takes place if there is a match between a bid and an ask.If there isn’t anyone to trade with, the bid will be recorded in theorder book, that lists bids (asks) in decreasing (increasing) order ofprice.





Apple’s share price and volume traded (NASDAQ)

(a) 9-12 November 2018 (hourly, candles)

(b) November 2010-2018 (daily, candles, 50- and 200-dayMoving Average)





Examples of order books

(a) Apple

(b) Unicredit





Asset market bubblesAn asset price bubble is a sustained and significant rise in the priceof an asset, that diverges from its fundamental value fueled byexpectations of future price increases.The dotcom (or tech) bubble was a rapid rise in equity valuationsfueled by Internet-based companies during the bull market in the late1990s: the index rose from 750 to 5,000 between 1995 and 2000.

Figure: Nasdaq Composite Index (a market capitalization-weighted index ofover 3,300 common equities listed on the technology-dominated Nasdaq stockexchange), 1974-2018.





Information, uncertainty, and beliefs

Changes in prices are messages containing information: changes inbeliefs about a firm’s future earnings usually result in instantaneousadjustments in its share price.

If markets are to work well, traders must respond to these messages.

But when they interpret a price increase as a sign of further priceincreases (momentum trading), the result can be self-reinforcingcycles of price increases (bubbles) followed by sudden price declines(crashes).

Three distinctive and related features of markets may give rise tobubbles:

resale value:ease of trading;ease of borrowing to finance purchases.





Do bubbles exist?

Do bubbles really exist, or are they an illusionbased only on hindsight?

Is it possible to know that a market isexperiencing a bubble before it crashes?

Some prominent economists working withfinancial market data disagree on this question.

Eugene Fama and Robert Shiller (two of the threerecipients of the 2013 Nobel Prize) have differentperspectives on the dotcom bubble:

Fama’s view : asset prices were based on the bestinformation available at the time and fluctuatedbecause information about the prospects of thecompanies was changing sharply.Shiller’s view : prices in the late 1990s had beendriven up simply by expectations that the pricewould still rise further (“irrational exuberance”).

Eugene F. Fama

(1939)

Robert J. Shiller

(1946)

Nobel Memorial Prize

in Economics 2013Giuseppe Vittucci Marzetti Principles of Economics 35/47




Modeling bubblesThe sequence of events can start if agents:

interpret a price rise to mean that other people have news that theydon’t have, and adjust their own expectations upwards; orthink there is an opportunity for speculation: to buy the stock nowand sell to other buyers at a profit later.

The initial increase in demand creates a positive feedback, leading tofurther increases in demand.





Negative vs positive feedback





Stable equilibrium

An equilibrium is stable if there is a tendency for the equilibrium tobe restored after it is disturbed by a shock.

The price dynamic curve is flatter than the 45° line.





Unstable equilibrium

An equilibrium is unstable if, when a shockdisturbs theequilibrium,there is asubsequenttendency to move even further away from theequilibrium.

The price dynamic curve is steeper than the 45° line.





Instability and bubbles

A self-reinforcing bubble is the outcome of an unstable equilibrium.

Instability caused by self-reinforcing price expectations can onlyhappen in markets for goods that can be resold, like financial assetsor durable goods.

The bubbles of the last 100 years have predominantly been focusedon real estate, stocks, and foreign investment.

There is no point buying more vegetables, fish, or fashion items inthe hope of making a capital gain on them, because the fish andvegetables will rot, and fashions will change.





Modeling crashes

A bubble bursts when some participants in the market perceive adanger that the price will fall.

Then

would-be buyers hold back;those who hold the assets will try to get rid of them.





Bubble bursts and short-selling

The market can stay irrational longer than you can stay solvent.

(John Maynard Keynes)

Traders might attempt to profit from identifying a bubble by“leaning against the wind”.

They might place bets on the bubble bursting by going short:

Short-selling entails borrowing shares at the current (high) price andimmediately selling them, with the intention of buying them backcheaply (to return to the owner) after the price crashed.

But this is an extremely risky strategy, since it requires accuracy intiming the crash:

If you are right about the bubble but you get the timing wrong, thenwhen you are due to buy the shares and return them to the owner,the price is higher than it was when you sold them.

In fact, many of those buying an asset may also be convinced of aneventual crash, but hoping to exit the market before it happens.




Rationing, queuing, and secondary marketsMarkets with controlled prices

Rationing, queuing, and secondary markets

Sometimes markets do not clearand goods are rationed (e.g.excess demand for tickets formusic and sporting events).

Some of those who obtain thegoods may be tempted to sellthem rather than use them.

The potential for rents maycreate a secondary market (e.g.scalpers).





Markets with controlled prices: rent ceiling

Rent ceiling is an example of price control:

City authorities often regulate taxi fares.Local or national government sometimes controls housing rents.

These are put in place if the main concern is something else thanPareto efficiency (e.g. fairness).

Price controls create economic rents, which may lead to theemergence of clearing secondary markets.





Housing rents and economic rents

Initially the market clears with 8,000 tenancies at a rent of e500.

An increase in demand with the (short-run) supply of rental housingbeing inelastic would make rents rise (from e500 to e830).

If the city authorities impose arent ceiling at e500, landlordswill continue to supply 8,000tenancies.

There are 12,000 people on thelong side of the market and8,000 people willing to paye1,100 or more, but tenanciesare not necessarily allocated tothe people with highest WTP.

Long-run solution: encouragehouse-building so as to shift outthe supply curve.




The role of economic rentsSummary

The role of economic rents

Stationary (or equilibrium) economic rents arise in equilibrium andare persistent (e.g. consumer/producer surplus, rents frombargaining).

Dynamic (or disequilibrium) economic rents occur in disequilibriumand are eliminated via a rent-seeking process (e.g. disequilibriumprice-setting, speculation).

Some types of economic rents help capitalist economies functionwell (e.g. employment rents, innovation rents).




The role of economic rentsSummary

Summary

Role of economic rents in market equilibration.

Market disequilibrium induces rent-seeking behavior, which may helpto clear the market.Rents can be stationary or dynamic.

The value of assets is uncertain, and they can be resold

They are prone to positive feedback process that can generatebubbles.Systematic vs. idiosyncratic risk.

Not all markets clear

Rationing, price controls, secondary market.


Principles of Economics - 11. Prices, Rent-seeking, and ...

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