3.4 — The Dynamic Benefits of Markets

# 3.4 — The *Dynamic* Benefits of Markets

## ECON 306 • Microeconomic Analysis • Fall 2022

### Ryan Safner<br> Associate Professor of Economics <br> <a href="mailto:safner@hood.edu"><i class="fa fa-paper-plane fa-fw"></i>safner@hood.edu</a> <br> <a href="https://github.com/ryansafner/microF22"><i class="fa fa-github fa-fw"></i>ryansafner/microF22</a><br> <a href="https://microF22.classes.ryansafner.com"> <i class="fa fa-globe fa-fw"></i>microF22.classes.ryansafner.com</a><br>

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# Outline

### [Why Markets Tend to Equilibrate, Redux](#7)
### [The Social Functions of Market Prices](#23)
### [Uncertainty and Profits](#37)

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# The Model is Not the Reality I

> *“All models are wrong, but some are useful.”*

- Lots of applications beyond this course

- Models help us *understand* reality, but they *are not* reality!
  - Don't mistake the map for the territory itself

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# The Model is Not the Reality II

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- Our models so far have given us interesting results: 
  - Markets reach equilibrium
  - Economic profits are zero in the long run in competitive markets

- Both are **fictional**!

- But the models **still** show us useful insights about how a market economy works

- Some readings in today’s readings page to help you understand

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# The Model is Not the Reality III

“Shame on the three of you who enjoyed this joke”
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# The Model is Not the Reality III

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# Why Markets Tend to Equilibrate, Redux

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# The Law of One Price I

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- .hi[Law of One Price]: *all* units of the *same* good exchanged on the market will tend to have the same market price (the market-clearing price, `$p^*)$`
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# The Law of One Price II

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![:scale 100%](https://www.dropbox.com/s/pjp9bpvqp54ldn4/individual1.png?raw=1)
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- .hi-purple[Arbitrage] opportunities: optimizing individuals recognize **profit opportunity**:
    - Buy at low price, resell at high price!
    - There are possible gains from trade or gains from innovation to be had
    
- .hi-purple[Entrepreneurship]: recognizing profit opportunities and entering a market as a seller to try to capture gains from trade/innovation
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# Arbitrage and Entrepreneurship I

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# Arbitrage and Entrepreneurship II

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# Arbitrage and Entrepreneurship III

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# Uncertainty vs. Risk

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# Uncertainty vs. Risk

- **“Known knowns”**: .hi-purple[perfect information]

- **“Known unknowns”**: .hi-purple[risk]
  - We know the probability distribution of states that *could* happen
  - We just don't know *which* state will be realized
  - We can estimate probabilities, maximize expected value, minimize variance, etc.

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# Uncertainty vs. Risk

- **“Unknown unknowns”**: .hi[uncertainty]
  - We don’t even know the probability distribution of states that *could* happen
  - *No model to optimize* in a world of uncertainty!
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# The Role of Entrepreneurial Judgment

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- Under true .hi[uncertainty], it’s not that we can’t assign probabilities to each outcome; we do not even have the knowledge necessary to list all possible outcomes!

- Requires .hi-purple[entrepreneurial judgment] to *both*:
  1. estimate possible actions *and*
  2. estimate the likelihood of their success

- .hi[Entrepreneur] is central player, earns pure profits (a residual) for *bearing uncertainty*

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# Entrepreneurial Judgment

1863-1947
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> “If I had asked people what they wanted, they would have said **faster horses**.” - Henry Ford

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# Entrepreneurial Judgment

> “It's really hard to design products by focus groups. A lot of times, **people don't know what they want until you show it to them**.” - Steve Jobs
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# Uncertainty and Entrepreneurship

Mark Zuckerberg

1984-
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> "Why were we the ones to build [Facebook]? We were just students. We had way fewer resources than big companies. If they had focused on this problem, they could have done it. 
The only answer I can think of is: **we just cared more**. 
**While some doubted** that connecting the world was actually important, **we were building**. While others doubted that this would be sustainable, **we were forming lasting connections**."
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# How Markets Get to Equilibrium I

- Each buyer and seller only know **their own** reservation prices

- Buyers and sellers adjust their bids/asks

- Markets do not *start* competitive, but *become* competitive!

- New entrepreneurs enter to try to capture gains from trade/innovation

- As these gains are exhausted, prices converge to equilibrium 
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# How Markets Get to Equilibrium II

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> `$\implies$` multiple prices

> `$\implies$` arbitrage opportunities

> `$\implies$` entrepreneurship

> `$\implies$` correcting mistakes

> `$\implies$` people update their behavior & expectations

- Markets are .hi-purple[discovery processes] that *discover* the right prices, the optimal uses of resources, and cheapest production methods, none of which can be known in advance!
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# How Markets Get to Equilibrium III

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- Economy as a .hi[cat]-and-.hi-purple[mouse] game between:
  - .hi-purple[Mouse]: preferences, technologies, alternative uses of resources
  - .hi[Cat]: market prices, least-cost technologies

- .hi[Cat] always chasing .hi-purple[mouse]
  - .hi-purple[Mouse] *always* moving
  - Any time .hi[cat] hasn’t caught .hi-purple[mouse]: profit opportunities

- **IF** .hi-purple[mouse] *froze*, market would rest at equilibrium 
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# The Social Functions of Market Prices

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# Prices are Signals I

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# Prices are Signals II

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- .hi-purple[Markets are social *processes* that generate information via prices]

- .hi-purple[Prices are never “given”], prices .hi-purple[emerge] dynamically from negotiation and market decisions of entrepreneurs and consumers

- **Competition**: is a .hi-purple[discovery process] which *discovers* what consumer preferences are and what technologies are lowest cost, and how to allocate resources accordingly

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# The Social Functions of Prices I

- .hi-purple[Conveys information]: good is relatively scarce

- .hi-purple[Creates incentives for]:
  - **Buyers**: conserve use of this good, seek substitutes
  - **Sellers**: produce more of this good
  - **Entrepreneurs**: find substitutes and innovations to satisfy this unmet need
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# The Social Functions of Prices II

- .hi-purple[Conveys information]: good is relatively abundant

- .hi-purple[Creates incentives for]:
  - **Buyers**: substitute away from expensive goods towards this good
  - **Sellers**: Produce less of this good, talents better served elsewhere
  - **Entrepreneurs**: talents better served elsewhere: find more severe unmet needs

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# The Social Functions of Prices III

- Think of diminishing marginal utility:
  - allocate scarce good to highest-valued use first
  - as supply becomes more plentiful (price falls), can allocate more units of the good to lower-valued uses (higher-valued uses already satisfied)
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# Uncertainty and Profits

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# Uncertainty, Tacit Information, and Profit I

- **Economic theory**: in a perfectly competitive market, in the long run, economic profit `$\rightarrow$` to zero

- **Real world**: there *are* often economic profits

- Our blackboard models assume perfect information

- In reality we have to deal with .hi-purple[uncertainty]

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# Uncertainty, Tacit Information, and Profit II

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- Imperfect information: mispricing and multiple prices `$\rightarrow$` arbitrage/profit opportunities
  - Some people recognize opportunities ($20 bills) that others do not see

- .hi-purple[In a world of certainty, there would be no profit]
  - The model world of perfect competition is a fictional world of certainty
  - The real world, *because* it’s uncertain, *has* profit opportunities!

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# Uncertainty, Tacit Information, and Profit III

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- Firms don’t actually *maximize* profits 😨, just a convenient assumption! 
  - In a world of uncertainty (unlike mere risk), there’s no way to *maximize* anything!

- Real world is *not* a mere constrained maximization problem!

- Better to think in **evolutionary** terms:
  - Firms that *best* adapt to market circumstances will *survive* and earn profit...whether by skill & talent or just dumb luck!
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.source[For more, see Alchian 1950, Gigerenzer, 2012, and Smith, 2003 in [today’s readings](/content/3.4-content/#readings).]

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# Uncertainty, Tacit Information, and Profit IV

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# Reminder: Profits and Entrepreneurship

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- In markets, production faces .hi[profit-test]:
  - <span class="hi-purple">Is consumer's willingness to pay `$>$` opportunity cost of inputs?</span>

- Profits are an indication that **value is being created for society**

- Losses are an indication that **value is being destroyed for society**

- Survival for sellers in markets *requires* firms continually create value and earn profits or die
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# Why We Need Prices, Profits, and Losses I

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- People often confuse the .hi[economic problem] with a .hi-purple[technological problem]

- .hi-purple[Technological problem]: how to allocate scarce resources to accomplish a particular goal
    - e.g. buy the right combination of goods to maximize utility
    - e.g. buy the right combination of inputs and produce output to maximize profits 
    - given stable prices, preferences, and technologies, **a computer can solve this problem**

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# Why We Need Prices, Profits, and Losses II

- .hi[Economic calculation problem]: how to determine which of the infinite technologically-feasible options are *economically* viable?

- .hi-purple[How to best make use of dispersed knowledge to coordinate conflicting plans of individuals for their own ends?]

- ONLY can be **discovered** through competition, prices, profits & losses

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# What if there Were No Prices? I

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# What if there Were No Prices? II

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# For More On The Socialist Calculation Debate

See lesson 4.2 in my History of Economic Thought Course: [The Socialist Calculation Debate](https://thoughtf20.classes.ryansafner.com/schedule)
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# And How Did The Soviet Union “Work” For So Long?

See lesson 12 in my Economics of Development Course: [Russia and the Post-Communist Transition](https://devf19.classes.ryansafner.com/schedule)
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