CH-6-7 Taxes and Subsidies – Modern Principles: Microeconomics : Chapter Notes

This Document Contains Chapters 6 to 7 Chapter 6 Taxes and Subsidies Learning Objectives After completing this chapter, students should: > be able to use a wedge analysis to show that taxes decrease the quantity traded and cause deadweight losses. > be able to use a wedge analysis to show that subsidies increase the quantity traded and cause deadweight losses. > understand that the bearer of the burden of a tax does not depend on who writes the check but instead on the relative elasticities of demand and supply. > be comfortable using supply and demand analysis in a variety of situations. Chapter Outline Commodity Taxes Who Ultimately Pays the Tax Does Not Depend on Who Writes the Check Who Ultimately Pays the Tax Depends on the Relative Elasticities of Supply and Demand The Wedge Shortcut Health Insurance Mandates and Tax Analysis Who Pays the Cigarette Tax? A Commodity Tax Raises Revenue and Reduces the Gains from Trade (Creates a Deadweight Loss) Elasticity and Deadweight Loss Subsidies King Cotton and the Deadweight Loss of Water Subsidies Wage Subsidies Takeaway Chapter Narrative This chapter opens with examples that show how strongly people’s behavior can respond to the incentives generated by taxes: where a person chooses to live and even the timing of deaths and births respond to the tax code. Tax analysis is used to examine health insurance mandates and cigarette taxes. Water and wage subsidies are also covered. Commodity Taxes Commodity taxes are levied on goods like fuel, liquor, and cigarettes, although most goods in the United States are taxed in some way. The textbook emphasizes three truths about commodity taxes: Who pays the tax does not depend on who writes the check to the government. Who pays the tax does depend on the relative elasticities of demand and supply. Commodity taxation raises revenue and causes lost gains from trade (deadweight loss). Who Ultimately Pays the Tax Does Not Depend on Who Writes the Check The easiest way to illustrate that who bears the burden of the tax does not depend on who writes the check to the government is to remind students that sellers view the tax as an increase in their costs, so the supply curve shifts up by the amount of the tax. Use a figure like Figure 6.1 in the text to illustrate that a new point, exactly above the old equilibrium by the amount of the tax, is not a new equilibrium. Because the demand curve is downward-sloping, buyers are not willing to purchase the same quantity as before at a higher price, so sellers, despite having to pay a $1 tax, must lower their price to increase the quantity demanded. Figure 6.1 A Tax on Apple Sellers In Figure 6.1, buyers end up paying $2.65, but the sellers have to give $1 of that to the government, so they receive only $1.65. Both buyers and sellers bear a portion of the tax burden. "The Tax = Price Paid by Buyers"-"Price Received by Sellers" Now put the same $1 tax on buyers, using a graph like Figure 6.2 in the text, but initially omit the dotted line, the supply curve shift. If buyers must pay a $1 tax, their demand curve shifts down by $1. Note that $1 directly below the old equilibrium is not a new equilibrium. There is a shortage, and buyers will bid against each other, raising the price until the new equilibrium, point d, is reached. Here buyers pay the sellers $1.65 but then send $1 to the government, effectively paying $2.65 total. Now draw in the supply shift on the graph to show that if the tax had been levied on the sellers, the tax burden would be shared in exactly the same way. The only difference is that when the tax is levied on the suppliers, the market price of $2.65 includes the tax, but when the tax is levied on buyers, the market price of $1.65 does not include the tax. Because the buyers must still pay the tax, their effective price remains $2.65 in either case. Teaching Tip: You can give the students examples of real taxes to emphasize this point. For example, the U.S. income tax is a tax on worker’s income. Ask the students who they think pays this tax. Conversely, most state sales tax laws are actual taxes on retail receipts, meaning they are placed on the retailer (supplier). Ask the students if they think the retailers pay this tax. The MRU video Commodity Taxes introduces commodity taxes in general and illustrates that the burden of a tax is the same regardless of who writes the check. The end of the video proposes the “tax wedge” as a shortcut for analyzing the effects of a tax. Figure 6.2 A Tax on Apple Buyers Who Ultimately Pays the Tax Depends on the Relative Elasticities of Supply and Demand The Wedge Shortcut The relative elasticities of supply and demand determine how the burden of a tax is split between buyers and sellers. The textbook employs the wedge shortcut method to explain this to students. To illustrate how a tax burden is split, start with a simple supply and demand diagram. Then, instead of shifting a curve when a tax is imposed, take the vertical distance of the tax, say, $1, from the y axis and push it right until it wedges between the supply and demand curve, just touching at the top and bottom. Where the top of the wedge touches the demand curve is the price paid by buyers (or gross price). The price received by the sellers (net price) is the point where the bottom of the wedge touches the supply curve. Now illustrate how changing the elasticity of either the supply or the demand curve will affect how the burden is split. Draw a figure, as in Figure 6.4 in the text, with a supply curve that is more inelastic than the demand curve. Point out how the sellers pay more of the tax when demand is more elastic than supply. Next, use the tax wedge to illustrate how buyers pay more of the tax when supply is more elastic than demand, as shown in Figure 6.4. The wedge makes it easy for students to figure out who bears more of a tax burden on the diagram, but they need to understand why the burden is split the way it is. Whenever demand is elastic, there are more substitutes for the taxed good: You can’t tax someone who has substitutes, because they will simply switch to another good. Similarly, supply can be more elastic than demand, such as when a factory could redeploy its capital and labor to produce a different untaxed or less heavily taxed good. Tell the students to remember that elasticity equals escape. Whoever is more elastic has more of an opportunity to escape and so is less likely to pay much of the tax. As long as an industry isn’t taxed completely out of existence, though, someone will pay the tax. So what matters is relative elasticity. Figure 6.4 The More Elastic Side of the Market Can Escape More of the Tax The MRU video Who Pays the Tax? explains how the burden of a tax depends on the relative elasticities of demand and supply. The end of the video provides an application to Social Security taxes. Health Insurance Mandates and Tax Analysis The Affordable Care Act (ACA) requires all employers to provide health insurance for their employees, which is essentially a tax on hiring labor because it drives up employers’ costs by the amount they pay for the insurance. Whether firms or workers end up paying for the insurance depends on their relative ability to escape the tax—in other words, the elasticities of demand and supply for labor. Firms can substitute machinery for labor or can move overseas to avoid the tax. Employees are unlikely to be able to quit working and are less likely to move overseas than their employers. For most workers, the elasticity of their supply of labor is lower than their employers’ elasticity of demand for labor, so workers are likely to bear most of the cost of mandated health insurance through lower wages. This is the scenario depicted in panel A of Figure 6.4. Who Pays the Cigarette Tax? In 2016, state cigarette taxes ranged from a low of 57 cents a pack in South Carolina to a high of $2.70 per pack in New Jersey. Who bears the burden of these taxes depends on relative elasticities. Not surprisingly, smokers have an inelastic demand for cigarettes of about 0.5. Cigarette companies have a very high elasticity of supply to any one state because they can easily ship their products to other states where they do not have to pay as much tax. As a result, buyers bear nearly all of the tax. This is borne out by actual cigarette prices. In 2016, cigarettes sold for about $8.20 per pack in New Jersey and $5.85 in South Carolina. After accounting for the taxes, the after-tax price received by the seller was $5.28 in South Carolina and $5.50 in New Jersey. The buyers are paying most of the tax difference. A Commodity Tax Raises Revenue and Reduces the Gains from Trade (Creates a Deadweight Loss) Because a tax drives a wedge between the price paid by buyers and the price received by sellers, it generates revenue for the government but also reduces the gains from trade. Use a graph like Figure 6.5 in the text to illustrate this to students. Figure 6.5 A Tax Generates Revenue and Creates a Deadweight Loss The tax revenue is easily found by multiplying the size of the tax (the height of the wedge) by the quantity traded. The deadweight loss is the area to the right of the tax wedge, underneath the demand curve and above the supply curve. Remind students that because the demand curve is still above the supply curve, the buyers value the units more than the sellers’ cost and so there are gains from trade if they exchange. Because there is a tax to be paid, however, these potential gains from trade get eliminated. The buyers and sellers do not get their surplus, and the government doesn’t gain any revenue, because these units are never traded. It is simply a deadweight loss that benefits no one. The tax revenue box to the left of the tax wedge is lost consumer and producer surplus, too, but it is not a deadweight loss because the government gets the revenue. Teaching Tip: It would help to give a concrete example here. Ask for a student who recently purchased an electronic item, such as a television, an iPod, or a stereo. Ask him about how much he paid. Then ask what his willingness to pay was and point out his consumer surplus. Make some assumption about the sellers’ cost that is close to the actual price he paid. Add a small tax to the price and ask him if he would have still bought the item. It’s likely he would have, so you can point out that with such a tax he would have lost some consumer surplus and the company some producer surplus, but the government would have gained the revenue. Then add a really big tax to the price to get him to say he wouldn’t have bought the item. Ask him in that case how much the government would have raised in revenue (zero) and how much consumer and producer surplus was lost. Next you can highlight how the deadweight loss changes when the elasticities of the curves change. As either of the curves becomes more inelastic, show the students how that the wedge will move toward the right. This will allow more trade to occur and therefore reduce the deadweight loss from the tax. Likewise, show students that, all else equal, the tax will generate more revenue for the government as well. You can then tie this back to the tax on cigarettes. One reason they are so popular is that they generate a great deal of revenue because we know the demand is quite inelastic. This is also why, as the book points out, cigarette taxes are a poor means of reducing smoking. The MRU video Tax Revenue and Deadweight Loss illustrate graphically the revenue generated and deadweight loss created by a tax. The last part of the video provides a detailed explanation of deadweight loss and provides and application using the yacht tax. Subsidies A subsidy is like a reverse tax. The textbook emphasizes three points about commodity subsidies: Who gets the subsidy does not depend on who gets the check from the government. Who benefits from a subsidy does depend on the relative elasticities of demand and supply. Subsidies must be paid for by taxpayers, and they cause inefficient increases in trade (deadweight loss). The effect of a subsidy is the reverse of the effect of a tax. With a subsidy, the price received by sellers exceeds the price paid by buyers by the amount of the subsidy. You can illustrate how a subsidy works with the same wedge tool you used for taxes, but start from the right side of a supply and demand diagram and move left toward equilibrium until the subsidy wedges between the supply curve and demand curve, as shown in Figure 6.7 in the text. The cost of the subsidy to the taxpayer is the size of the subsidy multiplied by the total number of units. A subsidy encourages too many trades. Point out to the students that after the equilibrium point, the subsidy has encouraged buyers and sellers to make trades although the seller’s cost is higher than the buyer’s value of the good. These nonbeneficial trades cause a deadweight loss because of the opportunity cost of the resources. The inputs the suppliers used to make the product could have been used elsewhere in the economy to produce a product of greater value. Potential Pitfall: Students often find it easy to understand the deadweight loss from unrealized gains from trade, but it sometimes takes them more effort to understand the deadweight loss from overproduction. You might have to go over it a couple times. Figure 6.7 The subsidy wedge As with taxes, it does not matter whether buyers or sellers receive the check from the government. Whoever bears the burden of a tax receives the benefit of a subsidy. Figure 6.8 in the text illustrates this with a relatively inelastic supply curve. You can use the wedge method to show that the sellers both bear more of the burden of the tax and receive more of a benefit from a subsidy when they are more inelastic than demanders. You can also show that the deadweight loss from the subsidy will also change based on the elasticities of the curves as will the overall cost of the subsidy. The MRU video Subsidies discusses subsidies in detail. The video ends with the application to water subsidies and the effect on California’s Central Valley farmers discussed in the text. Figure 6.8 Whoever Bears the Burden of a Tax Receives the Benefits of a Subsidy King Cotton and the Deadweight Loss of Water Subsidies In California’s Central Valley, cotton, alfalfa, and rice farmers often pay $20 to $30 per acre-foot for water that costs $200 to $500 per acre foot to produce. (An acre-foot is a volume equal to one acre by one foot.) The difference between the price and the cost is made up for with a government subsidy. The government has subsidized turning a California desert into a farming region even though the same crops could be produced more cheaply in a place like Georgia. This raises the question of who benefits from the water subsidy. Try asking the students to work out who are the main beneficiaries of the water subsidy. Ask whether suppliers or demanders have a more elastic demand. The elasticity of demand for California cotton is very high because it is easily replaced with Georgian or foreign cotton. California’s overall share of the world cotton market is too small to influence price much. Most of the benefit of the subsidy goes directly to the farmers of California’s Central Valley, the same people who lobby for the subsidy. They are politically powerful, so it’s no accident they’ve been subsidized since 1902. Wage Subsidies Economist Edmund Phelps has advocated wage subsidies rather than higher minimum wages to promote the welfare of low-skilled workers. Phelps would have the government subsidize a firm for each low-skilled worker the firm hires. He argues that such a subsidy could raise wages of low-skilled workers to the same level as the minimum wage while increasing, rather than decreasing, employment. Phelps argues that the tax revenue used for the subsidy might be more than offset by decreases in other costs, such as lower welfare payments and reduced crime and drug dependency. The Earned Income Tax Credit (EITC) is a subsidy that is similar to Phelps’ proposal but that is targeted more toward families with children. Teaching Tip: The textbook highlights Phelps’s argument but doesn’t make the obvious point that a wage subsidy, like any other subsidy, can encourage inefficient overconsumption, in this case of labor. You might want to take a moment to point out this inefficiency to your students. Teaching Tip: This is also a good example to highlight as you can return to it after the discussion of price floors and the minimum wage to compare the effects of price controls and subsidies. The MRU video Wage Subsidies provides a detailed illustration of the wages subsidies proposed by Edmund Phelps as discussed in this section of the text. Takeaway Students should be able to use a wedge analysis to show that taxes decrease quantity traded and subsidies increase quantity traded. They should understand and be able to graph the deadweight losses caused by taxes and subsidies. They should understand that the burden of a tax or benefit of a subsidy is determined by relative elasticities, not by who the government takes money from or gives the money to. The most important thing for students to take away from this chapter is an understanding that interfering with free market prices (with the use of taxes and subsidies) hinders the market’s ability to allocate resources efficiently. In- and Out-of-Class Activities Sales taxes are a major source of revenue for states. However, sales taxes are interesting because they apply so broadly. Have students check out https://www.taxadmin.org/assets/docs/Research/Rates/sales.pdf for information on the sales tax in your state. Ask your students to comment on the deadweight loss they believe is caused by a sales tax. > What goods are subject to sales tax? In other words, how would you define the tax? The sales tax is a tax on _____. The answer should be something close to all goods, depending on your state. (If you happen to live in a state with no sales tax, then refer to the states that have sales taxes. You might ask whether students would change their consumption patterns much.) > Going back to the determinants of elasticity in Chapter 5, ask your students whether the answer in the preceding blank tends to have elastic or inelastic demand. Are there a lot of substitutes for “all goods”? The more exclusions there are in your specific state, the more substitutes there are for the taxed goods, so the less of the tax buyers will bear. > Ask about the substitutes for the sellers. Are there other nontaxable things that sellers could easily produce instead? Have your students sum up the reasons a very broad tax, like a sales tax, causes less deadweight loss than a very narrow tax, like an excise tax. Be sure to reinforce the idea that the deadweight loss of a tax comes from the reduction in quantity—not from the change in prices! For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction: For Problems in the Section: Watch the MRU Video: Who Ultimately Pays the Tax Does Not Depend of Who Writes the Check Commodity Taxes Who Ultimately Pays the Tax Depends on the Relative Elasticities of Supply and Demand Who Pays the Tax? A Commodity Tax Raises Revenue and Reduces the Gains from Trade (Creates a Deadweight Loss) Tax Revenue and Deadweight Loss Subsidies Subsidies Subsidies Wage Subsidies Chapter 7 The Price Systems: Signals, Speculation, and Prediction Learning Objectives After completing this chapter, students should understand: > how markets are connected through time, geography, and different goods. > that the market is a result of a spontaneous order; it is not intentionally designed by anyone. > that free market prices serve a vital function in providing both information and incentives to consumers and producers. > the role of speculation in the market and how speculation predicts future market conditions. Chapter Outline Markets Link the World Markets Link to One Another From Oil to Candy Bars and Brick Driveways Solving the Great Economic Problem A Price Is a Signal Wrapped Up in an Incentive Speculation Signal Watching Prediction Markets Takeaway Chapter Narrative This chapter is designed to help students see the big picture of how markets coordinate our behavior. It contains little new technical material but instead tries to help students understand how the concepts of supply, demand, and equilibrium provide order in the world around them. The textbook’s authors’ motto is, “See the invisible hand. Understand your world.” This chapter epitomizes that message. It shows how markets link U.S. teens to Kenyan flower growers, Dutch clocks, and British airplanes. It explains how the price system provides incentives and information to coordinate the invisible hand, hence to solve the great economic problem of arranging our scarce resources to satisfy as many of our infinite wants as possible. Instructors will probably find that Chapters 7 and 8 are unlike other texts’ treatment of similar topics. These chapters are linked in the way they use supply and demand to explain the overall function of the price system. This entire chapter illustrates the price system when it is working, something that is often minimized in other texts. Chapter 8 explains what happens when the price system is impeded with price controls, which, although traditionally covered in texts, isn’t integrated into the overall market system framework as comprehensively as it is in this text. The goal is to give students a thorough understanding of and appreciation for the explanatory power of the supply and demand framework. The MRU video I, Rose motivates and introduces the material in this chapter using the worldwide market for roses as an example. You might show this video to open the discussion of this material. Markets Link the World Teaching Tip: In this chapter, you are going to be telling a lot of stories rather than teaching new formulas or graphs. Try to make it as interactive as possible by asking the students leading questions. The first example in this chapter is an excellent starting point for this method. The MRU video Markets Link the World provides additional motivation and examples of how markets link the world. This is another good video to stimulate discussion of this material. On Valentine’s Day, many of the approximately 180 million roses that are sold come from an area of Kenya northwest of Nairobi. Before disclosing this to the students, try asking them, “How many of you have ever benefited from trading with Kenyan women?” You will likely see few if any hands. Now you can tell them that one of the miracles of the market is that most of them have likely traded with female Kenyan flower growers without ever knowing it. This is because the price system has coordinated millions of people’s interactions to deliver flowers from Kenya. More than 50,000 tons of flowers are grown for export in Kenya every year, although most Kenyan women do not know much about Valentine’s Day—and they don’t have to. All they need to know is that if they de-bud roses so that they bloom just in time for delivery on February 14, the women will be paid more. Within hours after picking, the roses are sent to the world’s largest flower market, in Alsmeer, Holland, which handles about 20 million flowers on a typical day. The flowers are assembled into large lots and sold in front of clocks that measure prices rather than time, ticking downward from a high price until they reach a price that a buyer is willing to pay. Once the flowers are sold, they’re packed into planes and shipped to the major markets. A student’s girlfriend or boyfriend typically gets flowers within 72 hours after they were picked in Kenya. The worldwide market links all of these people with those who make the airplanes and cell phones for coordination and transport, those who make inputs for the planes and so on. Just one product that the students never questioned takes the cooperation and coordination of millions of people around the globe, and all of this cooperation is voluntary and undirected. That is the miracle of the market process. Markets Link to Each Other The textbook now returns to the market for oil and how it is linked to the Kenyan flower market and other markets around the world. The Kenyan flower market owes its existence to changes in the market for oil in the 1970s. Prior to the 1970s, roses were grown in U.S. greenhouses. The increasing oil prices of the 1970s raised the price of heating so much that it became cheaper to grow roses in warm countries and ship them to cold countries. No one could foresee or plan this change. It was imaginative entrepreneurs responding to price changes who built the Kenyan rose industry, and it was the price system that linked the markets together. From Oil to Candy Bars and Brick Driveways Try asking the students how a higher price of oil affects the cost of their candy bars (or better yet, find a student in your class eating one and call on her). The students should come up with the obvious answer: Higher oil costs raise the cost of production and transport, hence the cost of candy bars. The less obvious link is that ethanol fuel made from corn or sugar cane is a substitute for oil. When the price of oil rises, more corn and sugar producers switch from producing crops for food to producing them for fuel. Brazil is the world’s largest producer of both ethanol fuel and sugar. Higher oil prices encouraged Brazilians to use more of their sugar for ethanol production. This decreased the supply of sugar for candy, thus raising the cost of candy. The market for brick driveways is also linked to the market for oil. A substitute for a brick driveway is an asphalt driveway, and asphalt is made from oil. Try having students illustrate the relationship using multiple graphs again. Have them start with a reduced supply of oil raising the price of gasoline. How will that affect the supply of asphalt? How will that influence the demand for brick driveways? Potential Pitfall: It will be easy for students to nod their heads while hearing these stories. After telling a story, pause and ask students to draw out what happened using supply and demand graphs. This will help reinforce how the story you are telling connects the tools they are learning to the big picture of coordination around the world. After giving them a few minutes to work on it, draw the graphs yourself. The text has no graphs for flowers, candy, or asphalt. Teaching Tip: In this case, you could draw a supply restriction in oil raising the equilibrium price. Then ask them to draw how this affects the demand for ethanol, which is a substitute for oil. Ask your students how this affects the market for sugar, an input to ethanol, and how it affects the market for candy, for which sugar is a major input. You should be drawing a shift out in the demand for ethanol and sugar with increases in price and a shift in on the supply of candy, raising the cost of candy and lowering equilibrium quantity traded. The three graphs together will help illustrate the links between markets and how the story ties to the material they have already learned. Solving the Great Economic Problem The great economic problem is to arrange our scarce resources to satisfy as many of our infinite wants as possible. When the supply of one good, such as oil, goes down, we must economize by ceasing to use oil for lower-value purposes. The question is how. One solution is for a central planner to issue orders. Try asking the students what problems a central planner might encounter. See if they come up with these: > He’d have to know the value of oil in each of its millions of uses. > He’d have to know which of its consumers for each use value it most. > He’d have to know the value of each substitute for oil in each of their uses (and the substitutes’ substitutes). > He’d have to solve all of this and then issue millions of orders to get people to act on his assumptions. > People would have to give the planner truthful information, but they’d have an incentive to say that they all valued oil highly. > What about the central planner’s own incentive not to create an optimal plan even if he could? The United States briefly tried to plan the allocation of oil during the 1973–1974 oil crisis. President Nixon forbade gas stations to open on Sundays to discourage Sunday driving, something he apparently believed was a low-value use of gasoline. The planning in U.S. oil markets is covered more in Chapter 8. For now, suffice it to say that oil planning in the United States and more comprehensive central planning in the former Soviet Union and China were complete failures, and central planning has largely been abandoned around the world. Central planning failed around the world because of problems of incentives and information. The market harnesses information and provides incentives through the price system to solve the great economic problem. All individuals have a great deal of information about how they value oil for their own uses. The market system takes advantage of this information without forcing consumers to tell this information to any central planner. We want these consumers to compare their valuation of oil to other people’s valuations and to consume oil only if they have a valuation higher than alternative uses for the same oil. This is what the price system accomplishes. Draw a graph like Figure 7.1 in the text. Remind students that the height of the demand curve measures the value of the oil to the user at each point along the curve. The market price ensures that all of the satisfied wants have higher valuations than the unsatisfied wants and that the equilibrium price falls precisely so that the last consumer of oil has just a slightly higher value of oil than the first unsatisfied demander. The MRU video Information and Incentives provides an illustration of the information and incentives contained in prices using a graph like Figure 7.1 in the text. The market in which buyers compete against each other for products forces them to compare their value of asphalt on their driveway to asphalt’s value in its next-highest-value use. Because markets are linked, when buyers are comparing their valuation of asphalt, they are also comparing it to the value of oil, the demand for automobiles in China, the supply of ethanol, the price of sugar, and so on. The market solves the information problem by collapsing into its price all of the relevant information about the use of oil. The market solves the incentive problem because consumers are willing to take the asphalt only if they value it more highly than the price. Figure 7.1 The Market Price and Opportunity Cost The MRU video The Great Economic Problem discusses how different markets are linked to one another and how these linkages provide a way for societies to determine how their scarce resources are best used. A Price Is a Signal Wrapped Up in an Incentive Prices give incentives, send signals, and are predictions. When the price of oil rises, people have the incentive to economize. It’s also a signal to suppliers to invest more in oil exploration and to look for substitutes for oil. Often politicians and consumers don’t understand the signaling role of prices. After a natural disaster such as a hurricane, the price of ice, generators, and chainsaws often skyrockets. Although people complain about price gouging, the high prices are an important signal. They signal to consumers to reserve ice for its most valuable uses. And they signal suppliers that ice is desperately needed and to bring more in. Price signals tell consumers and entrepreneurs where the economy should expand and where it should contract. Teaching Tip: This might be an opportunity to discuss the 2008–2009 financial crisis in the United States. While the crisis itself is beyond the scope of this chapter, you might provoke a discussion about what housing and other prices were signaling during the crisis. Another example you can give that is a bit related to the text is the boom, and subsequent bust, of oil drilling in North and South Dakota. Oil was priced at over $155 a barrel in 2008, which led to increased drilling in areas previously not explored such as North and South Dakota. This high price, with the innovation of hydraulic fracturing, created an incentive to access new sources of oil, which increased the world’s supply and drove down the price. These new sources would have not been explored had the price of oil not risen so high. Now that the price of oil has fallen again, several of those newer wells are being turned off because they are too expensive to run at current prices. Here the price is sending the signal that we now have too much oil and firms are responding accordingly. Ask the students if they think a central planner in the United States would have an incentive to shut down these more expensive wells (consider the politics of this choice such as job loss and hoping other countries reduce their supply first). This will highlight the superiority of the price system rather than one that is political. The MRU video A Price Is a Signal Wrapped Up in an Incentive provides a discussion of how prices act as an incentive that motivates socially beneficial behavior as we try to deal with the problem of scarcity. Speculation Speculation is the attempt to profit from future price changes. Speculators attempt to buy low and sell high. The textbook illustrates the effect of speculators when they expect a war in the Middle East to disrupt the supply of oil a year from now. Without speculation, today’s price would be low and the future price would be much higher, as shown in the top panel of Figure 7.2 in the text. The MRU video Speculation illustrates how speculation can smooth prices and increase welfare using Figure 7.2 in the text. The video closes with a discussion of the role of futures markets in speculation. Figure 7.2 Speculation Tends to Smooth Prices over Time and Increase Welfare Speculators purchase oil today and store it, thus reducing today’s supply of oil and raising the price. But when production drops because of the war and prices begin to rise, the speculators take oil out of storage and drop the price below what it would have been. Potential Pitfall: Students are biased to believe that speculation drives up prices because that is the half of the process reported in the media most often. It’s important to point out that when speculators are correct, they actually smooth prices over time, as depicted in Figure 7.2. You might ask the students how many of them have turned in a claim on their auto insurance. Call on one who answers they have and ask about how much the repairs ended up costing, and then ask them if they could have, or would have liked to have, come up with those funds when they had their accident. You can explain that the person who sold them their policy is essentially a speculator! In this case, they do not think you are going to have an accident, so they are willing to sell you a policy where they will pay for all the damages if you have an accident. If they are right, they profit the amount you paid for the policy. If they are wrong, they lose the cost of the repairs. You benefit from this because you can smooth your spending by paying just a little each year to avoid having to pay a large lump sum in the unlikely case of an accident. Speculators aren’t always right, but they certainly have strong incentives to be, since they lose money—sometimes a lot of money—when they are wrong. Those who are consistently wrong lose their money and their ability to influence market prices. Investors can use oil futures to speculate on the price of oil, so that they don’t literally have to buy and hold quantities of oil. A future is a standard contract to buy or sell specified quantities of a commodity or financial instrument at a specified price with a specified delivery date. When someone buys futures and on the delivery date the price of the commodity is above the price specified in the contract, the investor makes a profit. When the market price on the delivery date is below the contract price, the investor loses money. Almost all futures contracts are settled for the cash difference between the future’s contract price and the market price, so that the oil doesn’t actually have to be delivered. Futures markets allow for risk reduction. An airline that wants to know its fuel cost in advance can purchase a futures contract for oil and lock in its cost months ahead of consumption. Farmers can sell futures so that when harvest time comes, they are protected if prices are lower. Futures are also commonly used for risk reduction in currency exchanges. A firm doing business in a foreign country can use currency futures to lock in exchange rates for future revenues. Signal Watching Futures markets provide valuable signals about what people expect market conditions to be like. If people believe war is likely in the Middle East, many will buy oil futures and drive the futures prices up. If bad weather is expected in Florida, the futures price for oranges will be higher. In fact, an economist found that the futures price for orange juice was so sensitive to weather that the predictions of the Florida Weather Bureau could be improved by using the futures prices to inform its forecasts. Predictions Markets Futures markets are so good at predicting events that economists have begun specifically designing markets to predict events. The best known of these is the Iowa Electronic Markets. Traders use real money to purchase “shares” of political candidates, and these shares pay $1 if the candidate wins and zero if he or she loses. The share price indicates the market’s estimation of the candidate’s chance of winning: A share price of 60 cents would indicate a 60% probability of winning. In the years since the market was established, it has proved more accurate than other forecasting methods, such as polling. Hewlett-Packard used a similar approach to predict hardware sales. Members of HP’s sales team bought shares that would pay $1 if sales were in a particular range. By examining all of the share prices for different sales ranges, HP could assign a probability to any combination of outcomes. In 15 of 16 trials the mean market-based prediction was significantly closer to the actual sales figure than the official company forecast. An advantage of the predictions market approach was that it avoided the problem of sales representatives who didn’t want to give bad news to their bosses. Instead, based on the sales reps’ specialized—and private—information, they were able to speculate and profit and in the process provide company leadership with better information. The Hollywood Stock Exchange uses Hollywood Dollars to trade options in movies, music, and Oscars. The exchange has proved that its prices are reliable predictors of future film profits. Teaching Tip: The book discusses the differences between the polls and the prediction markets in the 2016 U.S. presidential election. The core idea of both approaches is to collect information from very large groups of people and then use that to make a prediction, roughly the same thing a market does. Ask the students why they think the prediction markets placed a higher probability on a Trump win than the polls. Of course, the answer is in the markets there was real money at stake, whereas in the polls responders had nothing at stake (use the idea of opportunity cost of being wrong to highlight this). You can use this to highlight the importance of the incentive aspect of prices in that they require people to have “skin in the game.” Polls and surveys are good, but they do not require the same carefulness that markets do because there is less at stake (the opportunity cost of being wrong is smaller). The MRU video Prediction Markets explains how the information conveyed in prices can be used to predict the future. The video discusses the Iowa Electronic Markets and the Hollywood Stock Exchange as examples. Takeaway This chapter should help students see the big picture of how markets are linked geographically, through time, and across different goods. It should help them appreciate the absolutely vital role of free-market prices in coordinating these links. The prices provide the information and incentives that coordinate these markets without anyone issuing central commands. Hopefully this chapter makes Adam Smith’s invisible hand more visible to your students. In- and Out-of-Class Activities The following are true stories. For each situation, ask students to explain in a homework assignment or classroom discussion how the circumstances result in an inefficient allocation of resources and how the inefficiency might be resolved. > Free samples of a new McCafé product are being given away to McDonald’s customers. Customers are anxious to get one or more of the free samples. But upon leaving the restaurant, you notice that the trash cans are overflowing with the samples and the floor is wet with the new beverage that has leaked from the trash. > During an extended power outage following a winter storm, antigouging laws prevent a hardware store owner from raising the price of the last generator in stock. To avoid being overrun with anxious customers and having to decide who gets the generator, the owner takes the generator home and stores it in his garage, where it sits for weeks and is never used during the outage. While not a true story, you can also use the following example of price and antigouging laws. Ask for a volunteer from class and put them in the role of a gas station attendant with just one gallon of gasoline left after a major disaster. Confront the student with two potential consumers: One wishes to power a generator so that they can keep their tablet computer charged to stay current on an online game (or some other low valued use) and one consumer with a child with diabetes who needs the gasoline to keep a generator running to keep the insulin cold (a high valued use). Ask the student who they would like to give the gasoline to. Now randomly pick two students in the classroom and say that each one corresponds to one of the two consumers just described, and the gas station attendant must figure out which one is which. How will he do it? If he tries to use price, inform him that it is unfair for him to increase his price after a disaster (and illegal) and ask him to figure out another way. To make it more interesting, tell your two students which consumer they are and see how things change, if at all. For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction: For Problems in the Section: Watch the MRU Video: Markets Link the World I, Rose A Price Is a Signal Wrapped up in an Incentive A Price Is a Signal Wrapped Up in an Incentive Markets Link the World Markets Link the World Solving the Great Economic Problem The Great Economic Problem Solving the Great Economic Problem Information and Incentives Speculation Speculation Prediction Markets Prediction Markets Instructor Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766