modern principles microeconomics tyler cowen and alex tabarrok see the invisible hand understand...

Modern PrinciplesModern PrinciplesMicroeconomicsMicroeconomics

Tyler Cowen and Alex Tabarrok

See the Invisible HandUnderstand Your World

The RomanceThe Romance

Roses in February in Chicago. Quite incredible. Where do the Roses come from? Not from nearby greenhouses!

Bloemenveiling photo by Wilfried Overwater.

Markets are CooperativeMarkets are Cooperative

A rose is a truly international product. The market for roses links romantic Americans with

South American flower growers, Dutch clocks, Finnish cell phones, Colombian coffee (to keep the pilots awake) and much more.

Hundreds of thousands of people from Ecuador to Chicago cooperated to bring the rose to our handsome young man and they did so voluntarily, on the basis of self interest, and without central direction - this is the invisible hand in action.

Markets are CreativeMarkets are Creative

When oil was cheap roses were grown in heated greenhouses in NY and PA.

A rising price of oil in the 1970s was a signal to entrepreneurs to look for ways to use less oil so they could reduce the costs of growing roses.

Entrepreneurs discovered that transporting millions of roses thousands of miles was cheaper and greener (!) than growing them locally so rose production moved to Ecuador, Colombia, Kenya, Thailand and other countries with warmer climates.

Markets are ConnectedMarkets are Connected

Markets are connected in a complex web.

When one price changes every other price responds as entrepreneurs recalculate and reconfigure to help solve the “great economic problem” of producing as many valuable goods as possible from our limited resources.

Map of the World Wide Web(Barrett Lyon OPTE Project)

Modern Principles: The RoseModern Principles: The Rose

The rose is a symbol of worldwide cooperation.

The story of the rose demonstrates the power of trade and the creativity of entrepreneurs as they respond to the dual role of prices as signals and incentives.

The rose illustrates the invisible hand – how markets generate cooperation and coordination around the world.

The Role of PricesThe Role of Prices

A Price is a SignalWrapped Up

in an Incentive

Understanding the Price System Understanding the Price System

Understanding the Price System Understanding the Price System With Price ControlsWith Price Controls

1. Shortages2. Reductions in

product quality.3. Wasteful lines and

other search costs4. Loss of gains from

trade5. Misallocation of

resources

Understanding the Price SystemUnderstanding the Price Systemwith Price Controls with Price Controls

Reading the Price SignalsReading the Price Signals

In January news organizations reported that cold weather was increasing the price of oil and related products such as gasoline.

At the same time the WSJ reported that the February futures price of oil—the price for oil to be delivered one month in the future--was falling because of expectations of warmer weather.

Cold Temps Drive Higher Prices At Pump

WHIOTV, Jan 13, 2010

OIL FUTURES: Crude Falls As Temperatures Rise

The Wall Street Journal, Jan 12, 2010

VSVS

The Use of Information in MarketsThe Use of Information in Markets

Roll, Richard. 1984. Orange Juice and Weather. American Economic Review, 74, 5, 861-880.

From “The Use of Information in Markets” to From “The Use of Information in Markets” to Information Markets or Hayek to HansonInformation Markets or Hayek to Hanson

Friedrich Hayek Robin Hanson

Iowa Electronic Market2008 Presidential Candidates

$0.63 $.37

One “Obama share” pays $1 if Obama wins. Nothing otherwise.One “McCain share” pays $1 if McCain wins. Nothing otherwise.

PricesOn

August 8, 2008

Prediction Markets are Now WidespreadPrediction Markets are Now Widespread

• Prediction markets are about harnessing the amazing ability of markets to aggregate and summarize information.

• Prediction markets are not miraculous but they do tend to outperform other prediction mechanisms such as expert opinion or polls.

Prediction Markets(click)

Seeing the “Invisible Hand” Seeing the “Invisible Hand” throughoutthroughout

Principles of Economics Principles of Economics

The True ImportanceThe True Importanceof theof the

P=MC Condition of Profit MaximizationP=MC Condition of Profit Maximization

A

How to Minimize the Total Costs of Corn How to Minimize the Total Costs of Corn Production Across Two FarmsProduction Across Two Farms

Increase in Costs

SavingsC = A-B Decrease

in Costs

$200th unit

Cost of Producing 200th Unit

MC1

Quantity(Bushels of Corn)

0 25

$

Farm One

MC2

Quantity(Bushels of Corn)

200175

$

Farm Two

C

B

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Farm One Farm Two

To Minimize Total Costs Set MCTo Minimize Total Costs Set MC11=MC=MC22

Pat Sets PPat Sets P =MC=MC1 1 , Alex sets P, Alex sets P =MC=MC2 2

as a result MCas a result MC11=MC=MC2 2 A Much More Difficult ProblemA Much More Difficult Problem

$2.50 Price of Corn

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

Price of Corn

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

Pat Sets PPat Sets P =MC=MC1 1 , Alex sets P, Alex sets P =MC=MC2 2

as a result MCas a result MC11=MC=MC2 2

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

Pat Sets PPat Sets P =MC=MC1 1 , Alex sets P, Alex sets P =MC=MC2 2

as a result MCas a result MC11=MC=MC2 2

Price of Corn

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

Pat Sets PPat Sets P =MC=MC1 1 , Alex sets P, Alex sets P =MC=MC2 2

as a result MCas a result MC11=MC=MC2 2

Price of Corn

MC1

0 40 Quantity(Bushels of Corn)

$

MC2

160 Quantity(Bushels of Corn)

$

Pat’s Farm Alex’s Farm

The True Importance of the P=MCThe True Importance of the P=MC Condition Condition

is P=MCis P=MC11=MC=MC22 …=MC …=MCNN

Price of Corn

$2.50

Seeing the Invisible Hand

• Emphasize worldwide cooperation and coordination (roses, pencils, snickers!).

• Teach the price system (not just single markets).

• The dual role of prices as signals and as incentives.

• The “use of information” in prices illustrated with information markets.

• The minimization of the total costs of production as a result of profit maximization.

– A product of human action but not of human design!

Modern PrinciplesModern PrinciplesMicroeconomicsMicroeconomics

Tyler Cowen and Alex Tabarrok

See the Invisible HandUnderstand Your World