3.3 — Social Functions of Market Prices

# 3.3 — Social Functions of Market Prices
## ECON 306 · Microeconomic Analysis · Fall 2020
### Ryan Safner<br> Assistant 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/microF20"><i class="fa fa-github fa-fw"></i>ryansafner/microF20</a><br> <a href="https://microF20.classes.ryansafner.com"> <i class="fa fa-globe fa-fw"></i>microF20.classes.ryansafner.com</a><br>

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# The Model is Not the Reality I

- Applications in ECON electives

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

> *"All models are wrong. Some are useful"* - George Box

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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 II

Source: [SMBC](https://www.smbc-comics.com/comic/2013-09-19)

"Shame on the three of you who enjoyed this joke"
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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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- .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 `$\neq$` Risk

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# Uncertainty `$\neq$` Risk

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- **"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 `$\neq$` Risk

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- **"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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![:scale 80%](https://www.dropbox.com/s/0odct9z45lzonyb/frankknight.png?raw=1)

1885-1972
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- .hi-purple[“Knightian uncertainty”]: 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

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Henry Ford

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 knows **their own** reservation prices

- Buyers and sellers adjust their bids/asks

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

- 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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- Errors and imperfect information `$\implies$` 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 cat-and-mouse game between:
  - **"Underlying variables"**: preferences, technology, and resource availability
  - **"Response variables"**: market prices, least-cost technologies

- Response variables always chasing underlying variables
  - Underlying variables *always* changing
  - Any time underlying `$\neq$` response variables: profit opportunities

- **IF** underlying variables *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 substitites
  - **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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