THEMES AND CAPSTONE UNITS
17: History, instability, and growth
18: Global economy
19: Inequality
21: Innovation
22: Politics and policy
UNIT 11
RENT-SEEKING, PRICE-SETTING,
AND MARKET DYNAMICS
RENT-SEEKING EXPLAINS WHY PRICES CHANGE
(AND WHY SOMETIMES THEY DON’T), AND HOW
MARKETS WORK (SOMETIMES FOR BETTER,
SOMETIMES FOR WORSE)
• Prices are messages about conditions in the economy, and provide
motivation for acting on this information.
• People take advantage of rent-seeking opportunities when competit-
ive markets are not in equilibrium, often profiting by setting a price
different from what others are setting.
• This rent-seeking process may eventually equate supply to demand.
• Prices in financial markets are determined through trading mechanisms
and can change from minute to minute in response to new information
and changing beliefs.
• Price bubbles can occur, for example in markets for financial assets.
• Governments and firms sometimes set prices and adopt other policies
such that markets do not clear.
• Economic rents help explain how markets work.
Fish and fishing are a major part of the life of the people of Kerala in India.
Most of them eat fish at least once a day, and more than a million people are
involved in the fishing industry. But before 1997, prices were high and
fishing profits were limited due to a combination of waste and the bargain-
ing power of fish merchants, who purchased the fishermen’s catch and sold
it to consumers.
When returning to port to sell their daily catch of sardines to the fish
merchants, many fishermen found that the merchants already had as many
fish as they needed that day. They would be forced to dump their worthless
catch back into the sea. A lucky few returned to the right port at the right
time when demand exceeded supply, and they were rewarded by
extraordinarily high prices.
Stock exchange, Santiago, Chile
457
law of one price Holds when a
good is traded at the same price
across all buyers and sellers. If a
good were sold at different prices
in different places, a trader could
buy it cheaply in one place and sell
it at a higher price in another. See
also: arbitrage.
On 14 January 1997, for example, 11 boatloads of fish brought to the
market at the town of Badagara found the market oversupplied, and
jettisoned their catch. There was excess supply of 11 boatloads. But at fish
markets within 15 km of Badagara there was excess demand: 15 buyers left
the Chombala market unable to purchase fish at any price. The luck, or lack
of it, of fishermen returning to the ports along the Kerala coast is illustrated
in Figure 11.1.
Only seven of the 15 markets did not suffer either from over- or under-
supply. In these seven villages (on the vertical line) prices ranged from Rs4
per kg to more than Rs7 per kg. This is an example of how the law of one
price—a characteristic of a competitive market equilibrium—is sometimes
a poor guide to how actual markets function.
When the fishermen have bargaining power because there is excess
demand, they get much higher prices. In markets with neither excess
demand nor excess supply, the average price was Rs5.9 per kg, shown by the
horizontal dashed line. In markets with excess demand, the average was
Rs9.3 per kg. The fishermen fortunate enough to put in at these markets
obtained extraordinary profits, if we assume that the price in markets with
neither excess demand nor supply was high enough to yield economic
profits. Of course, on the following day they may have been the unlucky
ones who found no buyers at all, and so would dump their catch into the sea.
This all changed when the fishermen got mobile phones. While still at
sea, the returning fishermen would phone the beach fish markets and pick
the one at which the prices that day were highest. If they returned to a high-
priced market they would earn an economic rent (that is, income in excess
of their next best alternative, which would be returning to a market with no
excess demand or even one with excess supply).
By gaining access to real-time market information on relative prices for
fish, the fishermen could adjust their pattern of production (fishing) and
distribution (the market they visit) to secure the highest returns.
A study of 15 beach markets along 225 km of the northern Kerala coast
found that, once the fishermen used mobile phones, differences in daily
Average price in markets
with excess demand
Average price in markets with
neither excess demand or supply
Badagara
Aarikkadi
Chombala
Number of boatloads of fish
destroyed (excess supply)
Number of unsatisfied buyers
of fish (excess demand)
2
4
6
8
10
−12 −8 −4 0 4 8 12 16
Pr
ic
e
(R
s/
kg
)
Figure 11.1 Bargaining power and prices in the Kerala wholesale fish market
(14 January 1997). (Note: Two markets had the same outcome, with a price of Rs6.2
per kg.)
Robert Jensen. 2007. ‘The Digital
Provide: Information (Technology),
Market Performance, and Welfare in the
South Indian Fisheries Sector.’ The
Quarterly Journal of Economics 122 (3)
(August): pp. 879–924.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
458
Friedrich A. Hayek. 1994. The Road
to Serfdom. Chicago, Il: University
of Chicago Press.
prices among the beach markets were cut to a quarter of their previous
levels. No boats jettisoned their catches. Reduced waste and the elimination
of the dealers’ bargaining power raised the profits of fishermen by 8% at the
same time as consumer prices fell by 4%.
Mobile phones allowed the fishermen to become very effective rent-
seekers, and their rent-seeking activities changed how Kerala’s fish markets
worked: they came close to implementing the law of one price, virtually
eliminating the periodic excess demand and supply, to the benefit of fisher-
men and consumers (but not of the fish dealers who had acted as
middlemen).
This happened because the Kerala sardine fishermen could respond to
the information given by the prices at different beaches. It is another
example of the idea we introduced in Unit 8 to explain the effect of the
American Civil War on markets for cotton: that prices can be messages. For
the economist Friedrich Hayek, this was the key to understanding markets.
GREAT ECONOMISTS
Friedrich Hayek
The Great Depression of the 1930s
ravaged the capitalist economies of
Europe and North America,
throwing a quarter of the
workforce out of work in the US.
During the same period, the
centrally planned economy of the
Soviet Union continued to grow
rapidly under a succession of five-
year plans. Even the arch-
opponent of socialism, Joseph
Schumpeter, had conceded:
‘Can socialism work? Of course
it can … There is nothing wrong with the pure theory of socialism.’
Friedrich Hayek (1899–1992) disagreed. Born in Vienna, he was an
Austrian (later British) economist and philosopher who believed that the
government should play a minimal role in the running of society. He was
against any efforts to redistribute income in the name of social justice.
He was also an opponent of the policies advocated by John Maynard
Keynes designed to moderate the instability of the economy and the
insecurity of employment.
Hayek’s book The Road to Serfdom was written against the backdrop of
the Second World War, when economic planning was being used both by
German and Japanese fascist governments, by the Soviet communist
authorities, and by the British and American governments. He argued that
well-intentioned planning would inevitably lead to a totalitarian outcome.
His key idea about economics revolutionized how economists think
about markets. It was that prices are messages. They convey valuable
information about how scarce a good is, but information that is available
only if prices are free to be determined by supply and demand, rather
than by the decisions of planners. Hayek even wrote a comic book
(https://tinyco.re/9802258), which was distributed by General Motors,
to explain how this mechanism was superior to planning.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
459
‘Keynes and Hayek: Prophets for
Today’ (https://tinyco.re/0417474).
The Economist. Updated 14 March
2014.
exogenous Coming from outside
the model rather than being
produced by the workings of the
model itself. See also: endogenous.
endogenous Produced by the
workings of a model rather than
coming from outside the model.
See also: exogenous
Now, how many of the devices adopted in ordinary life to that end
would still be open to a seller in a market in which so-called
‘perfect competition’ prevails? I believe that the answer is exactly
none. Advertising, undercutting, and improving (‘differentiating’)
the goods or services produced are all excluded by definition—
’perfect’ competition means indeed the absence of all competitive
activities. (The Meaning of Competition, 1946)
Which of these systems [central planning or competition] is likely
to be more efficient depends mainly on the question under which
of them we can expect [to make fuller use] of the existing
knowledge. This, in turn, depends on whether we are more likely
to succeed in putting at the disposal of a single central authority
all the knowledge which ought to be used but which is initially
dispersed among many different individuals, or in conveying to
the individuals such additional knowledge as they need in order to
enable them to dovetail their plans with those of others. (The Use
of Knowledge in Society, 1945)
Unit 8 introduced the concept of competitive market equilibrium, a situ-
ation in which the actions of the buyers and sellers of a good have no
tendency to change its price, or the quantity traded, and the market clears. We
saw that changes from the outside called exogenous shocks, like an
increase in the demand for bread or a new tax, will alter the equilibrium
price and quantity.
The opposite of exogenous is endogenous, meaning ‘coming from the
inside’ and resulting from the workings of the model itself. In this unit, we
will study how prices and quantities change through endogenous responses
to exogenous shocks and the real-world competition that Hayek
complained was absent from the model of competitive equilibrium. We will
see that rent-seeking behaviour by market participants can bring about
market clearing, move markets to different equilibria in the long run, cause
bubbles and crashes, or lead to the development of secondary markets in
response to price controls.
But Hayek did not think much of the theory of competitive equilib-
rium that we explained in Unit 8, in which all buyers and sellers are
price-takers. ‘The modern theory of competitive equilibrium,’ he wrote,
‘assumes the situation to exist which a true explanation ought to account
for as the effect of the competitive process.’
In Hayek’s view, assuming a state of equilibrium (as Walras had done
in developing general equilibrium theory) prevents us from analysing
competition seriously. He defined competition as ‘the action of
endeavouring to gain what another endeavours to gain at the same time.’
Hayek explained:
The advantage of capitalism, to Hayek, is that it provides the right
information to the right people. In 1945, he wrote:
Hayek’s challenging ideas, and their application, are still fiercely debated
today.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
460
QUESTION 11.1 CHOOSE THE CORRECT ANSWER(S)
Figure 11.1 (page 458) shows how bargaining power affected prices in
Kerala beach markets on 14 January 1997. Based on this information,
what can we conclude?
The higher the excess supply, the lower the price of fish.
The price of fish in all markets with excess demand is 9.3.
The data satisfy the law of one price.
The data demonstrate that buyers have bargaining power when
there is excess supply.
11.1 HOW PEOPLE CHANGING PRICES TO GAIN RENTS
CAN LEAD TO A MARKET EQUILIBRIUM
When Lincoln’s decision to blockade the southern ports led to a drastic
shortage of cotton on the world market (Unit 8), people saw the opportun-
ity to benefit by changing the price. In turn, these price changes sent a
message to producers and consumers around the world to change their
behaviour.
The blockade was an exogenous shock that changed the market equilib-
rium. In a competitive equilibrium, all trades take place at the same price
(the market-clearing price), and buyers and sellers are price-takers. An
exogenous shift in supply or demand means that the price has to change if
the market is to reach the new equilibrium. The following example shows
how this can happen.
Figure 11.2 shows the competitive equilibrium in a market for hats. At
point A, the equilibrium price equalizes the number of hats demanded by
consumers to the number produced and sold by hat-sellers. At this point,
no one can benefit by offering or charging a different price, given the price
everyone else is offering or charging—it is a Nash equilibrium. Follow the
steps in Figure 11.2 to see how an increase in the demand for hats gives hat-
sellers an opportunity to benefit.
At the original point of competitive equilibrium (A) the price was $8,
and all buyers and sellers were acting as price-takers. When demand
increases, the buyers or sellers do not immediately know that the equilib-
rium price has risen to $10. If everyone were to remain a price-taker, the
price would not change. But when demand shifts, some of the buyers or
sellers will realize that they can benefit by being a price-maker, and decide
to charge a different price from the others.
For example, when a hat-seller notices that every day there are
customers wishing to buy hats, but none left on the shelf, she realizes that
some customers would have been happy to pay more than the going price,
and that some who paid the going price for their hat would have been
willing to pay more. So the hat-seller will raise her price the next day—
price-taking is no longer her best strategy, and she becomes a price-maker.
She does not know exactly where the new demand curve is, but she cannot
fail to see the people who want to buy hats go home disappointed.
By raising the price she raises her profit rate, and earns an economic
rent (at least temporarily)—that is, she makes higher profits than are
necessary to keep her hat business going. Moreover, because her price now
exceeds her marginal cost, she will produce and sell more hats. The same is
true of other hat-sellers who will experiment with higher prices and
increased outputs.
11.1 HOW PEOPLE CHANGING PRICES TO GAIN RENTS
461
As a result of the rent-seeking behaviour of hat-sellers, the industry
adjusts to the new equilibrium at point C in Figure 11.2. At this point the
market again clears, supply is equal to demand, and none of the sellers or
buyers can benefit from charging a price different from $10. They all return
to being price-takers, until the next change in supply or demand comes
along.
When a market is not in equilibrium, both buyers and sellers can act as
price-makers, transacting at a price different from the previous equilibrium
price. If we start from the original equilibrium and take the opposite case of
a fall in demand for hats, there will be excess supply at the going price of $8.
A customer at the hat shop might say to the hat-seller: ‘I see you have quite
a few unsold hats piling up on your shelf. I’d be happy to buy one of those
for $7.’ To the buyer this would be a bargain. But it’s also a good deal for the
seller, because at the reduced level of sales, $7 is still greater than the hat-
seller’s marginal cost of producing the hat.
0 5 10 15 20 25 30 35 40 45 50 55 60
Supply
New demand
Original demand
C
B
A
Quantity of hats (thousands)
Pr
ic
e
($
)
0
5
10
15
20
25
D
Figure 11.2 An increase in demand in a competitive market: Opportunities for
rent-seeking.
1. Equilibrium
At point A, the market is in equilibrium
at a price of $8. The supply curve is the
marginal cost curve, so the marginal
cost of producing a hat is $8.
2. An exogenous demand shock
The shock shifts the demand curve to
the right.
3. Excess demand
At the going price, the number of hats
demanded exceeds the number
supplied (point D).
4. Raising the price
When demand has increased, a hat-
seller who observes more customers
will realize that she can make higher
profits by raising the price. She could
sell as many hats at any price between
A and B.
5. Increasing quantity
If she sells the same quantity as before
at a higher price, the price exceeds the
marginal cost of a hat. She earns an
economic rent. But she could do even
better by increasing the quantity as
well.
6. A new equilibrium
As a result of the rent-seeking
behaviour of hat-sellers, the hat
industry adjusts. Prices and quantities
increase until a new equilibrium
emerges at point C.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
462
disequilibrium rent The economic
rent that arises when a market is
not in equilibrium, for example
when there is excess demand or
excess supply in a market for some
good or service. In contrast, rents
that arise in equilibrium are called
equilibrium rents.
innovation rents Profits in excess of
the opportunity cost of capital that
an innovator gets by introducing a
new technology, organizational
form, or marketing strategy. Also
known as: Schumpeterian rents.
Market equilibration through rent-seeking
The hats example illustrates how markets adjust to equilibrium through the
pursuit of disequilibrium economic rents:
• When a market is in competitive equilibrium: If there is an exogenous
change in demand or supply, there will be either excess demand or
excess supply at the original price.
• Then, there are potential rents: Some buyers are willing to pay prices that
are different from the original price, but above the marginal cost for the
seller.
• While the market is in disequilibrium: Buyers and sellers can gain these
rents by transacting at different prices. They 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 and sellers are
price-takers again.
Notice how market equilibration through rent-seeking resembles the
process of technological improvement through rent-seeking modelled in
Unit 2. There the exogenous change was the possibility of adopting a new
technology. The first firm to do so gained innovation rents: profits in
excess of the normal profit rate. This process went on until the innovation
was widely diffused in the industry and prices had adjusted so that there
were no further innovation rents to be had.
EINSTEIN
Equilibration through rent-seeking in an experimental market
Economists have studied the behaviour of buyers and sellers in
laboratory experiments to assess whether prices do adjust to equalize
supply and demand. In the first such experiment, done in 1948, Edward
Chamberlin gave each member of a group of Harvard students a card
designating them as ‘buyers’ or ‘sellers’ and stating their willingness to
pay or reservation price in dollars. They could then bargain amongst
themselves, and he recorded the trades that took place. He found that
prices tended to be lower, and the number of trades higher, than the
equilibrium levels. Chamberlin would repeat the experiment every year.
One of the students who took part in 1952, Vernon Smith, later conduc-
ted his own experiments and won a Nobel Prize in economics as a result.
He modified the rules of the game so that participants had more
information about what was happening: buyers and sellers called out
prices that they were willing to offer or accept. When anyone agreed to a
proposed deal, a trade took place and the two participants dropped out
of the market. His second modification was to repeat the game several
times, with the participants keeping the same card in each round.
Figure 11.3 shows his results. There were 11 sellers, with reservation
prices between $0.75 and $3.25, and 11 buyers with WTP in the same
range. The diagram shows the corresponding supply and demand func-
tions. You can see that, in equilibrium, six trades will take place at a price
of $2. But the participants did not know this, since they did not know
the price on anyone else’s card. The right-hand-side of the diagram
shows the price for each trade that occurred. In the first period there
were five trades, all at prices below $2. But by the fifth period most
11.1 HOW PEOPLE CHANGING PRICES TO GAIN RENTS
463
Pr
ic
e
($
)
0
Number of transactions in each periodQuantity
0 1 5 7 9 12 1
0.4
2 3451 2 34510 2 345 1 2 34 5 67 1 2 34 5 62 3 4 6 8 10 11
0.8
1.2
1.6
p
Demand Pe
ri
od
1
Pe
ri
od
2
Pe
ri
od
3
Pe
ri
od
4
Pe
ri
od
5
2.0
2.4
2.8
3.2
3.6
4.0
Supply
Figure 11.3 Vernon Smith’s experimental results.
Vernon L. Smith. 1962. ‘An Experimental
Study of Competitive Market Behavior’
(https://tinyco.re/3095861). Journal of
Political Economy 70 (3) (January):
p. 322.
prices were very close to $2, and the number of trades was equal to the
equilibrium quantity.
Smith’s experiment provides some support for applying the model of
competitive equilibrium to describe markets in which goods are identi-
cal–there are enough buyers and sellers, and they are well informed
about the trading of others. The outcome was close to equilibrium even
in the first period, and converged quickly towards it in subsequent
periods as the participants learned more about supply and demand. The
competitive model does not capture the rent-seeking behaviour during
periods of adjustment in the experiment, but it correctly predicts the
eventual outcome to be the price-taking equilibrium.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
464
EXERCISE 11.1 A SUPPLY SHOCK AND ADJUSTMENT TO A NEW MARKET
Consider a market in which bakeries supply bread to the restaurant trade.
A new technology becomes available to the bakeries, shifting the supply
curve as shown in the figure.
Pr
ic
e
(€
)
0
0.5
2.5
4.5
Quantity of loaves
0 1,000
1.0
1.5
2.0
3.0
3.5
4.0
2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000
A
B
Economic rent
Excess supply
Original supply (MC)
New supply (MC)
Demand
1. Explain why the bakeries would want to increase sales. Why can they
not do so at the original price?
2. Describe how the actions of bakeries could adjust the industry to a new
equilibrium.
3. Is it always the seller who benefits from the economic rents that arise
when the market is in disequilibrium?
4. What action might restaurants take while the market is not in equilib-
rium?
EXERCISE 11.2 COTTON PRICES AND THE AMERICAN CIVIL WAR
Read the introduction to Unit 8 and the ‘Great Economist’ box about
Friedrich Hayek in this unit. Use the supply-and-demand model to
represent:
1. The increase in the price of US raw cotton (show the market for US raw
cotton, a market with many producers and buyers).
2. The increase in the price of Indian cotton (show the market for Indian
raw cotton, a market with many producers and buyers).
3. The reduction in textile output in an English textile mill (show a single
firm in a competitive product market).
In each case, indicate which curve(s) shift and explain the result.
11.1 HOW PEOPLE CHANGING PRICES TO GAIN RENTS
465
price discrimination A selling
strategy in which different prices
are set for different buyers or
groups of buyers, or prices vary
depending on the number of units
purchased.
QUESTION 11.2 CHOOSE THE CORRECT ANSWER(S)
Figure 11.2 (page 462) shows the hat market before and after a
demand shift. Based on this information, which of the following state-
ments are correct?
After the demand increase, sellers will initially sell more hats at $8.
The adjustment to the new equilibrium is driven by the rent-seeking
behaviour of the buyers and the sellers.
While the market adjusts, some buyers may pay more for a hat than
others.
The new equilibrium price may be anywhere between A and B.
11.2 HOW MARKET ORGANIZATION CAN INFLUENCE
PRICES
Social interactions and market organization can both have a powerful
impact on prices. Data from fish markets (which are good for comparison
because fish are relatively homogeneous) show how influential both can be.
On the eastern coast of Italy, the Ancona fish market (https://tinyco.re/
6325896) uses a Dutch auction system. When a crate of fish goes down a
conveyor belt, a screen displays the initial price of the crate. That price
declines incrementally until a seller pushes a button to buy the case.
Transactions occur every four seconds on three active belts and €25
million of fish are sold annually. An auctioneer decides the initial prices,
and buyers representing supermarkets and restaurants compete to
determine final prices.
The Marseille fish market uses a different system. Sellers agree a price
with each buyer who approaches their stand. This is called pairwise trading.
If Paul is a seller, and buyer George approaches his stand to purchase a box
of sardines, Paul offers him a price. That price may differ from the price
Paul offers his next buyer. There is minimal haggling but George is free to
reject a price and find another seller.
Some individual vendors in the Marseille market vary the prices of the
same fish to different consumers by up to 30%. An individual buyer can end
up paying very different amounts for different transactions of the same fish.
Despite this, there is a typical downward-sloping relationship between
price and quantity in the aggregate market.
Alan Kirman used data on buyer loyalty to explain this kind of price
discrimination. The Marseille market is composed of approximately 45
sellers and 500 buyers, many of whom are retailers like those in Ancona.
Some buyers are extremely loyal to certain fishmongers, and others
circulate. More loyal customers pay slightly higher prices than their less
loyal counterparts. Kirman’s data reveal that this arrangement has led to
higher profits for sellers and higher payoffs for 90% of loyal customers.
How does this make sense? Buyer payoffs come from both price and the
satisfaction of demand. Imagine you are a buyer. On your first day at the
Marseille market you are equally likely to buy from any of the fishmongers.
You buy cod from Sarah and your supermarket makes a profit, making you
more likely to return to Sarah next day. In this way, your past experiences
inform your present decisions.
After continuing to buy from Sarah for some time, she begins serving
you cod before her other customers as a reward for your loyalty. So you
keep buying from Sarah because you are more likely to get all of the fish
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
466
that you demand. The benefits of being a loyal customer are especially
apparent when the weather limits the quantity of fish available.
Now imagine you are the fishmonger. Seller payoffs come from profits
and the satisfaction of your supply. By increasing the number of loyal
customers you have, your revenue becomes more reliable and your demand
predictions become more accurate.
If you give loyal customers priority over others—perhaps by serving
them first—you improve their experience buying from you, making them
more likely to return. Over time these customers become so loyal that they
will remain despite a small increase in the prices that you charge them.
In this manner, individual relationships and past experiences influence
prices. The pairwise trading structure allows for customer loyalty to have a
heavy influence on prices in the Marseille market.
Remarkably something very similar happens in Ancona, which has been
studied by Mauro Gallegati and his co-authors. Figure 11.4 shows that
some individual buyers in the market have very atypical price-quantity
relationships. But as shown in Figure 11.5, the aggregate price quantity
relationship is standard. Even without face-to-face interaction, buyer
loyalty is present and some consumers are more likely to buy from certain
ships. Unlike the Marseille market, however, many of these loyal customers
pay lower prices than their less loyal counterparts. This is puzzling, since
there is no face-to-face contact between buyers and sellers. The authors
believe that this is due to a complex learning process.
Another noteworthy fact about the Ancona market is that prices fall
during the day. In this case, why don’t buyers simply wait for better prices?
Once again we must consider a trade-off—if buyers wait until later in the
day, it becomes more likely that they will not be able to buy the fish that
they want. Many buyers may not be willing to accept that risk and will pay
higher prices to guarantee that they get their fish. Consistent with this ex-
planation, prices rise sharply at the end of the day when total supply is low.
Prices ultimately come from the interests of and relationships between
buyers and sellers. Market organization determines precisely how these
relationships influence prices.
0
1
2
3
4
5
6
7
8
9
10
11
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Total daily quantity (kg)
Av
er
ag
e
da
ily
pr
ic
e
(€
)
Figure 11.4 The price-quantity relationship for a single buyer in the Ancona fish
market.
Mauro Gallegati, Gianfranco Giulioni,
Alan Kirman, and Antonio Palestrini.
2011. ‘What’s that got to do with the
price of fish? Buyers behavior on the
Ancona fish market’ (https://tinyco.re/
6460122). Journal of Economic Behavior
& Organization 80 (1) (September):
pp. 20–33.
11.2 HOW MARKET ORGANIZATION CAN INFLUENCE PRICES
467
short-run equilibrium An equilib-
rium that will prevail while certain
variables (for example, the number
of firms in a market) remain con-
stant, but where we expect these
variables to change when people
have time to respond to the situ-
ation.
long-run equilibrium An equilib-
rium that is achieved
when variables that were held con-
stant in the short run (for example,
the number of firms in a
market) are allowed to adjust, as
people have time to respond the
situation.
11.3 SHORT-RUN AND LONG-RUN EQUILIBRIA
When we modelled equilibrium in the market for bread in Unit 8, we
assumed that there were a fixed number of bakeries (50) in the city. We
worked out the industry supply curve by adding together the amounts of
bread each bakery would supply at each price, and then found the equilib-
rium price and quantity.
But we also saw that at the equilibrium price, the bakeries were earning
rents (their economic profits were greater than zero), providing an oppor-
tunity for other firms to benefit by entering the market. Entry of new firms
would shift market supply, leading to a new equilibrium. This is an example
of how rent-seeking can move a market to a different equilibrium in the
long run.
Figure 11.6 shows the bread market equilibrium with 50 bakeries at
point A in the right-hand panel: 5,000 loaves are sold at €2 each. The left-
hand panel shows the isoprofit and marginal cost curves for each bakery
(assuming they are identical) and the point where it produces when the
price is €2: it produces 100 loaves (where price equals marginal cost). And
we can see that at point A it is above the average cost curve, earning a posit-
ive economic profit.
The market equilibrium at point A is described as a short-run equi-
librium. The phrase ‘short-run’ is used to indicate that we are holding
something constant for now, although it might change in future. In this
case, we mean that point A is the equilibrium while the number of firms in the
market remains constant. But because firms are earning rents, we do not
expect this situation to last. Follow the steps to see what happens in the
longer run.
When the long-run equilibrium is reached at point C, the price of
bread is equal to both the marginal and the average cost (P = MC = AC), and
every bakery’s economic profit is zero.
In the long run, profits to be made in the bread market are no higher
than the profits that potential bakery owners could make by using their
assets elsewhere. And, if any owners could do better by putting their
premises to a different use (or by selling them and investing in a different
business) we would expect them to do so. Although no one would be
0
4
8
12
16
0 150 300 450 600
Total daily quantity (kg)
Av
er
ag
e
da
ily
pr
ic
e
(€
)
Figure 11.5 The aggregate price-quantity relationship in the Ancona market.
Mauro Gallegati, Gianfranco Giulioni,
Alan Kirman, and Antonio Palestrini.
2011. ‘What’s that got to do with the
price of fish? Buyers behavior on the
Ancona fish market’. Journal of Eco-
nomic Behavior & Organization 80 (1)
(September): pp. 20–33.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
468
earning more than normal profits, no one should be earning less than
normal profits either.
We can use Figure 11.6 to work out how many bakeries there will be in
the long-run equilibrium. The left-hand panel shows that the price must be
€1.52, because that is the point on the firm’s supply curve where the firm
makes normal profits (P = MC = AC), and each bakery produces 66 loaves.
From the demand curve in the right-hand panel, we can deduce that at this
price the quantity of bread sold will be 6,500 loaves. So the number of
bakeries in the market must be 6,500/66 = 98.
Notice how the short-run and long-run equilibrium differ. In the short
run, the number of firms is exogenous—it is assumed to remain constant at
50. In the long run, the number of bakeries can change through the
endogenous rent-seeking responses of firms. The number of firms in the
long-run equilibrium is endogenous—it is determined by the model.
The concepts of short- and long-run equilibria don’t have much to do
with specific periods of time, except that some variables (such as the market
price and the quantity produced by individual firms) can adjust more
0 40 80 120 160 200
A
B
C
Zero economic
profit (AC curve)
Marginal cost
curve
Isoprofit
curve: €80
Isoprofit
curve: €200
0
A
B
C
Original
supply (MC)
New
supply (MC)
Supply (MC)
in long-run
equilibrium
Demand
Pr
ic
e,
C
os
t (
€)
0
4.5
Quantity of loaves (bakery)
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
Pr
ic
e
(€
)
0
4.5
Quantity of loaves (bread market)
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
10,0008,0006,0004,0002,000
Figure 11.6 The market for bread in the short run and the long run.
1. The short-run equilibrium
Initially there are 50 bakeries. The
market is at a short-run equilibrium at
point A. The price of a loaf of bread is
€2, and the bakeries’ profits are above
the normal level. They are earning
rents, so more bakeries will wish to
enter.
2. More firms enter
When new firms enter, the supply curve
shifts to the right. The new equilibrium
is at point B. The price has fallen to
€1.75. There are more bakeries selling
more bread in total, but each one is
producing less than before and making
less profit.
3. Price is still greater than average
cost
At B, the price is still above the average
cost—bakeries are making greater-
than-normal profits. This is still only a
short-run equilibrium, because more
firms will want to enter.
4. The long-run equilibrium
More bakeries will enter, lowering the
market price, until the price is equal to
the average cost of a loaf, and bakeries
are making normal profits. The long-
run equilibrium is at point C.
11.3 SHORT-RUN AND LONG-RUN EQUILIBRIA
469
quickly than others (such as the number of firms participating in a market).
So what we mean by the short run and the long run depends on the model.
The short-run equilibrium is achieved when everyone has done the best
they can from adjusting the easily adjustable variables while the others
remain constant. The long-run equilibrium happens when these other
variables have adjusted too.
Short-run and long-run elasticities
Remember from Unit 8 that when demand for a good increases, the increase
in the quantity sold depends on the elasticity of the supply curve (that is, the
marginal cost curve). So if the demand for bread increases, a steep (inelastic)
supply curve means that the price of bread rises a lot in the short run while
the number of bakeries is fixed, with a relatively small rise in quantity. But in
the longer run, this will lead to more bakeries entering, so the price falls, and
quantity increases more. We say that, because of the possibility of entry and
exit of firms, the supply of bread is more elastic in the long run.
The distinction between the short run and the long run applies in many
economic models. Besides the number of firms in an industry, there are lots
of other economic variables that adjust slowly, and it is useful to distinguish
between what happens before and after they adjust.
In the next section, we will see another example: both the supply and the
demand for oil are more elastic in the long run, because producers can
eventually build new oil wells, and consumers can switch to different fuels
for cars or heating. What we mean by the short run in this case is the period
during which firms are limited by their existing production capacity, and
consumers by the cars and heating appliances they currently own.
QUESTION 11.3 CHOOSE THE CORRECT ANSWER(S)
Figure 11.6 (page 469) shows the market for bread in the short run,
with 50 bakeries, and in the long run when more bakeries can enter. All
bakeries are identical. Which of the following statements is correct?
The supply curve of each bakery shifts as more bakeries enter the
market.
A and B cannot be long-run equilibria, as the bakeries are making a
positive economic rent.
More bakeries will want to enter the market when C is reached.
Bakeries will want to leave the market when C is reached, because
they don’t make any profit.
•••11.4 PRICES, RENT-SEEKING, AND MARKET DYNAMICS
AT WORK: OIL PRICES
Figure 11.7 plots the real price of oil in world markets (in constant 2014 US
dollars) and the total quantity consumed globally from 1861 to 2020. To
understand what drives the large fluctuations in the oil price, we can use
our supply and demand model, distinguishing between the short run and
the long run.
We know that prices reflect scarcity. If a good becomes scarcer, or more
costly to produce, the supply will fall and price will tend to rise. For more
than 60 years, oil industry analysts have been predicting that demand
would soon outstrip supply: production would reach a peak and prices
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
470
would then rise as world reserves declined. ‘Peak oil’ is not evident in
Figure 11.7. One reason is that rising prices provide incentives for further
exploration. Between 1981 and 2014, more than 1,000 billion barrels were
extracted and consumed, yet world reserves of oil more than doubled from
roughly 680 billion barrels to 1,700 billion barrels.
Prices have risen strongly in the twenty-first century, and due to the
decline in prices from 2010 onwards, an increasing number of analysts are
predicting that conventional oil, at least, has already reached a peak. But
unconventional resources such as shale oil are now being exploited.
Perhaps it will be climate change policies, rather than resource depletion,
that eventually curb oil consumption.
What makes the price messages in Figure 11.7 hard to read is the sharp
swings from high to low and back again over short periods of time. These
fluctuations cannot be explained by looking at oil reserves, because they
reflect short-run scarcity. Both supply and demand are inelastic in the
short run.
Short-run supply and demand
On the demand side, the main use of oil products is in transport services
(air, road, and sea). Demand is inelastic in the short run because of the
limited substitution possibilities. For example, even if petrol prices rise
substantially, in the short run most commuters will continue to use their
existing cars to travel to work because of the limited alternatives
immediately available to them. So the short-run demand curve is steep.
Traditional oil extraction technology is characterized by a large up-front
investment in expensive oil wells that can take many months or longer to
construct, and once in place, can keep pumping until the well is depleted or
oil can no longer be profitably extracted. Once the well is drilled, the cost of
extracting the oil is relatively low, but the rate at which the oil is pumped
faces capacity constraints—producers can get only so many barrels per day
from a well. This means that, taking existing capacity as fixed in the short
R. G. Miller and S. R. Sorrell. 2013.
‘The Future of Oil Supply’
(https://tinyco.re/6167443). Philo-
sophical Transactions of the Royal
Society A: Mathematical, Physical
and Engineering Sciences
372 (2006) (December).
Nick A. Owen, Oliver R. Inderwildi,
and David A. King. 2010. ‘The status
of conventional world oil
Reserves—Hype or cause for
concern?’ Energy Policy 38 (8)
(August): pp. 4743–4749.
1918
End of WWI
1929 Start of Great
Depression
1945
End of WWII
1973–74
First oil
shock
1979–80
Second oil shock
1990
Dissolution
of the Soviet
Union
2008 Start of global
financial crisis
0
20
40
60
80
100
120
140
30,000
60,000
120,000
1861 1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011 2021
Year
Pr
ic
e
pe
rb
ar
re
l,
P
($
20
14
pe
rb
ar
re
l)
O
il
co
ns
um
pt
io
n
(r
at
io
sc
al
e:
th
ou
sa
nd
s
of
ba
rr
el
s)
Figure 11.7 World oil prices in constant prices (1861–2020) and global oil
consumption (1965–2020).
BP. (2021) BP Statistical Review of World
Energy 2021.
11.4 PRICES, RENT-SEEKING, AND MARKET DYNAMICS AT WORK: OIL PRICES
471
oligopoly A market with a small
number of sellers, giving each
seller some market power.
run, we should draw a short-run supply curve that is initially low and flat,
and then turns upwards very steeply as capacity constraints are hit. We also
need to allow for the oligopolistic structure of the world market for crude
oil. The Organization of Petroleum Exporting Countries (OPEC) is a cartel
with a dozen member countries that currently accounts for about 40% of
world oil production. OPEC sets output quotas for its members. We can
represent this in our supply and demand diagram by a flat marginal cost
line that stops at the total OPEC production quota. At that point, the line
becomes vertical. This is not because of capacity constraints, but because
OPEC producers will not sell any more oil.
Figure 11.8 assembles the market supply curve by adding the OPEC pro-
duction quota to the non-OPEC supply curves (remember we obtain
market supply curves by adding the amounts supplied by each producer at
each price) and combines it with the demand curve to determine the world
oil price.
Pr
ic
e,
P
P0
Quantity, Q
OPEC profits Non-OPEC
profits
Demand
SOPEC
SWORLD
SNON-OPEC
0
QOPEC
Q0
QNON-OPEC
c
Figure 11.8 The world market for oil.
1. OPEC supply
OPEC’s members can increase produc-
tion easily within their current capacity,
without increasing their marginal cost
c. OPEC quotas limit their total produc-
tion to QOPEC.
2. The non-OPEC supply
Non-OPEC countries can produce oil at
the same marginal cost c until they get
close to capacity, when their marginal
costs rise steeply.
3. World supply curve
Total world supply is the sum of pro-
duction by OPEC and other countries at
each price.
4. The equilibrium oil price
The demand curve is steep: world
demand is inelastic in the short run. In
equilibrium, the price is P0 and total oil
consumption Q0 is equal to QOPEC +
Qnon-OPEC.
5. Profit
OPEC’s profit is (P0 – c) × QOPEC, the
area of the rectangle below P0. Non-
OPEC profit is the rest of the shaded
area below P0.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
472
income elasticity of demand The
percentage change in demand that
would occur in response to a 1%
increase in the individual’s income.
The 1970s oil price shocks
In 1973 and 1974, OPEC countries imposed a partial oil embargo in
response to the 1973–4 Middle East war, and in 1979 and 1980, oil produc-
tion by Iran and Iraq fell because of the supply disruptions following the
Iranian Revolution and the outbreak of the Iran–Iraq war. These are
represented in Figure 11.9 by a leftward shift of the world supply curve
Sworld, driven by a reduction in the volume of OPEC production to Q′OPEC.
Total production and consumption falls, but because demand is very price-
inelastic, the percentage increase in price is much larger than the
percentage decrease in quantity. This is what we see in the data in Figure
11.7. The oil price (in 2014 US dollars) goes from $18 per barrel in 1973 to
$56 in 1974, and then to $106 in 1980, but the declines in world oil con-
sumption after these price shocks are small by comparison (–2% between
1973 and 1975, and –10% between 1979 and 1983).
The 2000–2008 oil price shock
The years 2000 to 2008 were a period of rapid economic growth in indus-
trializing countries, especially China and India. The income elasticity of
demand for oil and oil products is higher in these countries than in
developed market economies, and demand for car ownership and tourist air
travel is growing relatively rapidly as they become wealthier. This increase
in income moves the demand curve to the right, as shown in Figure 11.10.
In this case, it is the inelastic short-run supply curve for oil that accounts
for the big increase in price and only a modest increase in world oil con-
sumption. The sharp price decrease in 2009 has the same explanation but in
reverse: the financial crisis of 2008–9 was a negative demand shock that
moved the demand curve to the left, so world consumption fell by about
3%, and the price of crude fell from over $100 per barrel in the summer of
2008 to $40–50 in early 2009.
Pr
ic
e,
P
P0
P1
Quantity, Q
Demand
SWORLDS′WORLD
c
0
QOPEC
Q1
Q′OPEC
Q0
Figure 11.9 The OPEC oil price shocks of the 1970s: OPEC decreases output.
11.4 PRICES, RENT-SEEKING, AND MARKET DYNAMICS AT WORK: OIL PRICES
473
Pr
ic
e,
P
P0
P1
Quantity, Q
Demand
Demand′
SWORLD
c
0
QOPEC
Q1Q0
Figure 11.10 The oil price shocks of 2000–8: Economic growth increases world
demand.
EXERCISE 11.3 THE WORLD MARKET FOR OIL
Using Figure 11.10:
1. Illustrate what happens when economic growth boosts world demand
(a) in the short run
(b) in the long run as producers invest in new oil wells
(c) in the long run as consumers find substitutes for oil
2. Similarly, describe the short and long-run consequences of a negative
supply shock similar to the 1970s shock.
3. If you observed an oil price rise, how in principle could you tell whether
it was driven by supply-side or demand-side developments?
4. How would the diagram, and the response to shocks, be different if
there were:
(a) a competitive market composed of many producers?
(b) a single monopoly oil producer?
(c) an OPEC cartel controlling 100% of world oil production and
seeking to maximize the combined profits of its members?
5. Why would individual OPEC member countries have an incentive to
produce more than the quota assigned to them?
6. Does this logic carry over to the situation in the real world where there
are also non-OPEC producers?
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
474
asset Anything of value that is
owned. See also: balance sheet,
liability.
government bond A financial
instrument issued by governments
that promises to pay flows of
money at specific intervals.
bond A type of financial asset for
which the issuer promises to pay a
given amount over time to the
holder. Also known as: corporate
bonds.
EXERCISE 11.4 THE SHALE OIL REVOLUTION
An important development in the past 10 years has been the re-
emergence of the US as a major oil producer via the ‘shale oil revolution’.
Shale oil is extracted using the technology of hydraulic fracturing or
‘fracking’: injecting fluid into ground at high pressure to fracture the rock
and allow extraction. In a speech called ‘The New Economics of Oil’
(https://tinyco.re/9345243) in October 2015, Spencer Dale, group chief
economist at oil producer BP plc, explained how shale oil production
differs from traditional extraction.
1. According to Dale, how has the shale oil revolution affected the world
market for oil?
2. How will the world oil market be different in future?
3. Explain how our supply and demand diagram should be changed if his
analysis is correct.
11.5 THE VALUE OF AN ASSET: BASICS
People buy fish, hats, and fuel for their consumption value: to eat, wear, or
burn them (respectively). Markets for assets can work differently because
buyers have a second motive: not only to benefit in some way while owning
the asset, but also to be able to sell it later. So what determines the value of
an asset, whether it is real estate, an artwork, or a financial asset, such as
shares in a firm?
Remember from Unit 6 that the profits of a firm belong to its
shareholders in direct proportion to the shares that each holds. These
profits are typically divided between dividends paid directly to
shareholders, and retained earnings used to maintain and expand the firm’s
ability to generate revenues. But since the future is so uncertain, how
should these shares be valued?
Two important determinants of the value of a financial asset (also called
a security) are the size of the cash flows that it is expected to generate, and
uncertainty in one’s forecasts of these cash flows.
Bonds
It is easiest to start with an asset that promises a fixed stream of payments
at specified dates over a finite period. Suppose investors are completely
confident that the promised payments will be made. The best example of
this is a government bond issued by a country with a negligible likelihood
of default, such as the US or Switzerland (this case was analysed in the
Einstein in Unit 10).
Investors will be willing to buy and hold the asset only if its rate of
return—the future payments relative to the price at which it can be bought
or sold—compares well with interest rates on similar assets elsewhere in the
economy. The promised stream of payments is fixed, so the lower the price
of the asset, the greater will be the interest rate that it yields to a buyer. In
other words, the price of the asset will be inversely related to the interest
rate that the asset yields. If other interest rates in the economy rise, the
interest rate on bonds will have to rise too—so the price of bonds will fall.
Now consider corporate bonds, which are not risk-free. The greater
the risk of default, the higher will be the interest rate that investors demand
in order to hold the asset. If two bonds promise exactly the same stream of
11.5 THE VALUE OF AN ASSET: BASICS
475
share A part of the assets of a firm
that may be traded. It gives the
holder a right to receive a
proportion of a firm’s profit and to
benefit when the firm’s assets
become more valuable. Also known
as: common stock.
systematic risk A risk that affects
all assets in the market, so that it is
not possible for investors to reduce
their exposure to the risk by
holding a combination of dif-
ferent assets. Also known as:
undiversifiable risk.
idiosyncratic risk A risk that only
affects a small number of assets at
one time. Traders can almost
eliminate their exposure to such
risks by holding a diverse portfolio
of assets affected by different risks.
Also known as: diversifiable risk.
systemic risk A risk that threatens
the financial system itself.
market capitalization rate The rate
of return that is just high enough to
induce investors to hold shares in a
particular company. This will be
high if the company is subject to
a high level of systematic risk.
payments, the riskier one will have a lower price. Investors will earn a
higher interest rate if they buy the riskier bond and it happens not to
default, but face a greater risk that the promised payments will not all
materialize.
Stocks
Stocks (also called shares) differ from bonds in two important respects:
there is no specific promised stream of payments, and the time period over
which payments will be made is not fixed. Firms expected to generate
greater net earnings will have higher valuations, and if expectations change,
so will the value of the shares. But like bonds, their value will also depend
on interest rates elsewhere in the economy, and on how risky the earnings
are thought to be.
Risk
But how should the risk of an asset be assessed? Answering this question
requires us to understand the distinction between systematic risk and
idiosyncratic risk. The earnings of a firm may rise above or fall short of
expectations for various reasons. Some events—such as changes in trade
policy, interest rates, or economy-wide demand for goods and services —
simultaneously affect broad classes of financial assets. Other events—such
as a successful drug trial, or lawsuit alleging safety problems for a vehicle—
affect only the specific firms that stand to lose or gain. The first source of
risk is called systematic or undiversifiable, the second idiosyncratic or
diversifiable.
A third type of risk, systemic risk, usually refers to risks that threaten
the financial system itself. We will examine examples of systemic risk, such
as the 2008 financial crisis, in Unit 17.
An important insight in the economics of finance is that diversifiable
risk is essentially irrelevant in the valuation of securities, because investors
can almost eliminate it by constructing portfolios that contain a large
number of assets, each of which has a very small weight. In any given period
some of the firms in the portfolio will experience positive shocks, and some
negative, but as long as shocks are truly idiosyncratic, they will tend to
cancel each other out and the portfolio itself will be largely unaffected.
Systematic risk is different. It arises from shocks that affect large classes
of securities simultaneously and cannot be diversified away. Different firms
are exposed to different levels of systematic risk, depending on the degree
to which their earnings are correlated with those of the market as a whole.
For example, the earnings of Ford or Chrysler are heavily dependent on
economic conditions in the economy as a whole, since people postpone
purchases of cars during economic downturns. In contrast, utility
companies providing gas and electricity to residential customers are
sheltered from such risks since energy consumption is not very sensitive to
economic conditions.
Investors will demand higher average returns from shares in companies
with high levels of systematic risk, since their earnings will tend to be
volatile in ways that cannot be easily diversified away. The rate of return
that will induce investors to buy shares in a company is sometimes called
the required rate of return, or the market capitalization rate. Ceteris
paribus, this rate will be higher for companies subject to greater systematic
risk. So for any given beliefs about expected future earnings, share values
will be higher for companies with lower market capitalization rates.
This insight was developed by
William Sharpe, John Lintner, and
others in the 1960s, building on
prior work by Harry Markowitz.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
476
fundamental value of a share The
share price based on anticipated
future earnings and the level of
risk.
speculation Buying and selling
assets in order to profit from an
anticipated change in their price.
Trading strategies
The share price computed from such considerations—anticipated future
earnings and the level of systematic risk—is sometimes called the
fundamental value of a share or security. Many institutional investors,
including actively managed mutual funds and some hedge funds, adopt
trading strategies based on buying assets that they perceive to be priced
below their fundamental values, and selling those that are overpriced
relative to fundamentals.
However, there are other trading strategies that are not based on an
assessment of fundamental value at all. For instance, some traders look for
evidence of momentum in asset prices, buying because they expect prices to
rise further, or selling because they expect prices to fall. An investor might
be willing to pay more than the fundamental value of a security if she
believes that the price will rise even further above this value. In this case,
the buyer could make a gain by buying at a low price and selling at a higher
price, even if the fundamental value of the security had not changed.
Buying and selling assets based on an assessment of their fundamental
values is a form of speculation, motivated by a belief that prices will soon
return to their fundamental values. Buying and selling based on perceived
momentum is also an example of speculation, motivated by a belief that
short-run trends have a degree of persistence. These strategies, and many
others, are present in modern financial markets. They determine the
behaviour of prices, and the possibility of bubbles and crashes (as we shall
see in later sections).
HOW ECONOMISTS LEARN FROM FACTS
The wisdom of crowds: The weight of stock (oxen) and the value
of stocks
What is the right price for, say, a share in Facebook? Would it be better
for the price to be set by economic experts, rather than determined in
the market by the actions of millions of people, few of whom have expert
knowledge about the economy or the company’s prospects?
Economists are far from understanding the details of how this
mechanism actually works. But an important insight comes from an
unusual source: a guessing game played in 1907 at an agricultural fair in
Plymouth, England. Attendees at the fair were presented with a live ox.
For sixpence (2.5p), they could guess the ox’s ‘dressed’ weight, meaning
how much saleable beef could be obtained. The entrant whose answer
written on a ticket came closest to the answer would win the prize.
The polymath Francis Galton later obtained the tickets associated
with that contest. He found that a player chosen at random missed the
correct weight by an average of 40 lbs. But what he called the ‘vox populi’
or ‘voice of the people’—the median value of all the guesses—was
remarkably close to the true value, deviating by only 9 lbs (less than 1%).
The insight that is relevant to economics is that the average of a large
number of not-very-well-informed people is often extremely accurate. It
is possibly more accurate than the estimate of an experienced veterin-
arian or ox breeder.
Galton’s use of the median to aggregate the guesses meant that vox
populi was the voice of the (assumed) most informed player but it was the
guesses of all the others that picked out this most informed player.
11.5 THE VALUE OF AN ASSET: BASICS
477
Vox populi was obtained by taking all of the information available,
including the hunches and fancies that drove outliers high or low.
Galton’s result is an example of the ‘Wisdom of the Crowd’. This
concept is particularly interesting for economists because it contains, in
a stylized format, many of the ingredients that go into a good price
mechanism.
As Galton himself noted, the guessing game had a number of features
contributing to the success of vox populi. The entry fee was small, but not
zero, allowing many to participate, but deterring practical jokers.
Guesses were written and entered privately, and judgements were
uninfluenced ‘by oratory and passion’. The promise of a reward focused
the attention.
Although many participants were well informed, many were less so
and, as Galton noted, were guided by others at the fair and their
imagination. Galton’s choice of the median value would reduce (but not
eliminate) the influence of these less-informed guessers, preventing indi-
vidual wild guesses (say, those 10 times the true value) from pulling the
vox populi away from the views of the group as a whole.
The stock market represents another expression of vox populi, where
people guess at the value of a company, often but not always quite
accurately tracking changes in the quality of management, technology,
or market opportunities.
The wisdom of crowds also explains the success of prediction
markets. The Iowa Electronic Markets (https://tinyco.re/4856966), run
by the University of Iowa, allows individuals to buy and sell contracts
that pay off depending on who wins an upcoming election. The prices of
these assets pool the information, hunches, and guesses of large numbers
of participants. Such prediction markets–often called political stock
markets—can provide uncannily accurate forecasts of election results
months in advance, sometimes better than polls and even poll-
aggregation sites. Other prediction markets allow thousands of people to
bet on such events as who will win the Oscar for best female lead. It was
even proposed to create a prediction market for the next occurrence of a
major terrorist attack in the US.
QUESTION 11.4 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements is correct?
The fundamental value of the shares in a firm is determined by
expected future profits and systematic risk.
If there is no new information regarding the future profitability or
systematic risk of a firm, but its share price keeps rising, the
fundamental value must be increasing.
Buying a share at a price above its fundamental value in the hope
that someone else would buy it from you at an even higher price is
guaranteed to lose money.
All investors always agree on the fundamental value of the shares
in a firm.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
478
secondary and primary markets
The primary market is where goods
or financial assets are sold for the
first time. For example, the initial
sale of shares by a company to an
investor (known as an initial public
offering or IPO) is on the primary
market. The subsequent trading of
those shares on the stock exchange
is on the secondary market. The
terms are also used to describe the
initial sale of tickets (primary
market) and the secondary market
in which they are traded.
stock exchange A financial
marketplace where shares (or
stocks) and other financial assets
are traded. It has a list of
companies whose shares are
traded there.
11.6 CHANGING SUPPLY AND DEMAND FOR FINANCIAL
ASSETS
When a company sells new shares (or stocks) to the public for the first time,
this is called an initial public offering (IPO). After that, the shares are traded
on the stock exchange. This is called trading on the secondary market.
Prices in trading in secondary markets are constantly changing. The
graph in Figure 11.11 shows how News Corp’s (NWS) share price on the
Nasdaq stock exchange fluctuated over one day in May 2014 and, in the
lower panel, the number of shares traded at each point. Soon after the
market opened at 9.30 a.m., the price was $16.66 per share. As investors
bought and sold shares through the day, the price reached a low point of
$16.45 at both 10 a.m. and 2 p.m. By the time the market closed, with the
share price at $16.54, nearly 556,000 shares had been traded.
At any time when the market for shares in News Corp is open, each of the
existing shareholders has a reservation price, namely the least price at which
the shareholder would be willing to sell. Others are in the market to buy, as
long as they can find an acceptable price. As traders’ beliefs about the
profitability of News Corp change, their willingness to buy and sell changes.
To see how the prices of financial assets are affected by such shifts in
demand and supply, follow the steps in Figure 11.12. The curves show the
hourly volume of shares that would be demanded and supplied at each price.
9:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00 13:30 14:00 14:30 15:00 15:30
16.30
16.40
16.50
16.60
16.70
Sh
ar
e
pr
ic
e
($
)
9:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00 13:30 14:00 14:30 15:00 15:30
0
35
70
105
140
Time of day
Vo
lu
m
e
tr
ad
ed
(t
ho
us
an
ds
)
Figure 11.11 News Corp’s share price and volume traded (7 May 2014).
Bloomberg L.P. (https://tinyco.re/
9335006), accessed 28 May 2014.
11.6 CHANGING SUPPLY AND DEMAND FOR FINANCIAL ASSETS
479
limit order An announced price
and quantity combination for an
asset, either to be sold or bought.
order book A record of limit orders
placed by buyers and sellers, but
not yet fulfilled.
In practice, stock markets don’t operate in fixed time periods, such as an
hour. Trade takes place continuously and prices are always changing,
through a trading mechanism known as a continuous double auction.
Anyone wishing to buy can submit a price and quantity combination
known as a limit order. For instance, a limit order to buy 100 shares in News
Corp at a price of $16.50 per share indicates that the buyer commits to
buying 100 shares, as long as they can be obtained at a price no greater than
$16.50 per share. This is the buyer’s reservation price. Similarly, a limit sell
order indicates a commitment to sell a given quantity of shares, as long as the
price is no less than the amount specified (the seller’s reservation price).
When a limit buy order is placed, one of two things can happen. If a
previously placed limit sell order exists that has not yet been filled, and it
offers the required number of shares at a price that is at or below the
amount indicated by the buyer, a trade occurs. If there is no such order
available, then the limit order is placed in what is called an order book
(which is really just an electronic record), and becomes available to trade
against new sell orders that arrive.
Orders to buy are referred to as bids, and orders to sell as asks. The order
book lists bids in decreasing order of price, and asks in increasing order.
The top of the book for shares in NWS at around midday on 8 May 2014
looked like the table in Figure 11.13.
0
0
16.50
6 7
16.65
Demand curve
New demand curve
Fall in supply
Rise in demand
A
B
Supply curve
New supply curve
Volumes of shares traded per hour (thousands)
Sh
ar
e
pr
ic
e
($
)
Figure 11.12 Good news about profitability.
1. The initial equilibrium
Initially the market is in equilibrium at
A: 6,000 shares are sold per hour at a
price of $16.50.
2. Good news about profitability
Some good news about the future
profitability of News Corp simul-
taneously shifts the demand curve …
3. Good news about profitability
… and the supply curve.
4. A new equilibrium
The new temporary market equilibrium
is at B. The price has risen from $16.50
to $16.65. In this illustration, demand
changes more than supply, so volume
rises too.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
480
Watch our video in which Rajiv
Sethi, one of the authors of this unit,
demonstrates how orders are
processed in a continuous double
auction. https://tinyco.re/9802311
Given this situation, a buy order for 100 shares at $16.57 would remain
unfilled and would enter the book at the top of the bid column. However, a
bid for 600 shares at $16.60 would be filled immediately, since it can be
matched against existing limit sell orders. 500 shares would trade at $16.59
apiece, and 100 shares would trade at $16.60. Whenever a buy order is
immediately filled, trade occurs at the best possible price for the buyer (the ask
price). Similarly, if a sell order is placed and immediately filled from existing
orders, trade occurs at the best possible price for the seller (the bid price).
We can now see how prices in such a market change over time. Someone
who receives negative news about News Corp, such as a rumour that a
board member is about to resign, and believes this information has not yet
been incorporated into the price, may place a large sell order at a price
below $16.56, which will immediately trade against existing bids. As these
trades occur, bids are removed from the order book and the price of the
stock declines. Similarly, in response to good news, orders to buy at prices
above the lowest ask will trade against existing sell orders, and transactions
will occur at successively increasing prices.
Since the price fluctuates, it is not easy to think of this market as being
in equilibrium. But it is nevertheless the case that the price is always
adjusting to reconcile supply and demand and hence clear the market.
Financial assets provide another example of markets equilibrating
through economic rent-seeking:
• Those who believe they will benefit from buying News Corp shares at a
particular price lodge a bid at that price.
• Those who believe they will benefit by selling lodge an ask at a particular
price.
• The price at any moment reflects the aggregate outcome of the rent-
seeking behaviour of all the actors in the market—including those who
are simply holding on to their shares.
EXERCISE 11.5 SUPPLY AND DEMAND CURVES
1. Use the data from the NWS order book in Figure 11.13 to plot supply
and demand curves for shares.
2. Explain why the two curves do not intersect.
Bid Ask
Price ($) Quantity Price ($) Quantity
16.56 400 16.59 500
16.55 400 16.60 700
16.54 400 16.61 800
16.53 600 16.62 500
16.52 200 16.63 500
Figure 11.13 A continuous double auction order book: Bid and ask prices for News
Corp (NWS) shares.
Yahoo Finance (https://tinyco.re/
6764389), accessed 8 May 2014.
11.6 CHANGING SUPPLY AND DEMAND FOR FINANCIAL ASSETS
481
commodities Physical goods
traded in a manner similar to
stocks. They include metals such as
gold and silver, and agricultural
products such as coffee and sugar,
oil and gas. Sometimes more
generally used to mean anything
produced for sale.
asset price bubble Sustained and
significant rise in the price of an
asset fuelled by expectations of
future price increases.
QUESTION 11.5 CHOOSE THE CORRECT ANSWER(S)
The figure shows an order book for News Corp shares. Which of the
following statements about this order book is correct?
Bid Ask
Price ($) Quantity Price ($) Quantity
16.56 400 16.59 500
16.55 400 16.60 700
16.54 400 16.61 800
16.53 600 16.62 500
16.52 200 16.63 500
A buyer wants 500 shares at $16.59.
A limit buy order at $16.56 means that the buyer would pay at least
$16.56 per share.
A limit sell order for 100 shares at $16.58 will be unfilled.
A limit buy order for 600 shares at $16.59 will be filled with 500
shares bought at $16.59 and the remaining 100 shares at $16.60.
11.7 ASSET MARKET BUBBLES
The flexibility demonstrated by News Corp stock prices is common in
markets for other financial assets such as government bonds, currencies
under floating exchange rates, commodities such as gold, crude oil and
corn, and tangible assets such as houses and works of art.
But share prices are not only volatile hour-by-hour and day-by-day.
They can also display large swings, often referred to as bubbles. Figure
11.14 shows the value of the Nasdaq Composite Index between 1995 and
2004. This index is an average of prices for a set of stocks, with companies
weighted in proportion to their market capitalization. The Nasdaq
Composite Index at this time included many fast-growing and hard-to-
value companies in technology sectors.
The index began the period at less than 750, and rose in five years to
more than 5,000 with a remarkable annualized rate of return of around
45%. It then lost two-thirds of its value in less than a year, and eventually
bottomed out at around 1,100, almost 80% below its peak. The episode has
come to be called the tech bubble.
Information, uncertainty, and beliefs
The term bubble refers to a sustained and significant departure of the price
of any asset (financial or otherwise) from its fundamental value.
Sometimes, new information about the fundamental value of an asset is
quickly and reliably expressed in markets. Changes in beliefs about a firm’s
future earnings growth result in virtually instantaneous adjustments in its
share price. Both good and bad news about patents or lawsuits, the illness
or departure of important personnel, earnings surprises, or mergers and
acquisitions can all result in active trading—and swift price movements.
Because stock price movements often reflect important information
about the financial health of a firm, traders who lack this information can
try to deduce it from price movements. Using Hayek’s language, changes in
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
482
momentum trading Share trading
strategy based on the idea that
new information is not
incorporated into prices instantly,
so that prices exhibit positive cor-
relation over short periods.
prices are messages containing information. If markets are to work well,
traders must respond to these messages. But when they interpret a price
increase as a sign of further price increases (momentum trading
strategies) the result can be self-reinforcing cycles of price increases,
resulting in asset price bubbles followed by sudden price declines, called
crashes.
Three distinctive and related features of markets may give rise to
bubbles:
• Resale value: The demand for the asset arises both from the benefit to its
owner (for example, the flow of dividends from a stock, or the
enjoyment of having a painting by a well-known artist in your living
room) and because it offers the opportunity for speculation on a change
in its price. Similarly, a landlord may buy a house both for the rental
income and also to create a capital gain by holding the asset for a period
of time and then selling it. People’s beliefs about what will happen to
asset prices differ, and change as they receive new information or
believe others are responding to new information.
• Ease of trading: In financial markets, the ease of trading means that you
can switch between being a buyer and being a seller if you change your
mind about whether you think the price will rise or fall. Switching
between buying and selling is not possible in markets for ordinary goods
and services, where sellers are firms with specialized capital goods and
skilled workers, and buyers are other types of firms, or households.
• Ease of borrowing to finance purchases: If market participants can borrow
to increase their demand for an asset that they believe will increase in
price, this allows an upward movement of prices to continue, creating
the possibility of a bubble and subsequent crash.
0
1,500
3,000
4,500
6,000
Jan 95 Jan 96 Jan 97 Jan 98 Jan 99 Jan 00 Jan 01 Jan 02 Jan 03 Jan 04
Date
D
ai
ly
cl
os
in
g
va
lu
e
Figure 11.14 The tech bubble: Nasdaq Composite Index (1995–2004).
Yahoo Finance (https://tinyco.re/
6764389), accessed 14 January 2014.
11.7 ASSET MARKET BUBBLES
483
Eugene Fama, quoted in ‘Interview
with Eugene Fama’
(https://tinyco.re/0438887), The
New Yorker. (2010).
Tim Harford. 2012. ‘Still Think You
Can Beat the Market?’
(https://tinyco.re/7063932). The
Undercover Economist. Updated 24
November 2012.
If the efficient market hypothesis is
accurate, how could the 2008 fin-
ancial crisis happen? Robert Lucas
on Fama’s efficient market
hypothesis: Robert Lucas. 2009. ‘In
Defence of the Dismal Science’
(https://tinyco.re/6052194). The
Economist. Updated 6 August
2009.
These words have become popular. I don’t think they have any
meaning … It’s easy to say prices went down, it must have been a
bubble, after the fact. I think most bubbles are twenty-twenty
hindsight. Now after the fact you always find people who said
before the fact that prices are too high. People are always saying
that prices are too high. When they turn out to be right, we anoint
them. When they turn out to be wrong, we ignore them. They are
typically right and wrong about half the time.
One thing we are not going to have, now or ever, is a set of models
that forecasts sudden falls in the value of financial assets, like the
declines that followed the failure of Lehman Brothers in
September. This is nothing new. It has been known for more than
40 years and is one of the main implications of Eugene Fama’s
efficient-market hypothesis … If an economist had a formula that
could reliably forecast crises a week in advance, say, then that
formula would become part of generally available information and
prices would fall a week earlier.
WHEN ECONOMISTS DISAGREE
Do bubbles exist?
The price movements in Figure 11.14 (and Figure 11.20 in the next
section), give the impression that asset prices can swing wildly, bearing
little relation to the stream of income that might reasonably be expected
from holding them.
But do bubbles really exist, or are they an illusion based only on
hindsight? In other words, is it possible to know that a market is
experiencing a bubble before it crashes? Perhaps surprisingly, some
prominent economists working with financial market data disagree on
this question. They include Eugene Fama and Robert Shiller, two of the
three recipients of the 2013 Nobel Prize.
Fama denies that the term ‘bubble’ has any useful meaning at all:
This is an expression of what economists call the efficient market
hypothesis, which claims that all generally available information about
fundamental values is incorporated into prices virtually instantaneously.
Robert Lucas—another Nobel laureate, firmly in Fama’s camp—
explained the logic of this argument in 2009, in the middle of the finan-
cial crisis:
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
484
Brunnermeier argues Lucas was
right to emphasize that financial
market frictions are a counter-
argument to the efficient market
hypothesis: Markus Brunnermeier.
2009. ‘Lucas Roundtable: Mind the
Frictions’ (https://tinyco.re/
0136751). The Economist. Updated
6 August 2009.
Robert J. Shiller. 2003. ‘From Effi-
cient Markets Theory to Behavioral
Finance’ (https://tinyco.re/
3989503). Journal of Economic
Perspectives 17 (1) (March):
pp. 83–104.
Burton G. Malkiel. 2003. ‘The Effi-
cient Market Hypothesis and Its
Critics’ (https://tinyco.re/4628706).
Journal of Economic Perspectives
17 (1) (March): pp. 59–82.
The classic examination of bubbles
was made by John Maynard Keynes
in Chapter 12 of his General
Theory. John Maynard Keynes.
1936. The General Theory of
Employment, Interest and Money
(https://tinyco.re/6855346).
London: Palgrave Macmillan.
Of course, as Bob Lucas points out, when it is commonly known
among all investors that a bubble will burst next week, then they
will prick it already today. However, in practice each individual
investor does not know when other investors will start trading
against the bubble. This uncertainty makes each individual
investor nervous about whether he can be out of (or short) the
market sufficiently long until the bubble finally bursts.
Consequently, each investor is reluctant to lean against the wind.
Indeed, investors may in fact prefer to ride a bubble for a long
time such that price corrections only occur after a long delay, and
often abruptly. Empirical research on stock price predictability
supports this view. Furthermore, since funding frictions limit
arbitrage activity, the fact that you can’t make money does not
imply that the ‘price is right’.
This way of thinking suggests a radically different approach for
the future financial architecture. Central banks and financial
regulators have to be vigilant and look out for bubbles, and should
help investors to synchronize their effort to lean against asset
price bubbles. As the current episode has shown, it is not sufficient
to clean up after the bubble bursts, but essential to lean against the
formation of the bubble in the first place.
Responding to Lucas, Markus Brunnermeier explains why this argument
is not watertight:
Shiller has argued that relatively simple and publicly observable
statistics, such as the ratio of stock prices to earnings per share, can be
used to identify bubbles as they form. Leaning against the wind by
buying assets that are cheap based on this criterion, and selling those
that are dear, can result in losses in the short run, but long-term gains
that, in Shiller’s view, exceed the returns to be made by simply investing
in a diversified basket of securities with similar risk attributes.
In collaboration with Barclays Bank, Shiller has launched a product
called an exchange-traded note (ETN) that can be used to invest in
accordance with his theory. This asset is linked to the value of the
cyclically adjusted price-to-earnings (CAPE) ratio, which Shiller believes
is predictive of future prices over long periods. So this is one economist
who has put his money where his mouth is: you can follow the
fluctuation of Shiller’s index on Barclays Bank’s website
(https://tinyco.re/7309155).
11.7 ASSET MARKET BUBBLES
485
irrational exuberance A process by
which assets become overvalued.
The expression was first used by
Alan Greenspan, then chairman of
the US Federal Reserve Board, in
1996. It was popularized as an eco-
nomic concept by the economist
Robert Shiller.
So there are two quite different interpretations of the ‘tech bubble’ episode
in Figure 11.14:
• Fama’s view: Asset prices throughout the episode were based on the best
information available at the time and fluctuated because information
about the prospects of the companies was changing sharply. In John
Cassidy’s 2010 interview with Fama in The New Yorker, he describes
many of the arguments for the existence of bubbles as ‘entirely sloppy’.
• Shiller’s view: Prices in the late 1990s had been driven up simply by
expectations that the price would still rise further. He called this
‘irrational exuberance’ among investors. The first chapter of his book
Irrational Exuberance explains the idea.
EXERCISE 11.6 MARKETS FOR GEMS
A New York Times article (https://tinyco.re/6343875), describes how the
worldwide markets for opals, sapphires, and emeralds are affected by
discoveries of new sources of gems.
1. Explain, using supply and demand analysis, why Australian dealers
were unhappy about the discovery of opals in Ethiopia.
2. What determines the willingness to pay for gems? Why do Madagascan
sapphires command lower prices than Asian ones?
3. Explain why the reputation of gems from particular sources might
matter to a consumer. Shouldn’t you judge how much you are willing to
pay for a stone by how much you like it yourself?
4. Do you think that the high reputation of gems from particular origins
necessarily reflects true differences in quality?
5. Could we see bubbles in the markets for gems?
QUESTION 11.6 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements about bubbles is correct?
A bubble occurs when the fundamental value of a share rises too
quickly.
A bubble is less likely to occur in a market where people can easily
switch from buying to selling.
Momentum trading strategies make bubbles more likely to occur.
Bubbles can only occur in financial markets.
•11.8 MODELLING BUBBLES AND CRASHES
We have seen that bubbles could occur in markets for financial assets because
demand depends, in part, on expectations about the prices at which they may
be resold in future. This argument might also apply to durable goods—such as
houses, paintings, and ‘collectibles’ like vintage cars or stamps. Can we apply
our model of price-taking buyers and sellers to such markets?
Figure 11.15 illustrates the supply and demand for shares in a (so far)
hypothetical firm called the Flying Car Corporation (FCC). Initially the
share price is $50 on the lowest demand curve. When potential traders and
investors receive good news about expected future profitability, the
John Cassidy. 2010. ‘Interview with
Eugene Fama’ (https://tinyco.re/
4647447). The New Yorker.
Updated 13 January 2010.
Robert J. Shiller. 2015. Irrational
Exuberance, Chapter 1
(https://tinyco.re/4263463).
Princeton, NJ: Princeton University
Press.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
486
positive feedback (process) A
process whereby some initial
change sets in motion a process
that magnifies the initial change.
See also: negative feedback
(process).
demand curve shifts to the right, and the price increases to $60 (for
simplicity, we assume that the supply curve doesn’t move).
Initially the exogenous rise in demand has the same effect as in the
markets for bread and hats. Follow the steps in Figure 11.15 to see what
happens next.
The sequence of events in Figure 11.15 can happen if individuals interpret
a price rise to mean that other people have received news that they hadn’t
heard themselves, and adjust their own expectations upwards. Or they may
think there is an opportunity for speculation: to buy the stock now and sell to
other buyers at a profit later. Either way, the initial increase in demand
creates a positive feedback, leading to further increases in demand.
This does not happen in the bread market. People do not respond to a rise
in bread price by buying more bread and filling their freezer. To model mar-
kets for assets like shares, paintings, or houses, we need to allow for the
additional effects of beliefs about future prices. Figure 11.16 contrasts two
alternative scenarios following an exogenous shock of good news about
future profits of FCC that raises the price from $50 to $60 as in Figure 11.15.
In the left-hand panel, beliefs dampen price rises: some market
participants respond to the initial price rise with scepticism about whether
the fundamental value of FCC is really $60, so they sell shares, taking a
Volume of trade
0
50
0
60
70
80
Demand curve
Demand curve 2
Demand curve 3
Demand curve 4 Supply curve
Initial good news
Response to initial price rise
Response to further price rise
Sh
ar
e
pr
ic
e
($
)
Figure 11.15 The beginning of a bubble in FCC shares.
1. The initial price
Initially the price of a share in a firm
called the Flying Car Corporation (FCC)
is $50 on the lowest demand curve.
2. The response to good news
When potential traders and investors
receive good news about expected
future profitability, the demand curve
shifts to the right, and the price
increases to $60.
3. The effect of a price rise
Observing the price rise, potential
buyers treat it as further good news.
The demand curve shifts up simply
because the price has increased, and
the price rises again to $70.
4. The beginning of a bubble
This further rise may lead to another
shift in demand, continuing the process.
11.8 MODELLING BUBBLES AND CRASHES
487
stable equilibrium An equilibrium
in which there is a tendency for the
equilibrium to be restored after it is
disturbed by a small shock.
profit from the higher price. This behaviour reduces the price and it falls to
a value somewhat above its initial level, where it stabilizes. The news has
been incorporated into a price between $50 and $60, reflecting the aggreg-
ate of beliefs in the market about the new fundamental value of FCC.
By contrast, in the right panel beliefs amplify price rises. When demand
rises, others believe that the initial rise in price signals a further rise in
future. These beliefs produce an increase in the demand for FCC shares.
Other traders see that those who bought more shares in FCC benefited as
its price rose and so they follow suit. A self-reinforcing cycle of higher
prices and rising demand takes hold.
If beliefs dampen price changes and restore the market to equilibrium
after a price shock, we say that the equilibrium is stable. Figure 11.17 shows
how we can model the process of price adjustment in the case of a stable equi-
librium. The left-hand panel shows supply and demand curves for FCC
shares, with an equilibrium price P0 corresponding to their fundamental
value. The right-hand panel shows the relationship between prices in suc-
cessive periods of time, called the price dynamics curve (PDC). If Pt, the price in
period t, is equal to P0, then the price in the next period, Pt+1, will be the same,
because at the equilibrium there is no tendency for change. But if the current
price Pt is not at the equilibrium, the PDC shows what the price will be in the
next period. Follow the steps in Figure 11.7 to see how, with a PDC like the
one shown here, the market will return to equilibrium after a shock.
In Figure 11.17, the PDC is flatter than the 45° line, so when the price is
above the equilibrium, it will adjust downwards again until equilibrium is
restored. This PDC represents the case in which beliefs about the
fundamental value of the asset dominate any tendency to interpret the price
rise as a signal of further price rises.
Let’s now suppose that following the initial increase in the share price
P1, demand increases: shares in FCC are now seen as a better investment.
Even if everyone knows that the fundamental value of the shares is still P0,
some people believe that the price will continue to rise for some time. If the
conviction takes hold that the price will increase further, then owning more
shares is a good strategy. There will be a capital gain from holding them
because they can be sold later for more than the price paid to acquire them.
Others believe P
has risen above
its fundamental
value
Good news
about future
profits
Demand rises
P↑
Price falls to a
level somewhat
above its initial
level and
stabilizes
Others believe
the rise in P
signals it will
rise further
Good news
about future
profits
Demand rises
P↑
As a result,
demand goes
up and P
rises further
Beliefs dampen price rises Beliefs amplify price rises:
a bubble
Figure 11.16 Positive vs negative feedback.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
488
unstable equilibrium An equilib-
rium such that, if a shock disturbs
the equilibrium, there is
a subsequent tendency to move
even further away from the equilib-
rium.
In this case, as shown in the left-hand panel of Figure 11.18, the higher
price shifts the demand curve to the right. In the right-hand panel, the PDC
is steeper than the 45° line. This tells us that the price next period is further
from the equilibrium at P0 than the price this period. This PDC represents
the case of an unstable equilibrium.
In the next period the price rises again. In a self-reinforcing bubble, this
process can continue indefinitely—at least until something happens to
change the expectation of continuously rising prices (and of a growing
deviation of the price from its fundamental value).
Instability caused by self-reinforcing price expectations can only happen
in markets for goods that can be resold, like financial assets or durable
goods. There is no point buying more vegetables, fish, or fashion items in
the hope of making a capital gain on them, because the fish and vegetables
will rot, and fashions will change. However, in the markets for tulip bulbs in
the seventeenth century, office space in Tokyo in the late 1980s, and houses
in Las Vegas in the 2000s (see Exercise 11.10), people continued buying as
prices rose, accelerating prices further, because they expected to benefit by
reselling the asset.
In Unit 17 we will use a model with a price dynamics curve to look at
the role of the housing market in the financial crisis of 2008. In Unit 20, a
similar model helps explain how humans interact with the natural environ-
ment and why in some situations we observe both stabilizing processes and
vicious circles of runaway environmental collapse.
Q1 Q0
Supply
Price unchanged
from year to year
Demand0
Excess supply
P2
P0
P0 P3 P2 P1
45º
P1
P0
Quantity, Q
Pr
ic
e,
p
er
io
d
t +
1
Pr
ic
e,
P
Price, period t
Price
dynamics
curve,
PDC
Price shock
Figure 11.17 A stable equilibrium in the market for FCC shares.
1. The equilibrium price
The left-hand panel shows the supply
and demand curves in a market where
the equilibrium price is P0. The 45° line
on the right shows that when the price
in period t is P0, the price in period t + 1
will be the same. There is no tendency
to change.
2. A price shock
Suppose that, following a temporary
blip in demand for shares, the price in
this market is P1. There is excess
supply.
3. The price adjusts
The PDC shows that if the price this
period is P1, then it will be P2 next
period.
4. Beliefs dampen prices
Since the PDC is flatter than the 45°
line, P2 is closer to the equilibrium than
P1. Investors are influenced by their
beliefs about the fundamental value of
FCC, which is P0.
5. Moving back to equilibrium
Prices get closer to P0. The process
continues until equilibrium is regained.
11.8 MODELLING BUBBLES AND CRASHES
489
How do bubbles come to an end?
A bubble bursts when some participants in the market perceive a danger that
the price will fall. Then would-be buyers hold back, and those who hold the
assets will try to get rid of them. The process in Figure 11.15 is reversed.
Figure 11.19 uses the supply and demand model to illustrate what happens. At
the top of the bubble the shares trade at $80. Both the supply and demand
curves shift when the bubble bursts, and the price collapses from $80 to $54—
leaving those who owned shares when the price was $80 with large losses.
If the price of an asset has been driven up solely by beliefs about future price
rises, there should be opportunities for those who are well informed about the
value to profit from their superior information. So if the rise in the Nasdaq
index in Figure 11.14 was indeed a bubble, why did those who identified it as a
bubble fail to profit by placing gigantic bets on a major price decline?
Leibniz: Price bubbles
(https://tinyco.re/L110801)
Q0
P1
P0
Supply
Price
unchanged
from year
to year
Demand0 Demand1
P1
P0
P0 P3P2P1
45º Price shock
Price
dynamics
curve,
PDC
Quantity, Q
Pr
ic
e,
p
er
io
d
t +
1
Pr
ic
e,
P
Price, period t
Figure 11.18 An unstable equilibrium.
Volume of trade
Sh
ar
e
pr
ic
e
($
)
0
80
54
0
Supply curve
New supply curve
New demand curve
Increased supply
Demand curve
Fall in demand
Figure 11.19 The collapse of FCC’s share price.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
490
short selling The sale of an asset
borrowed by the seller, with the
intention of buying it back at a
lower price. This strategy is
adopted by investors expecting the
value of an asset to decrease. Also
known as: shorting.
0
8,000
16,000
24,000
32,000
40,000
48,000
56,000
64,000
Jan
13
Sep
13
Ma
y 1
4
Jan
15
Sep
15
Ma
y 1
6
Jan
17
Sep
17
Ma
y 1
8
Jan
19
Sep
19
Ma
y 2
0
Jan
21
Sep
21
Date
Bi
tc
oi
n
pr
ic
e
($
)
Figure 11.20 The value of Bitcoin (2013–2021).
Coindesk.com. 2021. Bitcoin News,
Prices, Charts, Guides & Analysis
(https://tinyco.re/8792662) and
Bitcoincharts (https://tinyco.re/
4434190). Both accessed October 2021.
As it happens, many large investors did ‘lean against the wind’ by placing
bets on the bubble bursting, including some well-known fund managers on
Wall Street. They did so by selling short (shorting): borrowing shares at
the current high price and immediately selling them, with the intention of
buying them back cheaply (to return to the owner) after the price crashed.
But this is an extremely risky strategy, since it requires accuracy in timing
the crash—if prices continue to rise, the losses can become unsustainable.
You may be right about the bubble but if you get the timing wrong, then
when you are due to buy the shares and return them to the owner, the price
is higher than it was when you sold them. You will make a loss and may not
be able to repay your loan.
Indeed, many of those buying an asset may also be convinced of an
eventual crash, but hoping to exit the market before it happens. This was
the case during the tech bubble when Stanley Druckenmiller, manager of
the Quantum Fund with assets of $8 billion, held shares in technology
companies that he knew were overvalued. After prices collapsed and
inflicted significant losses on the fund, he used a baseball metaphor to
describe his error. ‘We thought it was the eighth inning, and it was the
ninth,’ he explained, ‘I overplayed my hand.’
EXERCISE 11.7 WHAT IS THE FUNDAMENTAL VALUE OF A BITCOIN?
A bubble may have occurred in the market for the virtual currency called
Bitcoin. Bitcoin was introduced by a group of software developers in 2009.
Where it is accepted, it can be transferred from one person to another as
payment for goods and services.
Unlike other currencies it is not controlled by a single entity such as a
central bank. Instead it is ‘mined’ by individuals who lend their computing
power to verify and record Bitcoin transactions in the public ledger. At the
start of 2013, a Bitcoin could be purchased for about $13. On 4 December
2013 it was trading at $1,147. It then lost more than half its value in two
weeks. These and subsequent price swings are shown in Figure 11.20.
Use the models in this section, and the arguments for and against the
existence of bubbles, to provide an account of the data in Figure 11.20.
11.8 MODELLING BUBBLES AND CRASHES
491
EXERCISE 11.8 THE BIG TEN ASSET PRICE BUBBLES OF THE LAST 400
YEARS
According to Charles Kindleberger, an economic historian, asset price
bubbles have occurred across a wide variety of countries and time periods.
The bubbles of the last 100 years have predominantly been focused on
real estate, stocks, and foreign investment.
• 1636: The Dutch tulip bubble
• 1720: The South Sea Company
• 1720: The Mississippi Scheme
• 1927–29: The 1920s stock price bubble
• 1970s: The surge in loans to Mexico and other developing economies
• 1985–89: The Japanese bubble in real estate and stocks
• 1985–89: The bubble in real estate and stocks in Finland, Norway and
Sweden
• 1990s: The bubble in real estate and stocks in Thailand, Malaysia,
Indonesia and several other Asian countries between 1992 and 1997,
and the surge in foreign investment in Mexico 1990–99
• 1995–2000: The bubble in over-the-counter stocks in the US
• 2002–07: The bubble in real estate in the US, Britain, Spain, Ireland, and
Iceland
Pick one of these asset price bubbles, find out more about it, and then:
1. Tell the story of this bubble using the models in this section.
2. Explain the relevance to your story, if any, of the arguments in the ‘Do
bubbles exist?’ box in Section 11.7 about the existence of bubbles.
QUESTION 11.7 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements about asset prices are correct?
A bubble occurs when beliefs about future prices amplify a price
rise.
When positive feedback occurs, the market is quickly restored to
equilibrium.
Negative feedback is when prices give traders the wrong informa-
tion about the fundamental value.
When beliefs dampen price rises, the market equilibrium is stable.
QUESTION 11.8 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements about short selling (shorting) is
correct?
Shorting is used to benefit from a price fall.
Shorting involves selling shares that you currently own.
The maximum loss a trader can incur by shorting is the price he
receives from the sale of the shares.
Shorting is a sure way of profiting from a suspected bubble.
Charles P. Kindleberger.
2005. Manias, Panics, and Crashes:
A History of Financial Crises (Wiley
Investment Classics)
(https://tinyco.re/9848004).
Hoboken, NJ: Wiley, John & Sons.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
492
•11.9 NON-CLEARING MARKETS: RATIONING, QUEUING,
AND SECONDARY MARKETS
Tickets for Beyoncé’s 2013 world tour sold out in 15 minutes for the
Auckland show in New Zealand, in 12 minutes for three UK venues, and in
less than a minute for Washington DC in the US. When American singer
Billy Joel announced a surprise concert in his native Long Island, New York
in October 2013, all available tickets were snapped up in minutes. In both
cases it’s safe to say that there were many disappointed buyers who would
have paid well above the ticket price. At the price chosen by the concert
organizers, demand exceeded supply.
We see excess demand for tickets for sporting events, too. The London
organizing committee for the 2012 Olympic games received 22 million
applications for 7 million tickets. Figure 11.21 is a stylized representation
of the situation for one Olympic event.
The number of available tickets, 40,000, is fixed by the capacity of the
stadium. The ticket price at which supply and demand are equal is £225.
The organizing committee do not choose this price, but a lower price of
£100; at this price 70,000 tickets are demanded. There is excess demand of
30,000 tickets.
Some of those who obtain tickets for a popular event may be tempted to
sell them rather than use them. In Figure 11.21, anyone who buys a ticket
for £100 with the intention of reselling could sell it for at least £225,
receiving a rent of £125 (compared with the next best alternative of not
buying a ticket).
Number of tickets (thousands)
Ti
ck
et
p
ri
ce
(£
)
0 40
225
100
0
Supply curve
Excess demand
Ec
on
om
ic
re
nt
Demand curve
70
Figure 11.21 Excess demand for tickets.
11.9 NON-CLEARING MARKETS: RATIONING, QUEUING, AND SECONDARY MARKETS
493
rationed goods Goods that are
allocated to buyers by a process
other than price (such as queueing,
or a lottery).
The potential for rents may create a parallel or secondary market. In the
case of tickets for concerts and sporting events, part of the initial demand
comes from scalpers: people who plan to resell at a profit. Tickets appear
almost instantly on peer-to-peer trading platforms such as StubHub
(https://tinyco.re/6667216) or Ticketmaster (https://tinyco.re/0560780),
listed at prices that may be multiples of what was originally paid. In the last
few days of the 2014 Winter Olympics in Sochi, tickets for the Olympic
Park with a face value of 200 roubles were sold outside the Park for up to
4,000 roubles.
Prices in the secondary market equate demand and supply, and alloca-
tions are accordingly made to those with the greatest willingness to pay.
The assumption that this market-clearing price will be much higher than
the listed price is responsible, in part, for the initial frenzied demand for
tickets. Nevertheless, some individuals who buy at the lower prices hold on
to their tickets, and attend an event that they would otherwise be unable to
afford.
Event organizers may try to prevent scalping. In Sochi, the security
officers were supposed to intervene. But prevention is increasingly difficult,
as online sales provide new opportunities for scalping on a large scale using
‘ticket-bots’: software that automatically buys tickets within moments of
their release. The New York Times estimated that scalpers made $15.5
million (https://tinyco.re/8299453) from just 100 performances of the
Broadway musical Hamilton in the summer of 2016.
In the case of the London Olympics, the organizing committee set the
price, and the tickets were allocated by lottery. This is an example of goods
being rationed rather than allocated by price. The organizers could have
chosen a much higher price (£225 for the event in Figure 11.21), which
would have cleared the market. But that would have meant that people
willing to pay less than £225 would not have seen the event. By allocating
the tickets through a lottery, some people with a lesser willingness to pay
(perhaps because they had limited incomes) would also get to see the
Games.
There was much public debate about the process, and some anger, but
IOC President Jacques Rogge defended it as ‘open, transparent and fair’.
There are other cases where the producer of a good chooses to operate
with persistent excess demand. The New York restaurant Momofuku Ko
offers a 16-course tasting menu at lunch for $175, and has just 12 seats.
Online reservations may be made one week in advance, open at 10 a.m.
daily, and typically sell out in three seconds. In 2008, the proprietor David
Chang sold a reservation at a charity auction for $2,870. Even taking into
account the willingness of individuals to pay more for an item when the
proceeds go to charity, this suggests substantial excess demand for reserva-
tions—but he has not raised the price.
EXERCISE 11.9 IOC POLICY
1. Do you think the IOC policy of using a lottery is fair?
2. Is it Pareto efficient? Explain why or why not.
3. Using the criteria of fairness and Pareto efficiency, how would you
judge the widely criticized practice of ‘scalping’ tickets.
4. Can you think of any other arguments for or against scalping?
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
494
EXERCISE 11.10 THE PRICE OF A TICKET
Explain why the seller of a good in fixed supply (such as concert tickets or
restaurant reservations) might set a price that the seller knows to be too
low to clear the market.
QUESTION 11.9 CHOOSE THE CORRECT ANSWER(S)
Figure 11.21 (page 493) is a stylized representation of the market for
an event at the 2012 London Olympic Games. 40,000 tickets were
allocated by lottery, at £100 each.
Assume that buyers could resell their tickets in the secondary market.
Which of the following statements is correct?
The market cleared at £100.
The probability of obtaining a ticket was 4/7.
The economic rent earned by those selling in the secondary market
was £100.
The lottery organizers should have chosen a price of £225.
•11.10 MARKETS WITH CONTROLLED PRICES
In December 2013, on an unusually cold and snowy Saturday in New York
City, demand for taxi services rose appreciably. The familiar metered
yellow and green cabs, which operate at a fixed rate (subject to minor
adjustments for peak and night-time hours), were hard to find. Those
looking for taxis were accordingly rationed, or faced long waiting times.
But there was an alternative available—another example of a secondary
market: the on-demand, app-based taxi service called Uber, which by
March 2017 would be operating in 81 countries. This recent entrant in the
local transportation market uses a secret algorithm that responds rapidly to
changing demand and supply conditions.
Standard cab fares do not change with the weather, but Uber’s prices can
change substantially. On this December night, Uber’s surge-pricing
algorithm resulted in fares that were more than seven times Uber’s
standard rate. This spike in pricing choked off some demand and also led to
some increased supply, as drivers who would have clocked off remained on
the road and were joined by others.
City authorities often regulate taxi fares as part of their transport policy,
for example to maintain safety standards, and minimize congestion. In
some countries, local or national government also controls housing rents.
Sometimes this is to protect tenants, who may have little bargaining power
in their relationships with landlords, or sometimes because urban rents
would be too high for key groups of workers.
Figure 11.22 shows a situation in which local government might decide
to control the housing rent in a city (note that here we mean rent in the
everyday sense of a payment from tenant to landlord for use of the accom-
modation). Initially the market is in equilibrium, with 8,000 tenancies at a
rent of €500—the market clears. Now suppose that there is an increase in
demand for tenancies. Rents will rise, because the supply of rental housing
is inelastic, at least in the short run: it would take time to build new houses,
11.10 MARKETS WITH CONTROLLED PRICES
495
rent ceiling The maximum legal
price a landlord can charge for a
rent.
so more tenancies can only be supplied immediately if some owner-
occupiers decide to become landlords and live elsewhere themselves.
Suppose that the city authorities are concerned that this rise would be
unaffordable for many families, so they impose a rent ceiling at €500.
Follow the steps in Figure 11.22 to see what happens.
Number of tenancies
Supply curve
New supply
curve
Controlled rent
Market clearing rent
Demand curve
New demand curve
12,000
H
ou
si
ng
re
nt
(€
)
0 8,000
1,100
0
830
500
Ec
on
om
ic
re
nt
Excess demand
Figure 11.22 Housing rents and economic rents.
1. The market clears
Initially the market clears with 8,000
tenancies at rent of €500.
2. An increase in demand
Now suppose that there is an increase
in demand for tenancies.
3. Rent increases
The supply of housing for rent is
inelastic, at least in the short run. The
new market-clearing rent, €830, is
much higher.
4. A rent ceiling?
Suppose the city authorities impose a
rent ceiling at €500. Landlords will
continue to supply 8,000 tenancies, so
there is excess demand.
5. The short side of the market
When the price is below the market-
clearing level, the suppliers are on the
short side of the market. They, not the
demanders, determine the number of
tenancies.
6. Some people would pay much more
There are 12,000 people on the long
side of the market. Only 8,000 obtain
tenancies. There are 8,000 people
willing to pay €1,100 or more, but
tenancies are not necessarily allocated
to the people with highest willingness
to pay.
7. A secondary market
If it were legal, some tenants could
sublet their accommodation at €1,100,
obtaining an economic rent of €600
(the difference between €1,100 and the
controlled rent of €500).
8. The long-run equilibrium
The long-run solution for making more
tenancies available at a reasonable
rent is for the city authorities to
encourage house-building so as to shift
out the supply curve.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
496
short side (of a market) The side
(either supply or demand) on which
the number of desired transactions
is least (for example, employers are
on the short side of the labour
market, because typically there are
more workers seeking work than
there are jobs being offered). The
opposite of short side is the long
side. See also: supply side, demand
side.
With a controlled price of €500 there is excess demand. In general a
controlled price will not clear the market, and trade will then take place on
the short side of the market: that is, the quantity traded will be whichever
is lower of the quantities supplied and demanded. In Figure 11.22, the price
is low and suppliers are on the short side. If the price were high (above the
market-clearing price), demanders would be on the short side.
When the rent is €500, the number of tenancies will be 8,000. Of the
12,000 people on the long side of the market, 8000 would pay €1,100 or
more, but tenancies are not allocated to those with highest willingness to
pay. Those lucky enough to obtain tenancies may be anywhere on the new
demand curve above €500.
The rent control policy puts more weight on maintaining a rent that is
seen to be fair, and affordable by existing tenants who might otherwise be
forced to move out, than it does on Pareto efficiency. The scarcity of rental
accommodation gives rise to a potential economic rent: if it were legal (it
usually isn’t), some tenants could sublet their accommodation, obtaining an
economic rent of €600 (the difference between €1,100 and €500).
If the increase in demand proves to be permanent, the long-run solution
for the city authorities may be policies that encourage house-building,
shifting out the supply curve so that more tenancies are available at a
reasonable rent.
EXERCISE 11.11 WHY NOT RAISE THE PRICE?
Discuss the following statement: ‘The sharp increase in cab fares on a
snowy day in New York led to severe criticism of Uber on social media, but
a sharp increase in the price of gold has no such effect.’
QUESTION 11.10 CHOOSE THE CORRECT ANSWER(S)
Figure 11.22 (page 496) illustrates the rental housing market. Initially,
the market clears at €500 with 8,000 tenancies. Then, there is an
outward shift in the demand curve, as shown in the diagram. In
response, the city authority imposes a rent ceiling of €500 and
prohibits subletting. Based on this information, which of the following
statements are correct?
There are 4,000 potential tenants who are left unhoused.
The market would clear at €1,100.
If subletting was possible, then those renting could earn an eco-
nomic rent of €330.
Excess demand could be eliminated in the long run by building
more houses.
This brief economic analysis of
rent controls in Paris points out the
counter-productive effects: Jean
Bosvieux and Oliver Waine. 2012.
‘Rent Control: A Miracle Solution
to the Housing Crisis?’
(https://tinyco.re/0599316).
Metropolitics. Updated 21
November 2012.
Richard Arnott, on the other hand,
argues that economists should
rethink their traditional opposition
to rent control: Richard Arnott.
1995. ‘Time for Revisionism on
Rent Control?’ (https://tinyco.re/
7410213). Journal of Economic
Perspectives 9 (1) (February):
pp. 99–120.
11.10 MARKETS WITH CONTROLLED PRICES
497
disequilibrium rent The economic rent that arises when a
market is not in equilibrium, for example when there is excess
demand or excess supply in a market for some good or service.
In contrast, rents that arise in equilibrium are called equilib-
rium rents.
equilibrium rent Rent in a market that is in equilibrium. Also
known as: stationary or persistent rents.
•••11.11 THE ROLE OF ECONOMIC RENTS
An economic rent is a payment or other benefit that someone receives that
is superior to his or her next best alternative. Throughout this unit, we have
seen how economic rents play a role in the changes that take place in the
economy.
• In the real case of the Kerala fisherman, and the hypothetical market for
hats, rent-seeking by buyers or sellers in response to a situation of excess
supply or demand brought about a market-clearing equilibrium.
• In the model of the bread market, rents (economic profits) can arise in a
short-run equilibrium in which the number of firms is fixed. In the long
run, other bakeries enter the market in pursuit of these rents.
• In the world oil market, rents for oil producers arise from the con-
straints on producers and consumers that make supply and demand
curves inelastic in the short-run, but in turn provide incentives for
building new wells for exploration.
• In asset markets, rents arise when the price deviates from the
fundamental value of the asset, providing opportunities for speculation
and creating the potential for bubbles.
• In markets that do not clear because prices are controlled, excess
demand gives rise to a potential economic rent, which leads (unless
prevented by regulation) to the development of a clearing secondary
market.
• Another example, from Unit 2, is the innovation rent obtained by early
innovators, which provides the incentive to adopt a new technology.
In each of these examples, rents arise because of
some kind of disequilibrium, or short-run con-
straint—we call them dynamic or disequilibrium
rents. They set in motion a process—rent-
seeking—that ultimately creates an equilibrium in
which these kinds of rents no longer exist. In
contrast, we have also seen examples of persistent
or stationary rents. The main examples are shown
in the table in Figure 11.23.
Type Description Unit
Bargaining In a bargaining situation, how much the outcome exceeds the
reservation option (next best alternative)
4.5
Employment Wages and conditions above an employee’s reservation
option providing an incentive to work hard
6.9
Monopoly Profits above economic profits made possible by limited
competition
7
Government-
induced
Payments above the actor’s next best alternative not
competed away because of government regulation (for
example rent control, intellectual property rights)
9
Figure 11.23 Examples of stationary rents.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
498
In the models studied in this unit, we have seen that if markets do not
clear, there are disequilibrium rents that give incentives for people to
change the prices or quantities at which they transact, and so bring about
market clearing. The labour market (see Unit 9) is different: it does not clear
in equilibrium. Employees therefore receive a rent—the difference between
the wage and their reservation option. But in this case it is a persistent or
equilibrium rent: because a contract to work hard is unenforceable there
is no way any buyer (the employer) or seller (the worker) can benefit by
changing his or her price or quantity.
Economic rents and rent-seekers often have a bad name in economics.
People disapprove because they think about rents as those arising from
government-created monopolies (taxi licenses, intellectual property rights)
or privately created monopolies. These rents indicate that the good or
service will be sold at a price exceeding its marginal cost, and so the
markets for these goods are not Pareto efficient.
But we have now seen the usefulness of some economic rents. They
encourage innovation, provide incentives for employees to work hard,
encourage new entrants to a market and thereby lower prices for con-
sumers, and can bring an out-of-equilibrium market to a Pareto-efficient
equilibrium.
QUESTION 11.11 CHOOSE THE CORRECT ANSWER(S)
Which of the following are stationary rents?
Innovation rent where firms make positive economic profits from a
new invention.
Employment rent where the wage is set high to induce workers to
work hard.
Monopoly rent where firms make excess profits due to limited com-
petition.
Speculative rent where profits are made by correctly betting on the
price changes in a bubble.
11.12 CONCLUSION
Prices are messages about the conditions in a market economy. In situations
of market disequilibrium, or short-run equilibrium arising from temporary
constraints, people act on price messages if they are able to do so, in pursuit
of economic rents. In markets for goods this often leads in the long run to
market clearing and the eventual disappearance of the rents.
Assets are purchased partly for their resale value. In markets for finan-
cial assets, supply and demand shift rapidly as traders receive new
information. The price adjusts in a continuous double auction to reconcile
supply and demand. Prices in asset markets send messages to traders about
future prices, which can cause the price to deviate from the fundamental
asset value; in this case rent-seeking may create a bubble or a crash.
Sometimes suppliers or regulators choose to override price messages,
leading to excess supply or demand, for example for concert tickets, taxi
cabs, or housing tenancies. Economic rents can then persist—unless a
secondary market is allowed to develop.
11.12 CONCLUSION
499
Concepts introduced in Unit 11
Before you move on, review these definitions:
• Market equilibration through rent-seeking
• Long-run and short-run equilibria
• Fundamental value of an asset
• Continuous double auction
• Order book
• Price bubble
• Stable and unstable equilibria
• Secondary and primary markets
• Dynamic and stationary economic rents
11.13 REFERENCES
Consult CORE’s Fact checker for a detailed list of sources.
Arnott, Richard. 1995. ‘Time for Revisionism on Rent Control?’
(https://tinyco.re/7410213). Journal of Economic Perspectives 9 (1)
(February): pp. 99–120.
Bosvieux, Jean, and Oliver Waine. 2012. ‘Rent Control: A Miracle Solution
to the Housing Crisis?’ (https://tinyco.re/0599316). Metropolitics.
Updated 21 November 2012.
Brunnermeier, Markus. 2009. ‘Lucas Roundtable: Mind the frictions’
(https://tinyco.re/0136751). The Economist. Updated 6 August 2009.
Cassidy, John. 2010. ‘Interview with Eugene Fama’ (https://tinyco.re/
4647447). The New Yorker. Updated 13 January 2010.
Harford, Tim. 2012. ‘Still Think You Can Beat the Market?’
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24 November 2012.
Hayek, Friedrich A. 1994. The Road to Serfdom. Chicago, Il: University of
Chicago Press.
Keynes, John Maynard. 1936. The General Theory of Employment, Interest and
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Kindleberger, Charles P. 2005. Manias, Panics, and Crashes: A History of Fin-
ancial Crises (Wiley Investment Classics) (https://tinyco.re/9848004).
Hoboken, NJ: Wiley, John & Sons.
Lucas, Robert. 2009. ‘In defence of the dismal science’ (https://tinyco.re/
6052194). The Economist. Updated 6 August 2009.
Malkiel, Burton G. 2003. ‘The Efficient Market Hypothesis and Its Critics’
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(March): pp. 59–82.
Miller, R. G., and S. R. Sorrell. 2013. ‘The Future of Oil Supply’
(https://tinyco.re/6167443). Philosophical Transactions of the Royal
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(December).
Owen, Nick A., Oliver R. Inderwildi, and David A. King. 2010. ‘The Status
of Conventional World Oil Reserves—Hype or Cause for Concern?’
(https://tinyco.re/9394545). Energy Policy 38 (8) (August):
pp. 4743–4749.
Shiller, Robert J. 2003. ‘From Efficient Markets Theory to Behavioral
Finance’ (https://tinyco.re/3989503). Journal of Economic Perspectives
17 (1) (March): pp. 83–104.
UNIT 11 RENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
500
Shiller, Robert J. 2015. ‘The Stock Market in Historical Perspective’
(https://tinyco.re/4263463). In Irrational Exuberance. Princeton, NJ:
Princeton University Press.
The Economist. 2014. ‘Keynes and Hayek: Prophets for Today’
(https://tinyco.re/0417474). Updated 14 March 2014.
11.13 REFERENCES