I’m giving a talk soon on economics, and I want to demonstrate the following statement: “the market price is always the best way of allocating resources.” Then show that price controls always screw this up by creating shortages/surpluses. This is how I plan to do this…
Take 5 apples to the talk. Pick someone to play the entrepreneur and give him the apples. Everyone else plays consumers. I ask the consumers to think of how much they would be willing to pay for an apple. Then I get the entrepreneur to guess the selling price that will maximise his income, given that any apples he doesn’t sell he must give back to me. If his price is too low, there will be a shortage, and some people that really really want an apple will go without. If his price is too high, he won’t sell all 5, and he’ll have to give them back to me (wastage).
I have thought of a possible objection to this. What if there are four people who want to pay £1 for an apple, and no-one else wants to pay more than 30p? If the entrepreneur is trying to maximise his income, he will want to set the price at £1 (£4 income). Screw the fifth apple. He’s not going to lower the price to 30p just to sell them all because then he will only make £1.50 income.
I am not very familiar with ‘elasticity’ as a concept, which I think is the relevant concept here. Can someone explain to me how I should caveat my statement that the market price always allocates resources efficiently? Wouldn’t a maximum price control of 30p in this scenario lead to a better allocation of resources?
Excellent. That would definitely prove how economics works.
But if you want to deliver the whole package add to your speech the fact that there is such thing as market manipulation. “Corporatism & monopoly power”
Specially when Demand is inelastic with respect to a particular commodity.
A word about price controls. In the real world, they are only introduced when prices are “too high”, meaning there is a scarcity, meaning everyone wants apples, but are unhappy with the high price, because they are accustomed to paying less.
So the real experiment would be getting them all nice and hungry, closing the lunchroom, and bringing in one McDonalds meal to sell. You say “Ok we have price controls. This whole meal costs a penny. Who gets to buy it. Let’s see, we’ll go in alphabetical order.” The class starts complaining that it’s not fair, they should all get a chance. So you say, ah, you see the problem of price controls then. The first one in line will get what there is, everyone else gets nothing"
“Now I’ll show you another problem. Nobody gets that meal, because I’m not selling it. I paid way more than a penny, and I’m not foollish enough to give it away for a penny.” More grumbles, and rumbling stomachs.
Then you remove the price contols, and say “Tell you what, I’ll sell it at a nice high price. Each item, the soda, the chips, the burger, are going to go for the price of a full meal. Any takers?” Hopefully, the thing will get divvied up, so that everyone gets at least a piece.
Of course they have to be using their own real money, not playing with monoply money or cash you gave them for the purpose of the experiment.
Student - thanks for the suggestions. I will have a google about for something. The link you provided doesn’t suggest any games that would show what I want to show - namely (1) that an optimal price exists that will distribute apples efficiently (meaning the five apples end up in the hands of the five people who want them the most), and (2) that entrepreneurs are more likely to find the optimal price than governments.
Could you elaborate on this? I should point out, I haven’t read much economics except from the Mises site, so my knowledge of how mainstream economists think is probably lacking. There may well be some people with economics degrees in my audience, so I need to be ready to respond to objections like this.
Wolfman - thanks, but that’s not the way I want to go with it. Once I’ve shown that entrepreneurs are best at setting prices, and government intervention screws things up, I intend to apply that to the cases of the minimum wage and the interest rate.
Twisted - after my volunteer entrepreneur has found the optimal price, I will join the game, playing the role of government. I will force the entrepreneur to sell at a lower-than-optimal price and we’ll see that the apples don’t end up in the hands of the five people who want them most (shortage). Then I’ll go the other way and force a higher-than-optimal price and we’ll see that some apples will be wasted (surplus). That should demonstrate the effects of price controls pretty well.
Smiling Dave - starving my audience may not go down too well! I will speaking late morning, so presumably I’ll have some people that want to buy an apple for lunch, even if the optimal price turns out to be very low. And I will be doing this ‘for real’; real apples, no fake money, and my entrepreneur can keep whatever profits he makes.
So what I want to show is that an entrepreneur, simply by trying to maximise his profits, sets the price at the perfect level to optimise the distribution of resources. Where I am coming unstuck is that this might not always be the case, as in the example in my OP. If this does occur, I want to be able to say something like ‘this has happened because of X, and in the real world X almost never happens because of Y’. But I don’t know the terminology here.
You could try this. Let your entreprenuer buy the apples from you. This will mean that he has something to loose if he cannot sell the apples. This would reflect that in a free market the risk is borne by the entreprenuer. Giving a justification for his profit. Then have an auction. Start with some point slightly above his cost. Make a note of how many audience members would be willing to pay. Then increase the amount. Make a note of how many are williing to buy at that price. Keep raising the price and counting potential buyers untill you have exactly five. Then introcuce your price ceiling at any level below that to illistrate the shortage of apples to fill demand at that artificial level. And show how the allowcation of those resources with your fixed price is irrational and we have now way of knowing whether those who desire the apples the most actually recieved them.
In addition you could keep cost to your entreprenuer a secret untill all the bidding is done. Then disclose his cost and let the audience decide what the “fair price” is. With all of the differing opinions you can show that the government action will subject the allocation of apples to politcal factors. Those with political power get the apples those without political power get nothing.
I don’t like the idea of an auction because I want to stress that entrepreneurship is about estimating demand. Real world entrepreneurs don’t have the benefit of an auction to help them find the optimal price. They just have to take a guess and may the best forecaster win. I will be kind and allow my entrepreneur to make multiple guesses though; the wrong guesses will give me the chance to explain how setting a price too high or too low causes a non-optimal distribution of apples.
But the forecaster has something to base his estimate on. In the market you have many different sellers at an array of different prices. An enterprenuer will use that information when setting his own price. If you just let him guess with no information as to the value scale of his customers (your audience) then his price is meaningless. The same as if the government set it. The auction would recreate market information about your buyers. With this information and the known costs to him, he could set a meaningful price.
the wrong guesses will give me the chance to explain how setting a price too high or too low causes a non-optimal distribution of apples.
A way you could do this is maybe do the auction with only 25% of the audience. Maybe a certain section or first couple of rows. That way there would be the uncertainty that could cause a entreprenuer to make an inacurate forecast. But I really think they need something real to base their prices on. In the real world they are estimates based on limited information.
Only suggestions though. I think it is great that you are putting yourself out there.
Yeah, I hear what you’re saying. I still think I’ll go for the guessing method though. Apples are sold nearby for around 60p I think, so that’s something real they can base their price on. The guesses could be considered market research that will give a bit more information before the final decision must be made, but not so much information that it takes the fun out of it.
It’s true that in this particular example, the price that would acheive the most efficient allocation of resources is not the price that would maximise the revenue of the entrepreneur. However, this has happened because of the limitations of the experiment. In the real world, the two prices almost always coincide.
Entrepreneurs always attempt to set their price at the point at which their demand curve becomes elastic. That is, the highest price they can charge such that any further increase in price would lead to a fall in volume of sales and reduce total revenue. In this case, that price is £1 per apple. However, in this experiment, we had a closed market, with only one seller. If we had more than one seller, each would try to set their price according to their own individual demand curve, which will be different from the demand curve of the industry as a whole.
Suppose the industry demand curve for apples in the real world was the same shape as the demand curve in this room. Then, a price of £1 would maximise revenues for the industry as a whole. However, all the firms selling apples would have to agree in advance to sell for no less than £1. They would have to form an apple cartel. But as with all other cartels, without government protection, it will collapse, due to both internal and external forces.
Internally, each member of the cartel could increase their revenues just by lowering their price (say to 90p). The temptation for individual firms to break the cartel agreement is very strong. If some firms start lowering their price, they will gain market share at the expense of the other members of the cartel. In turn, those other members would have to lower their price to remain competitive. Before long, the cartel will collapse.
Even if the cartel was very strong, with all firms sticking to a price of £1, there is still external pressure. Attracted by the high profits available for charging 90p for an apple, new firms will enter the industry and gain market share at the expense of the cartel members. Again, the cartel will collapse. The only way cartels can be maintained is by using violence (government) to prevent new firms entering the industry.
In our experiment, we also assumed away the time and costs of production. In fact, it is not revenue that entrepreneurs seek to maximise, but profits, which we may define here as simply revenue minus costs. If it is profitable to produce and sell apples at 30p, then there is always an incentive for new firms to enter the market and undercut the firms charging more. As a result of competition, profits will reduce, tending towards the “going rate of profit”, which is the interest rate. At this time, resources would be allocated as efficiently as possible, given the demand and supply conditions. So the market always tends towards the most efficient allocation of resources.
It went down pretty well, sparking a good debate. I did not have time in my hour to get onto the third part of it: the business cycle. So I asked for another hour slot a couple of weeks later, and gave this expanded presentation on the business cycle.
It was a good experience. I may be doing more as the opportunity arises.
By the way, my demonstration failed because I had four people on 50p and two apples. Damnit. I now wish I had done it like an auction. My audience still got the point I was trying to make though. Live and learn.
I just saw where you updated. Glad to hear that it was a good experience. I would definitely take any opportunities to do more presentations. The more opportunities the more refined the presentaion can be. I’m going to check out the powerpoint when I get home (almost every is blocked here at work).
By the way, my demonstration failed because I had four people on 50p and two apples. Damnit. I now wish I had done it like an auction. My audience still got the point I was trying to make though. Live and learn.
I hate to hear that. But a learning experience that you can build on. Its hard to account for all of the potential snags that a room full of people can create even in the best laid plans. (kinda why central planning fails, you could have always told the audience that was your point all along…)
I would suggest bringing a random selection of varied trinkets of approximately equal dollar value, enough so each person in the classroom can have at least one but if they had two or three it would be even better (expands the range of bargaining). Some trinkets are inevitably going to be more “cool” than others… insomuch as you can guess which these might be, you could skew the distribution of trinkets to create some artificial scarcity just to make things interesting. Perhaps you could preface the exercise with an explanation of what it is and show off the trinkets so the students have a chance to form some valuations over them. Then, using random assignment (pull them out of the bag without looking and give to students), distribute the trinkets. After the trinkets have been distributed, let the students begin exchanging them however they like. At the end of the exercise, they should get to keep the trinkets (which is why you want to choose trinkets of reasonable cost… i.e. go to the dollar store or Good Will, not Toys R Us), so this gives them an incentive to exchange so if there’s a trinket they’d really rather have than the one they have, they’ll go to the bother of getting up out of their chair to try to get it.
This is barter and it demonstrates the non-zero sum nature of exchange. After each exchange, both students who engaged in the exchange expected to be better off. This shows how, even for a finite distribution of resources, voluntary exchange can increase human wealth (satisfaction with the state of affairs).
If you wanted to show the emergence of money, I think the experiment would become a little more costly. You would need a trinket that is more marketable than any other (you could “guarantee” this by getting a trinket of higher dollar value) and you’d want to first distribute that to each student (say, one “monetary” trinket each) and then distribute the other trinkets as described above. Then, students could try to “make a profit” by buying and selling the less marketable trinkets in terms of the more marketable trinket which would become a de facto medium of exchange (money). Since the goal is simply to make a profit, you could participate in this as a peer trying to get back as much of your stuff as possible so you can return it and relieve yourself of some of the cost of this experiment.
I know these exercises don’t quite get to what you were asking in your OP but I think they might be more valuable since they would be truly grounded in human action and therefore more persuasive than more elaborate exercises that necessarily require that everyone “pretend” to some extent.
@trulib: I just looked at your powerpoint and it is visually stunning! The photo of all those surplus cars in a shipping yard was like a smack in the face. Can you record a voice-over and post this to YouTube? I bet it would be a big hit. I would recommend we Mises-forum-goers petition to get it put up on a Mises daily or at least on the blog.