Reading: Lesson 2 – How Market Prices Emerge

Description:

Prices emerge from the multitude of exchange interactions between buyers and sellers in the market. Prices reflect the unique, situational, and ever changing knowledge of individual circumstances and preferences. Prices reflect how people value available scarce resources relative to their alternatives.

How do prices adjust in a market economy? What role is played by the profit-seeking entrepreneur? In this lesson, students will participate in an activity called “A Market for Crude Oil,” in which they will seek to maximize their profits through buying and selling barrels of oil. Students will see how, through the many interactions of different buyers and sellers, prices “emerge” and stabilize.

 

Time Required:

45 min

 

Required Materials:

Internet connection, writing instrument, Activity Materials

Activity Materials Include:

• Buy cards, enough for half of the class
• Sell cards, enough for half of the class
• Score sheets for “A Market in Crude Oil,” one for each student
• Supply and Demand Schedules, one for each student
• Crude Oil Supply and Demand (graph sheet), one per student
• A Market Survey, one per student
• One colored armband (construction paper or yarn) for each seller.
• The following visuals are also needed: (1) sample Buy/Sell Cards; (2) Class Tally Sheet; and (3) Graphing Supply, Demand, and Marking Clearing Price.

 

Prerequisites:         

Module 3 – How Can Entrepreneurs Use Economics to Make Better Decision?

Module 4 – How Does Trade Create Wealth?

Lesson 5.1 – Role of Prices

5.2.A: Complete the following activity and share your ideas with the group [45 min]

Activity: A Market for Crude Oil

Teacher Tip: This activity requires a class of at least 20 students to be effective. The instructions and handouts for the game can be found here: http://www.learner.org/workshops/economics/support/econclass_wk2.pdf

In a free market economy, prices emerge gradually from the interactions of buyers and sellers. When people engage in buying or selling, they are engaging in an act of information-sharing and -developing. Market prices are discovered through the interactions of buyers and sellers working to meet their individual needs. It is important to keep in mind, however, that prices are always changing due to a number of factors, including innovation and changing circumstances. In this activity, students will participate in a simulation of a market for crude oil and will see how prices emerge through continuous buying and selling.

 

Directions:

1. Explain to students that they will be participating in an activity in which half of them will be buyers, and the other half sellers, of barrels of crude oil. Display Visual 1 (Sample Buy and Sell Cards), explaining that each buyer will receive a buyer card, on which a price is listed; likewise, sellers will receive a seller card, which also has price listed on it. The prices listed on the cards vary.

2. Explain that buyers must try to buy a barrel at the lowest possible price. They should not buy for more than the price on their card, although this is sometimes necessary to make a transaction and get another Buy card. Stress that buyers should not reveal the price of their cards at any time.

Teacher Tip: You may wish to assign two students to handle the distribution and collection of the buy and sell cards during the game, and another student to record each transaction on the Class Tally Sheet (Visual 2). The Class Tally Sheet should be large enough for all students to easily see it. Buy and Sell cards should be kept in separate piles and shuffled between each of the three rounds.

3. Repeat step 2 with a Sell Card. Tell sellers that they will receive one sell card at a time. Explain that students must try to sell their barrels of crude oil at the highest possible price. They should try not to sell for less than the price on their cards, although sometimes this is necessary in order to make a transaction and get another Sell card. Stress that sellers should not reveal the price on their cards at any time.

 

 

4. Explain the following rules:

a. Any buyer can talk with any seller.

b. The goal for both buyers and sellers is to make as much money as possible; buyers make money by buying barrels at amounts less thanwhat appears on their card, while sellers make money by selling for amounts greater than what appears on their card.

c. All students are free to make as many transactions in a round as time permits.

d. All transaction amounts must be made in whole dollar increments.

e. When a transaction is made, both the seller and the buyer report the agreed upon price to     the recorder who will enter it on Visual 2 (Class Tally Sheet). Display Visual 2. Remind students to watch the tally sheet so that they will know what prices are being paid for a barrel of oil.

f. After a transaction, students should turn in their cards and receive new ones, re-enter the marketplace, and resume making transactions. It is important that students receive a new card after every transaction.

5. Hand out individual score cards. Review procedures for completing the score sheet.

6. Clear a large area in the classroom and designate it as the marketplace.

 

7. Divide the class into two equal-sized groups. One group will be sellers, the other buyers. Distribute a colored armband to each seller. Explain that the buyers will be buyers throughout the game and sellers will be sellers throughout the game.

 

8. Explain that you will conduct three rounds of trading lasting five minutes each. Announce when one minute remains in each round.

 

9. Use Visual 2 to record transactions.

 

10. Encourage students to make as many deals as they can in the time permitted. Remind students that it is permissible to take a loss in order to get a new transaction card.

 

11. During the time between trading rounds, direct students’ attention to the record of all transactions on the Class Tally Sheet, Visual 2. Point out that it contains useful information for them. Do not elaborate.

 

12. At the end of the three rounds, allow students time to calculate their total net gain or net loss. Remind students that in the real market exchanges would be made for millions of barrels, so their gains or losses would be in millions of dollars too.

 

13. Determine the buyer and seller who had the largest net gains.

 

14. Conduct post game discussion. Possible answers are shown below.

1. At what price was crude oil most frequently sold in each round? (Have students examine data on their score sheets and on the Class Tally Sheet.)
2. In which round did the greatest spread in prices occur? (Examine data.)
3. Why did the prices become more clustered in later rounds? (Competition among buyers and sellers based on greater information is the most important cause. Markets tend to move toward an equilibrium price as buyers and sellers obtain information about the quantity of products available at different prices.)

 

15. Distribute the Supply and Demand Schedules and Crude Oil Supply and Demand Graphs. Inform students that the information on the buyer and seller cards can be converted to supply and demand schedules and used to construct a graph that illustrates the behavior of buyers and sellers. The focal point of the graph—the point at which the line for market supply and the line for market demand intersect—is called the market clearing price or the equilibrium price of the product traded (in this case, crude oil).

 

16. Tell students to construct the graph by placing dots at the points that correspond to all combinations of prices and quantities shown in the supply schedule on Activity 4. Then do the same, but use small crosses instead of dots, for the demand schedule. Connect the dots to produce the supply schedule; connect the crosses to produce the demand schedule. Tell students to label each curve. Assist students who have difficulty. When they have finished, project Visual 3 and have students compare their graphs to it.

 

17. Tell the class the graph indicates that, given enough time, this competitive market would generate a market price of $34 per barrel of crude oil. At that price, 16 barrels of crude oil would be sold. Ask: How does this compare with the market clearing price in the class simulation? (Answers may vary. Typically, a price of about $34 will not prevail until students play several rounds of the game. But in later rounds, their transactions should converge toward the

market price.)

 

18. After students complete the graphing exercise, summarize the important points by asking:

1. What does the demand schedule show? (The quantities of crude oil buyers are willing and able to purchase at all possible prices.) Explain that this entire schedule is what economists call demand.
2. What does the supply schedule show? (The quantities of crude oil sellers are willing to produce and sell at all possible prices.) Explain that this entire schedule is what economists call supply.
3. When the only thing that changes is the price of a product, what relationship exists between the price of a good or service and the quantity people are willing to buy? (As price rises, the quantity demanded decreases, and vice versa.)
4. When the only thing that changes is the price of a product, what relationship exists between the price of a good or service and the quantity producers are willing to sell? (When price rises, the quantity supplied increases, and vice versa.)
5. What happens in the market if the price is set higher than the market clearing price? (Quantity supplied is greater than quantity demanded.) Point out that this is called a surplus.
6. At what price does a surplus occur? (All prices above the market clearing price of $34.)

 

1. What happens in the market if the price is set lower than the market clearing price? (Quantity demanded is greater than quantity supplied.) Point out that this is called a shortage.
2. At what price does a shortage occur? (All prices below the market clearing price of $34.)

 

Discussion: Use the questions below to review the key points of the lesson.

1.  How do markets and prices help coordinate the activities of the participants in a complex economy?

1. Prices contain information about the value of various resources, products, etc. Without needing to know the details of why a price has changed, individuals can make intelligent choices about how to use these resources.
2. When a price rises, it indicates to producers that the value of that product is increasing, and provides an incentive to produce more of that good. Thus resources are channeled into more productive, value-creating efforts. When a price falls, it indicates that the value of the product is decreasing, and gives producers an incentive to produce less of the good (and to channel resources into a more productive effort).
3. Prices send signals to consumers as well. When prices increase, consumers know to find alternatives, to take care of their current possessions, etc. When prices fall, consumers will buy more of the good, possibly with the idea of saving it for future use.

 

2.  How do prices adjust in a market economy?

1. Prices are a function of the willingness of buyers and sellers to exchange in order to obtain a new good or service. This willingness is in turn a function of the value they attach to different goods, services, and resources such as time or money. A seller will set a price at a certain level; if no one buys it at that price, they know to lower the price; if the good is constantly running out, it is a signal to the seller to raise the prices. Over the course of countless exchanges, a price will “emerge” and stabilize.
2. Prices are never stable for long, however, due to factors such as innovation, changing attitudes, and changes in supply.

 

3.  What role is played by the profit-seeking entrepreneur?

1. Profit-maximizing entrepreneurs will seek out and direct their efforts toward the most productive, highly-valued uses of their resources.
2. Entrepreneurs, as producers/sellers of goods and services, will compete with each other on price, attempting to offer potential customers the most attractive products and prices (while still being able to make a profit). This typically means lowering the price of their products.
3. By introducing new products and improving upon existing ones, entrepreneurs can change the “value ranking” of different uses of various resources.

4.  Why is interventionism in market prices often self-defeating?

1. Shortages occur when the price is set below the market-clearing price. When this happens, consumers demand more goods than what producers are willing to supply at that price. The result is that people fail to get the goods or services that they need.
2. Surpluses occur when the price is set above the market-clearing price. When this happens, producers supply more goods than what consumers are willing to buy at that price. The result is that resources and products go unused and are thus wasted.

 

 

Lesson Recap

• Prices contain information about how people value various resources and products.

 

• Prices emerge from the countless exchange interactions between buyers and sellers of a particular good or service. Prices are constantly changing due to various disruptions in the market.

 

• When a price rises, it indicates to producers that the value of that product is increasing, and provides an incentive to produce more of that good. When a price falls, it indicates that the value of the product is decreasing, and gives producers an incentive to produce less of the good.

 

• Prices send signals to consumers as well. When prices increase, consumers know to find alternatives, to take care of their current possessions, etc. When prices fall, consumers will tend to buy more of the good.

 

• Government interference with market prices distorts the information transmitted by prices and leads to undesirable shortages and surpluses.

 

• Shortages occur when the price is set below the market-clearing price. The result is that people fail to get the goods or services that they need.

 

• Surpluses occur when the price is set above the market-clearing price. The result is that resources and products go unused and are thus wasted.

 

 

 

Additional Resources

Article: The Economics of Price Fixing, by D.T. Armentano (FEE.org)

“The most important function of a free price (a price not fixed or regulated by the state) is its ability to serve as an indication of the relative scarcity of a commodity, and automatically ration that scarce commodity to the highest demander. As long as the price of an article is allowed to fluctuate and match the supply with demand, there will be neither surpluses nor shortages, i.e., the market will be cleared at some equilibrium price.”

 

 

 

Article: Prices, by Ludwig von Mises (FEE.org)

“The pricing process is a social process. It is consummated by an interaction of all members of the society. All collaborate and cooperate, each in the particular role he has chosen for himself in the framework of the division of labor. By competing in cooperation and cooperating in competition all people are instrumental in bringing about the result, viz., the price structure of the market, the allocation of the factors of production to the various lines of want-satisfaction, and the determination of the share of each individual.”

 

Book: Economics in One Lesson - How the Price System Works by Henry Hazlitt (FEE.org)

“The whole argument of this book may be summed up in the statement that in studying the effects of any given economic proposal we must trace not merely the immediate results but the results in the long run, not merely the primary consequences but the secondary consequences, and not merely the effects on some special group but the effects on everyone.”

 

Article: Where Do Prices Come From? By Russell Roberts (The Library of Economics and Liberty) – “Prices adjust to equate how much people want to buy with how much they want to sell. And if people want to buy more than they did before, prices rise. If people want to sell more than they did before, prices fall”

 

Video:(Khan Academy, 10:16 min)

“Equilibrium price and quantity for supply and demand”

 

Video:(Khan Academy, 9:04 min)

“How the equilibrium price or quantity might change due to changes in supply or demand.”