Week 2: Rent-Seeking, Price-Setting And Market Dynamics Flashcards
What is competitive equilibrium?
Competitive equilibrium is when buyers and sellers are both price-takers, and
markets clear
Equilibrium price responds to exogenous shocks, which are changes from outside
the model
What did Friedrich Hayek say about prices?
Prices are messages (signals)
They convey valuable information about how scarce a good is, but
this happens only if prices are free to be determined by supply and
demand (i.e. no government intervention)
Capitalism provides the right information to the right people
The government should play a minimal role in society, Hayek was
against income redistribution in the name of social justice
How does market equilibrium through rent seeking work?
- Competitive Equilibrium (Point A):
The market is in balance. Buyers and sellers are price-takers (no one makes extra profit).- Exogenous Shock (e.g., Increase in Demand):
Buyers now want to pay more, so the price rises above marginal cost (Point B), creating disequilibrium. - Market Disequilibrium:
With the new higher price, buyers and sellers can earn economic rents (profits) by transacting at different prices.
• This turns them into price-makers, meaning they can set prices. - Market Adjustment:
Buyers and sellers keep adjusting prices and transacting until the market returns to a new equilibrium (Point C), where the price is once again balanced.
- Exogenous Shock (e.g., Increase in Demand):
This whole process of earning rents and adjusting prices is called market equilibration through rent-seeking.
Where do prices come from and what is short and long term equilibrium?
Prices come from the interests of and relationships between buyers and sellers
The way in which the market is organized determines how these relationships influence prices
Short-run equilibrium: An equilibrium that prevails while certain variables remain constant
Long-run equilibrium: An equilibrium achieved when variables that were held constant in the
short run are allowed to adjust, as people have time to respond the situation
How does the supply and demand for oil work in the short run vs. the long run?
Main Uses of Oil: Transport (air, road, sea), plastics, textiles, and cosmetics.
• Short Run:
• Inelastic supply and demand: Oil companies can’t quickly increase production, and industries dependent on oil have no substitutes, so prices don’t change much in the short term.
• Long Run:
• Elastic supply and demand: Producers can build new oil wells, develop new technologies, and consumers can switch to alternative fuels, making the supply and demand for oil more flexible, causing larger price change
How do prices work in the oil market and what is peak oil?
Prices as Messages: Prices in the oil market reflect short-run scarcity, not consumption.
• Scarcity and Price:
• If oil becomes scarcer or harder to produce, supply decreases and prices tend to rise.
• Peak Oil:
• The point when oil production reaches its max rate (peak oil) isn’t clearly seen because high prices encourage more exploration, potentially delaying peak oil.
What causes short term fluctuations in the oil market?
Short-Run Fluctuations = Short-Run Scarcity:
1. Demand is inelastic: People can’t easily switch to other fuels right away.
2. Supply is inelastic:
• Drilling new oil wells is expensive and has fixed capacity.
• New exploration is complex and takes time.
• Geopolitics: OPEC plays a role in oil production control.
• Negative Supply Shock:
• If supply drops (e.g., from an oil shortage), prices increase much more than quantity decreases because of inelastic supply and demand.
Why do people buy assets and what determines its value?
People buy assets for two reasons:
1. To benefit from owning it (monetary or otherwise)
2. To be able to sell it later (liquidity) at higher price (profit)
What determines the value of an asset?
The value of a financial asset (also called a security) depends on:
1. The size of the cash flows that it is expected to generate over time (price increase + dividends)
2. The uncertainty in one’s forecasts of these cash flows
What is a bond, and how do interest rates and prices affect it?
Bond: A security that pays a fixed amount of money at specific intervals for a set period.
• Government Bond: A bond issued by the government that pays regular interest payments (coupons) over a long period (e.g., 30 years). Low risk, leading to low interest rates.
• Corporate Bond: Issued by companies. Higher risk of default, so they offer higher interest rates.
• Price and Yield Relationship:
• Bond prices and returns (yields) are inversely related.
• If bond prices go up, the yield goes down, because the fixed coupon payment stays the same while the price increases.
• Example:
• A Microsoft bond issued at $100 with a 10% coupon rate pays $10 annually for 20 years and returns the $100 face value at the end.
• If the bond price rises to $110, the coupon stays at $10, but the yield drops to around 9% (not the original 10%).
The coupon rate is fixed, but the yield fluctuates with the bond’s price in the secondary market.
What are stocks and how do they differ from bonds?
Stocks differ from bonds as they do not offer a specific stream of payments and the time period
over which payments will be made it is also not fixed
Stocks (or shares) = units of ownership in a company, a formal claim on a part of assets of a firm
and hence on its profits
Firms expected to generate greater net earnings will have higher valuations = higher share price
Expectations play a crucial role in determining the price
What factors affect the value of bonds and stocks, and how do risks differ?
The value of both bonds and stocks depends on uncertainty over their earnings.
• Systematic Risk:
• Events that affect broad classes of financial assets (e.g., changes in tariffs, interest rates, or geopolitical events).
• Cannot be diversified—it affects the entire market.
• Idiosyncratic Risk:
• Events that affect only a specific firm or asset (e.g., Volkswagen emissions scandal, new laws against nuclear energy).
• Diversifiable—investors can spread risk by holding a diverse portfolio.
• Market Capitalization Rate:
• The return required by investors to buy shares in a company.
• Higher for companies facing greater systematic risk because it can’t be diversified away.
• Example:
• Automakers face more systematic risk (e.g., changes in tariffs or regulations) compared to utilities companies, which are more stable and less affected by such broad events.
What are trading strategies?
The fundamental value of a security = the price of a share is based on
anticipated future earnings and the level of risk
Trading strategies:
1. Buy assets that are priced below their perceived fundamental value, and sell assets that are
priced above their perceived fundamental value
2. Look for momentum in asset prices (how investors perceive an asset), buying when
expecting prices to rise further (e.g. video conferencing platforms vs airlines during COVID)
Both types of trading are a form of speculation. They determine the behaviour of prices
and the possibility of bubbles and crashes
How does stock exchange work and how are trades made?
• A stock exchange is a marketplace where financial assets from listed companies are traded.
• Trades happen through a continuous double auction that sets the current price of an asset.
• Limit Orders: Investors place orders to buy or sell at a specific price (e.g., 100 Microsoft shares at $15).
• Matching: If a bid (buy order) matches an ask (sell order), a trade occurs.
• Order Book:
• Bids: Orders to buy, listed in decreasing price.
• Asks: Orders to sell, listed in increasing price.
• The price adjusts to reflect supply and demand.
If there’s no match, the order stays in the book until it is matched.
What is a market bubble and how does it form?
• A market bubble occurs when the price of an asset rises far above its true value.
• Prices reflect information about a company’s health.
• If traders think rising prices mean they’ll keep rising (momentum trading), it can lead to a cycle of continuous price increases (the bubble), followed by a sudden crash when prices fall sharply.
What is a self reinforcing bubble?
A self-reinforcing bubble happens when prices keep rising due to the belief that they will continue to rise.
• This continues until something changes people’s expectations, stopping the price from rising further (possibly leading to a price crash).
• Bubbles only happen in markets for goods that can be resold, like financial assets or durable goods, because they can hold value.
• For example, vegetables, fish, and fashion items can’t be bought for profit since they lose value over time (e.g., fish rots, fashion goes out of style).
What is a short selling bubble?
If an investor expects the value of an asset to decrease, an investment strategy can be employed to
profit from the upcoming crash
Short-selling: sale of an asset borrowed by the seller with the intention of buying it back at a lower price
Example: pay $1 to borrow Microsoft stock for a month and immediately sell it on the market for $100
(total gain = $100 - $1 = $99). In a month time the borrowed stock needs to be returned, if the price of
Microsoft falls to $95 it is possible to buy it back at current price $95 clearing a profit ($99 - $95 = $4)
Risky business: You may be right about the bubble but if you get the timing wrong, if the price of the
borrowed share is higher than it was when you sold it when you are due to return the share to the owner,
you will lose money (if price is $110 then $99 - $110 = -$11)
What happens when markets don’t clear and how does economic rents form?
• Market Rationing: When markets don’t clear, goods are allocated using methods like queueing, lotteries, or other mechanisms instead of price.
• Example - Champions League Final:
• 40,000 tickets are available, but 70,000 tickets are demanded at £100 each.
• Excess demand of 30,000 tickets leads to economic rent.
• Tickets may be resold in a secondary market for £225, creating a rent of £125 per ticket.
• Economic Rent: Extra income earned from a scarce resource, which is higher than the next best alternative (e.g., using a ticket to watch the game).
How do economic rents impact different markets?
Economic Rents play a key role in changes within the economy by creating incentives for action.
• Kerala Fisherman: Rent-seeking occurs when buyers or sellers respond to excess supply or demand, bringing the market to equilibrium.
• Oil Market:
• Rents for oil producers arise from inelastic supply and demand in the short run.
• This creates incentives for new oil wells and exploration projects.
• Asset Markets:
• Rents occur when prices deviate from an asset’s fundamental value, leading to speculation and potential bubbles.
• Non-Clearing Markets (Controlled Prices):
• Excess demand creates the potential for economic rent, leading to the development of a secondary market, unless regulated.
What is dynamic vs stationary economic rents?
Dynamic economic rents arise in disequilibrium and are reduced or eliminated through
rent-seeking activities (e.g. speculation, disequilibrium pricing). These rents are
temporary and occur when markets are adjusting toward a new equilibrium
Stationary economic rents occur in equilibrium and tend to persist over time (e.g.
producer/consumer surplus, bargaining rents). These rents are stable and result from
long-term factors like market structure or contracts
Certain types of economic rents support the functioning of capitalist economies (e.g.
innovation rents, employment rents). These rents incentivize productive activities, such
as technological progress and job creation
