MSP Explained

 

A Level Economics 58: Volatile Prices

Volatile prices refer to significant and unpredictable fluctuations in the prices of goods, services, or financial assets over a short period. These fluctuations often occur due to various factors, including changes in supply and demand conditions, geopolitical events, economic shocks, speculation, or other unforeseen events.

Market participants may experience periods of rapid price increases (price spikes) or sharp declines (price crashes), which can create uncertainty and instability in the affected markets. Volatility can be measured using statistical indicators such as standard deviation or volatility indices, which quantify the degree of price variation.

Now, let's examine how volatile prices can contribute to market failures with relevant examples:

1. Market Failure due to Price Uncertainty: Volatile prices can lead to price uncertainty, making it challenging for producers and consumers to plan and make informed decisions. Uncertainty about future prices can create inefficiencies, as economic agents may delay investments or purchases, leading to suboptimal resource allocation.

   Example: In the agricultural sector, price volatility of crops can make it difficult for farmers to predict their incomes accurately. As a result, some farmers may reduce investments in technology or land, leading to lower agricultural productivity and potential food supply disruptions.

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3. Market Failure due to Information Asymmetry: In situations where some market participants have access to better information than others, price volatility can exacerbate information asymmetry. Parties with superior information may exploit price fluctuations to their advantage, leading to adverse outcomes for less informed participants.

   Example: In financial markets, high-frequency traders may have access to real-time market data, allowing them to take advantage of price fluctuations to execute trades before other market participants. This creates information asymmetry, as retail investors may not have the same access, resulting in unequal market conditions.

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5. Market Failure due to Speculative Behavior: Volatile prices can attract speculative behavior, where individuals or institutions buy and sell assets purely for short-term profit, rather than based on the intrinsic value of the asset. Speculation can lead to market bubbles and bursts, resulting in misallocation of resources and financial instability.

   Example: During the housing bubble of the mid-2000s, housing prices experienced significant volatility due to speculative behavior and risky lending practices. The eventual burst of the bubble led to a financial crisis, causing severe economic consequences.

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7. Market Failure due to Price Distortions: In the presence of volatile prices, firms and consumers may make decisions based on short-term fluctuations rather than long-term economic fundamentals. This can lead to inefficient resource allocation and suboptimal production and consumption decisions.

   Example: In the oil industry, volatile oil prices can lead to price distortions, impacting investment decisions in exploration and production. During periods of high prices, investment may increase, leading to excess capacity when prices eventually decline.

While volatile prices themselves may not be a market failure, they can exacerbate existing market failures or contribute to suboptimal outcomes in certain economic sectors. Effective market regulation, transparency, and stability measures can help mitigate the negative impacts of volatile prices and promote more efficient resource allocation in the economy.

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Price Stabilization Mechanism:

Price stabilization is a government intervention or policy aimed at preventing excessive fluctuations in the prices of essential goods and services. The objective is to stabilize prices and ensure affordability for consumers while providing predictable and fair returns to producers. Price stabilization mechanisms are typically used during periods of extreme price volatility or in response to supply shocks to maintain economic stability and protect vulnerable consumers from sudden price spikes or crashes.

Working of a Price Stabilization Mechanism:

A price stabilization mechanism can be implemented through various methods, including price ceilings, buffer stocks, and market interventions:

1. Price Ceilings: Price ceilings, also known as maximum prices, are government-imposed limits on the maximum price that can be charged for a specific good or service. The government sets the price ceiling below the market equilibrium price to prevent prices from rising beyond a certain level.

Example: During a period of soaring food prices, the government may set a price ceiling on staple food items to ensure affordability for consumers.

2. Buffer Stocks: Buffer stocks involve the creation and management of stockpiles of essential goods by the government. These stockpiles act as a reserve to be released into the market during times of shortage to stabilize prices.

Example: The government may establish a buffer stock of grains and other agricultural commodities to be released when there is a sudden decrease in supply due to adverse weather conditions.

3. Market Interventions: In some cases, the government may directly intervene in the market by buying or selling goods to influence prices. These interventions can be temporary measures to stabilize prices during periods of high volatility.

Example: The government may purchase excess supply of perishable goods from farmers at fair prices during times of oversupply to prevent market prices from plummeting.

Benefits and Limitations of Price Stabilization Mechanisms:

Benefits:

• Price stabilization mechanisms help protect consumers from sudden price spikes, making essential goods more affordable and accessible.
• They provide stability and predictability to producers, ensuring they receive fair returns for their goods.
• These mechanisms can reduce market distortions, maintain economic stability, and promote consumer confidence.

Limitations:

• Price stabilization mechanisms may lead to unintended consequences, such as excess demand or supply distortions in the market.
• The cost of implementing and maintaining price stabilization mechanisms can be significant and may strain government resources.
• In some cases, price controls can discourage investment and innovation in the affected industries.

Conclusion:

A price stabilization mechanism is a government intervention designed to stabilize prices and prevent extreme fluctuations in the market. By employing price ceilings, buffer stocks, or market interventions, governments aim to protect consumers from sudden price shocks and ensure stability in essential markets. However, such mechanisms should be carefully designed and managed to avoid unintended consequences and ensure long-term economic sustainability.

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Guaranteed Minimum Price Scheme:

A guaranteed minimum price (GMP) scheme is a government policy that aims to support producers by ensuring that they receive a minimum price for their goods or services, even if the market price falls below that level. The government intervenes to stabilize prices and protect producers from the risks of price volatility and unpredictable market conditions. GMP schemes are often implemented in agricultural sectors to support farmers and provide them with income security.

Working of Guaranteed Minimum Price Scheme:

The working of a guaranteed minimum price scheme involves the following key steps:

Setting the Minimum Price: The government sets a minimum price for a specific agricultural commodity, which acts as a floor price below which the producers' sales are guaranteed.

Market Monitoring: The government continuously monitors the market conditions and the prevailing prices of the commodity. If the market price falls below the minimum price, the GMP scheme is triggered.

Market Intervention: When the market price falls below the minimum price, the government steps in as a buyer of last resort. It purchases the excess supply from producers at the minimum price to stabilize the market and provide support to farmers.

Creating Buffer Stocks: In some cases, the government may create buffer stocks by stockpiling the purchased commodities. These buffer stocks can be used to release supply during times of shortages or to control price fluctuations.

Example of Guaranteed Minimum Price Scheme:

Consider a situation where the government implements a guaranteed minimum price scheme for wheat. The minimum price for a bushel of wheat is set at $10. If the market price falls below $10 due to factors like oversupply or international competition, farmers can sell their wheat to the government at the guaranteed price of $10 per bushel. This ensures that farmers receive a fair and stable income, even during periods of low market prices.

Benefits and Limitations of Guaranteed Minimum Price Scheme:

Benefits: Provides income stability and support to producers, especially small-scale farmers, during times of market volatility or adverse weather conditions.
Encourages farmers to continue production, knowing they have a guaranteed price for their produce.
Helps to prevent sharp declines in farmers' income and mitigates the risks associated with fluctuating market prices.

Limitations: The cost of implementing a guaranteed minimum price scheme can be substantial and may require significant government funding.
The scheme may lead to the accumulation of surplus stocks if market prices remain consistently below the guaranteed price.
Depending on the design and implementation, the scheme may distort market incentives and hinder efficiency.

Conclusion:

A guaranteed minimum price scheme is a government policy aimed at stabilizing incomes for producers in the face of price volatility and market uncertainties. By setting a floor price and intervening when market prices fall below that level, the scheme provides support to farmers and ensures their economic resilience. However, successful implementation requires careful monitoring and management to strike a balance between supporting producers and maintaining market efficiency.

The biggest lesson of GameStop

Rana Foroohar in The FT

Much has been written about whether the GameStop trading fiasco is the result of illegal flash mobs or righteous retail investors storming a rigged financial system. Robinhood’s decision to block its retail customers from purchasing the stock while hedge funds continued trading elsewhere has turned the event into a David and Goliath story. 

But that story is predicated on a false idea, which is that markets that have been “democratised” and that people trading on their phones somehow represent a more inclusive capitalism. 

They do not. Markets and democracy are not the same thing, although most politicians — Democrats and Republicans — have acted since the 1980s as if they were. That period was marked by market deregulation, greater central bank intervention to smooth out the business cycle via monetary policy following the end of the Bretton Woods exchange rate system, and the rise of shareholder capitalism. This combined to begin moving the American economy from one in which prosperity was based on secure employment and income growth, to one in which companies and many consumers focused increasingly on ever-rising asset prices as the most important measure of economic health. 

Right now, short-term fiscal stimulus aimed at easing the economic pain from Covid-19 is distorting the picture. But putting that aside, the US economy is at a point where capital gains and distributions from individual retirement accounts make up such a large proportion of personal consumption expenditure that it would be difficult for growth to continue if there were a major correction in asset prices. 

That is one reason why the GameStop story has so unnerved people. It reminds Americans how incredibly dependent we all are on markets that can be very, very volatile. 

The 40-year shift towards what President George W Bush referred to as an “ownership society” came at a time when the nature of the corporation and the compact between business and society was changing, too. The two phenomenon are of course not unrelated. 

The transformation of markets put more short-term pressure on companies, which cut costs by outsourcing, automating, using less union labour and dumping defined benefit pensions for 401k plans, which put responsibility for choosing investments, and the risks of bad outcomes, on individual workers. In 1989, 31 per cent of American families held stock. Today it is nearly half. Now, it seems, we are all day traders. My 14-year-old recently told me I should “buy the dip,” which did nothing to quell my fears that we are in the midst of an epic bubble. 

GameStop is the perfect reflection of all of this. The ultimately unsuccessful effort to squeeze short-sellers by pushing up the share price illustrates the risks of the markets. At the same time, the company itself illustrates how the nature of employment has changed. In a 2015 Brookings paper, University of Michigan sociologist and management professor Jerry Davis tracked the job growth linked to every initial public offering from 2000 to 2014 and found that the single largest creator of organic new employment was, amazingly, GameStop. The then-fast growing retail chain had an army of mostly part-time game enthusiasts who generally made just under $8 an hour. They were “the new face of job creation in America, ” wrote Davis, whose 2009 book Managed by the Markets is a wonderful history of the rise of the “ownership” society. 

I contacted Davis, who is now at Stanford University working on a new book about the changing nature of the corporation, to ask his thoughts about GameStop and the controversy surrounding it. He sums up the big picture about as well as anyone could: “Rescuing an extremely low-wage employer from short-sellers by pumping up its stock is not exactly storming the Bastille.” What’s more, he adds, “Robinhood easing access to stock trading does not democratise the stock market any more than Purdue Pharma democratised opioid addiction. Democracy is about voice, not trading.” 

I hope that politicians and regulators keep this core truth in mind during the coming hearings about GameStop and Robinhood. I fully expect Treasury secretary Janet Yellen will, based on her recent pledge to staff to address long-term inequality. 

While apps and social media have led more people to trade shares, that has not made our system of market-driven capitalism stronger. Our economy is largely based on consumer spending, and that consumption rests on asset price inflation which can now be brewed up by teenagers in their bedrooms. If current employment trends continue, many of the latter will end up working gig economy jobs without a safety net to catch them when their portfolios collapse. 

That is neither sustainable nor supportive of liberal democracy. That is why I applaud Joe Biden’s core economic promise to move the US economy from one that prioritises “wealth” to one that rewards work. 

The details of the GameStop debacle should be parsed and any villains punished. But we must not lose sight of the main lesson: an economy in which individual fortunes are so closely tied to the health of the stock market rather than income growth is fragile. Speculation, no matter how widely shared, isn’t democracy.