Lesson 2: Missing Markets and Missing Prices

Concepts:

• Markets provide information in the form of prices.
• Opportunity cost
• Prices
• Information costs
• Investment
• Demand and Supply
• Markets
• Competition

Content Standards and Benchmarks (3, 7 and 8):

Standard 3: Different methods can be used to allocate goods and services. People, acting individually or collectively through government, must choose which methods to use to allocate different kinds of goods and services.

Benchmarks:

• No method of distributing goods and services can satisfy all wants.
• There are different ways to distribute goods and services (by prices, command, majority rule, contests, force, first-come-first-served, sharing equally, lottery, personal characteristics, and others), and there are advantages and disadvantages to each.
• Scarcity requires the use of some distribution method, whether the method is selected explicitly or not.
• There are essential differences between a market economy, in which allocations result from individuals making decisions as buyers and sellers, and a command economy in which resources are allocated according to central authority.
• People in all economies must answer three basic questions: What goods and services will be produced? How will these goods and services be produced? Who will consume them?
• National economies vary in the extent to which they rely on government directives (central planning) and signals from private markets to allocate scarce goods, services, and productive resources.
• Comparing the benefits and costs of different allocation methods in order to choose the method that is most appropriate for some specific problem can result in more effective allocations and a more effective overall allocation system.

Standard 7: Markets exist when buyers and sellers interact. This interaction determines market prices and thereby allocates scarce goods and services.

Benchmarks:

• Market prices are determined through the buying and selling decisions made by buyers and sellers.
• Relative price refers to the price of one good or service compared to the prices of other goods and services. Relative prices are the basic measures of the relative scarcity of products when prices are set by market forces (supply and demand).

Standard 8: Investment in factories, machinery, new technology, and the health, education, and training of people can raise future standards of living.

Benchmarks:

• Scarce goods and services are allocated in a market economy through the influence of prices on production and consumption decisions.
• Changes in supply or demand cause relative prices to change; in turn, buyers and sellers adjust their purchase and sales decisions.
• Government-enforced price ceilings set below the market clearing price and government – enforced price floors set above the market clearing price distort price signals and incentives to producers and consumers. The price ceilings cause persistent shortages, while the price floors cause persistent surpluses.

Lesson Theme:

In the absence of markets, the planning ministry of the Soviet Union faced an impossible task in trying to gather, analyze, and disseminate the information necessary to answer the basic economic question of how to allocate resources for the purposes of production and consumption by an entire nation.

Key Points:

1. The opening lesson alluded to the great imbalances of the Soviet economy and how these imbalances were the logical consequence of the choice made by the revolutionaries and their successors to create a centrally directed economy emphasizing priority sectors.
   • The next four lessons will look at the components of the Soviet economy with an eye to revealing the structural weaknesses that, despite massive investment, prevented the Soviets from reaching the levels of production and of productivity achieved by western economies.
2. Review: All economies, whether planned or market-based, face choices about how to allocate resources.
   • There are simply not enough resources – natural, human, or capital – to allow all wants to be met.
   • This constraint results from scarcity rather than from the type of economic structure.
     • All economic systems must make choices about how to use limited resources.
   • Different economic systems use different methods to decide what combination of goods and services to produce and how to direct resources to their end uses.
   • Regardless of the type of system, the inescapable fact of scarcity results in many interests competing for the resources that are available.
3. Market economies make decentralized decisions about resource use; centrally directed (or command) economies like the Soviet Union, used centralized decision making.
   • In market based systems, coordination of production and distribution is left to individual initiative.
     • Suppliers of goods and services, motivated by profit, produce in response to demand by consumers.
     • Suppliers of capital, natural resources, and labor offer their services, in return for income, in response to demand by producers of goods and services.
   • The choice to buy or sell any resource, product, or service involves an opportunity cost – the value of the choice that is foregone. (Choosing is Refusing).
     • Prices offer buyers and sellers information regarding the value of the resources for various uses as well as the value of the goods and services made from those resources.
     • Prices let producers and sellers know when to expand or reduce supply; by comparing the cost of producing a unit to the potential revenue to be earned.
     • Prices impose constraints on buyers who must pay for whatever is consumed out of their limited budgets.
     • Market prices allocate resources (and goods) to their highest valued uses – uses with values above the opportunity costs.
       • Thus Michael Jordan plays professional basketball rather than playing baseball or being a singer. Ross Perot, on the other hand, develops and leads companies rather than playing professional basketball.
4. The Soviet Union had almost no legal markets, and prices and wages were set by the central planners. The economic problem then became: In the absence of the information that markets provide, how are the questions of production and distribution to be answered? This was the dilemma facing the central planning ministry of the Soviet economy.
   • Major economic goals for the Soviet Union were set by the Politburo and Gosplan.
     • The goals tended, of necessity, to be very broad in nature, but clearly reflected the priorities of the leaders.
   • This centrally directed goal setting (through 5 Year Plans, etc.) had some advantages, particularly in the early years when the economy was fairly simple:
     • The system had the ability to mobilize high investment levels, which lead to rapid industrial growth.
     • The goal-setting process served the priorities of government leaders, who saw in rapid industrial growth the steady enhancement of military capability.
     • The control mechanism for allocating resources was relatively simple.
     • The system could eliminate any wasteful competition and could exploit economies of scale (the efficiencies that may result from large-scale, over small scale, production).
5. In the Soviet Union, central planning attempted to take the place of markets.
   • In market economies, the buying and selling interactions of producers and consumers set prices, identify priorities in both consumer and resource markets, and generate information vital to accurate forecasting of future demand and resource availability.
   • In planned economies, some one or some central agency must
     • project desired output in both the consumer and producer sectors;
     • identify available resources; and
     • make decisions about the allocation of those resources based on output goals in the many separate sectors of the economy.
   • The implementation of economic plans in the USSR was the responsibility of Gosplan, the central planning agency.
     • In its annual plan, Gosplan calculated theoretical inter-industry balances and tried to model the resource requirements for every product group.
   • The administrative requirements of such a plan resulted in the creation of more than 50 vertically integrated industrial ministries that were:
     • responsible for assigning production plans and allocating resources to enterprises scattered across 9 times zones in Europe and Asia; and
     • by the 1980s, responsible for coordinating and directing the production of 24 million different products.
   • The ministries faced the daunting task of trying to gather information and the frustration of having little ability to alter the Gosplan’s distribution of resources .
     • Although prices were fixed by Gosplan, a retailer could get some signal that stylish women’s shoes were in deficit or that four fingered gloves were in surplus and could pass this information to the ministry level in Moscow.
     • However, the ministry had little hope of increasing the supply of women’s shoes because it could not significantly affect the allocation of resources.
       • Decisions about overall resource allocation were made by the Politburo.
6. In the economy of the Soviet Union, production responded to administrative instructions, not to market signals, with predictable consequences:
   • There was no reliable or efficient way to measure consumer demand for goods and services, or consumer satisfaction with the goods and services they were able to acquire.
     • Everything produced was distributed and (sooner or later) sold, so there was no measure to project quality, style, or changing consumer tastes.
     • Highly desired goods generated long lines of waiting customers, but not higher prices; therefore, valuable resources were not systematically allocated to their highest valued uses because values of goods and of resources were not reflected in prices.
     • Styles and production levels might be set at the ministry level for women’s boots. In the event that women didn’t like the boots and didn’t buy them, the factory still produced to its target, and the boots were shipped to warehouses and stored for years.
   • The ministry engaged in a great deal of negotiation to acquire resources.
     • The control that officials had over resources led to the common practice of taking favors, or even bribes, in return for resources.
       • While officials did not own the resources, they certainly controlled them.
       • In anticipation of shortages, production managers often hoarded spare parts, tools, and other resources badly needed elsewhere.
   • The system also encouraged ministers to conceal information on resource needs and production capabilities.
   • The lack of good information and a feedback mechanism meant that resources were often assigned to less than their highest valued uses.
   • Because the production targets were usually set as aggregates to be implemented by local officials and plant managers, the targets often resulted in incentives for illogical production.
     • Size rather than number became the motivator when production goals were given in weight or tonnage of production, rather than in units.
     • Examples include:
       • lamps with heavy lead bases to increase tonnage; and
       • huge nails and extremely thick panes of glass when nail and glass production were measured by weight.
     • Targets set in number of units rather than weight resulted in very small products:
       • thin nails,
       • fragile glass,
       • an overabundance of baby-sized clothes.
7. In addition to missing markets for goods and services, the Soviet Union coped with missing markets in resources like financial and physical capital and land.
   • The lack of capital markets meant that all major investment decisions were made by planners.
     • Planners, who didn’t face the costs of their decisions, frequently tied up resources in large scale grandiose projects.
     • This left out the possibility of small scale individually financed projects – such as are a major component of successful western economies.
   • Land uses and housing were determined by planners as well.
     • This led to inflexible conditions of use that hobbled the Soviet economy:
       • housing concentrated at the edges of cities;
       • factories built in the countryside despite high transportation costs; and
       • shoddy high rise apartment buildings that workers considered undesirable.

Conclusion:

As the Soviet economy became more complex, costs of information about resource values and people’s desires rose astronomically. The planning problems became increasingly daunting and eventually insurmountable. No matter their size or complexity, the ministries could not hope to replace the information gathering and dissemination functions so efficiently carried out by market prices. The lack of market information on the values of goods, services, and resources in the Soviet Union, and the increasing ability of western market based economies to use and move information rapidly widened the gap in standards of living.

Activity:   Missing Markets – The Task of the Planning Ministry

Demonstration Video

Lesson Overview:

In this simulation, student “ministers” find that their ability to distribute goods and services to satisfy consumer wants and needs is severely hampered by their inability to access the information that markets provide. Students compare the level of consumer satisfaction that results from a centrally planned allocation of 2 goods to the allocation of the same goods by markets.

Economic Concept:

Markets provide important information about price and consumer demand that is not available to planners who must make allocation decisions in centrally directed (command) economies.

Economics Content Standards:

Standard 3: Different methods can be used to allocate goods and services. People, acting individually or collectively through government, must choose which methods to use to allocate different kinds of goods and services.

Benchmarks:

• There are different ways to distribute goods and services (by prices, command, majority rule, contests, force, first-come-first-served, sharing equally, lottery, personal characteristics, and others), and there are advantages and disadvantages to each.
• There are essential differences between a market economy, in which allocations result from individuals making decisions as buyers and sellers, and a command economy in which resources are allocated according to central authority.
• National economies vary in the extent to which they rely on government directives (central planning) and signals from private markets to allocate scarce goods, services, and productive resources.
• Comparing the benefits and costs of different allocation methods in order to choose the method that is most appropriate for some specific problem can result in more effective allocations and a more effective overall allocation system.

Standard 8: Prices send signals and provide incentives to buyers and sellers. When supply or demand changes, market prices adjust, affecting incentives.

Benchmarks:

• Scarce goods and services are allocated in a market economy through the influence of prices on production and consumption decisions.

Materials:

• Record chart for blackboard or overhead transparency
• 50-75 #2 pencils, unsharpened
• 100 assorted Halloween size candy bars
• “production chips” (colored paper clips, poker chips, etc.)
• prizes for successful store managers (large candy bar, fast food certificate, etc.)

Time required:

• 1-2 class periods

Assessment:

The following story appears in Meltdown (by Paul Craig Roberts and Karen LaFollette, Washington D.C.: The Cato Institute, 1990, p. 19-20):

“Although demand for boots had been falling, shoe factories concentrated on premium-maximizing [heavy woolen] boots. During the first year, the Russian Shoe Trade Association (Rosobuvtorg) imposed 10,000 extra pairs on retailers, filling warehouses and stores. The next year the same thing happened, except this time the trade association manager insisted that sellers take 38,300 more pairs of boots, on top of the 13,000 pairs that now languished in storage. So shoe sellers ended up with the boots, knowing full well that they could never sell them. At last count, retailers were buried under 200,000 pairs of boots that filled every imaginable space.”

Suppose that, instead of the Russian Trade Association, Nike had made the first 10,000 pairs of women’s woolen boots. Rewrite the above description to include the changes in:

• the flow of information,
• the resulting allocation and pricing decisions that Nike would have made, and
• the impact of those decisions on the consumers.

Procedures

Part 1

1. Appoint 2 planning ministers and tell them that they must decide how to use available resources to produce 2 consumer goods – pencils and candy. Show the ministers and the class the pencils and candy and then offer the ministers the following information:
   • You have enough resources to produce 25 pencils or 50 pieces of candy or any of the proportionate combinations: 24p and 2c, 23p and 4c etc. (Depending on the class, you may want to list the combinations on the board.)
     • Note well: These numbers are based on a class of about 25-28 students. Reduce the numbers for smaller classes. Numbers must be small enough that not all student wants are easily satisfied.
   • You are to instruct the production managers at the pencil and candy factories how much to produce and sell and at what price to sell each item.
   • Your goals are to:
     • use all available resources (no idle resources), and
     • keep consumers as happy as possible
   • Your classmates will be the consumers in this economy, and each will have 20 rubles to spend.
   • Because we are interested in how you made your decision as well as what you decided, I am going to send an observer along to listen to you make your decisions. The observer may NOT participate in your discussion in any way.
   • The observer is only there for purposes of debriefing the exercise and I will pay candy for his/her time and effort.
2. Appoint an observer who can be counted on to pay attention while staying in the background. Instruct the observer to take notes so that he/she can tell us later how the ministers made their decision, what problems they faced, etc.
3. Send the ministers and the observer out in the hall. Tell them they will have only 2-3 minutes to make their decisions.
4. While the ministers are deliberating, choose 2 factory managers. Set them up at the front of the room in front of black board signs for “Candy” and “Pencils.”
5. Distribute 20 ruble cards to the rest of the class. Tell them that the cards work like debit cards and the amount they spend will be marked off at the store.
   • They are free to buy pencils and/or candy or to not spend their money at all. If they have the money, they may purchase as many items as they wish.
   • Explain to the class that as high school students, they will soon be taking a test to determine whether or not they will be admitted to the elite State University.
     • Remind them that admission to the university is literally the difference between a life of some comfort and a life of poverty.
     • Also tell them that to get into the examination room, each student must have at least one new, unsharpened, number 2 pencil. They may want to keep this in mind as they make their purchases.
6. Call the ministers back into the room. When they tell you the production amounts, distribute candy and pencils to the factory managers, but do not let them announce the production amounts.
   • Post the prices of candy and pencils on the blackboard and distribute the correct number of pencils and candy to the factory managers.
   • Tell the planning ministers that they may stand in the doorway if they would like to, but they may not interact with the consumers.
     • (If your classroom door has a window, close the door and let the ministers observe – if they want to – through the glass.)
7. Conduct a 2-3 minute selling round in which students can come to the pencil or candy managers and purchase goods at the posted price.
   (Call time to end the trading session before consumers buy a good other than their first choice just because the factory is out of their first choice and they can’t buy it.)
   • Call time and halt the transactions whether or not all the pencils and candy have been sold.
   • Record the numbers of pencils and candy sold.
   • Record the number of citizens who are dissatisfied because they couldn’t buy what they wanted to.
   • Collect any remaining pencils and candy from the 2 factory managers.
8. Instruct the ministers that in planning for the second round, they may change the allocation of pencils and candy if they wish, but that their superiors have decided to hold prices constant to promote stability in the economy.
   • Send the ministers and the observer into the hall to make their decisions.
9. Distribute another 20 rubles to the class.
   • Announce that congratulations are in order. Everyone passed the university exams!
   • The polite thing to do would be to have a party for all your friends and relatives to thank them for their support. You’ll need lots of candy for your guests, of course.
10. Recall the ministers of planning and have them deliver their allocation information.
    • Provide the required number of pencils and candy to the factory managers. (Do not announce the numbers.)
    • Remind students of the prices of pencils and candy.
11. Conduct the second selling round as you did the first.
    • Call time and record the sales.
    • Count and record the number of unhappy consumers.
    • Collect any remaining “goods.”
12. End this portion of the simulation. (To keep down the cost of running the simulation, you may want to collect all the pencils to use with another class.)Debrief:
    • How did the ministers of planning make their decisions about the allocation of resources and the prices of the products?
      • Ask the ministers and the observer to report.
    • Did their allocation decision change over the rounds of the activity?
      • Why or why not?
    • Ask the class how satisfied they were as consumers.
      • Did they get all of the pencils and candy that they wanted to buy?
    • Did the desire, or demand, for pencils and candy change during the rounds?
      • Is this realistic?
      • Do the desires of consumers change from week to week in real life?
      • Were the planning ministers able to get information about these changes?
    • What were some problems created by having central planners do the allocating and pricing of goods?
    • Do you think that having ministers of planning decide on allocation and prices of pencils and candy was a good way to make decisions?
      • Why or why not?

    Note: In some instances, students may have resorted to secondary sales or even bribery to get pencils and candy. This is OK and should be discussed in the debriefing as a possible consequence of the frustrations created by the misallocation of pencils and candy by the ministers.

13. At this point, there are two options. The shorter option is to complete the exercise by conducting a large group discussion in which students draw on their own experiences in markets. The teacher’s goal is to focus student thinking on a comparison between allocation by planners and allocation by “unplanned” markets. Emphasize to students
    • the responsiveness of markets, and
    • the role of prices in providing the information makes that responsiveness possible.

    If your class has little opportunity to examine markets, you may want to run the (optional) second part of the activity, in which the students actually create a market for pencils and candy.Discussion Questions (or homework worksheet to be discussed the next day):

    • Suppose that the sellers of pencils and candy had been in the United States. What would have been different?
    • What would determine the number of pencils and pieces of candy in each store?
      • How would the store manager know that people’s desires for products had changed?
      • What might he or she do?
      • Suppose he raises the price and people still buy pencils; what information does the manager have about people’s desire for pencils?
      • Would the store manager need to know why people’s desires had changed?
    • Suppose the store manager made a mistake and had too many pencils (like the ministers did). What would happen?
    • Is the store manager better able or worse able than the planner to gather information that lets him provide the things customers want? Why? How does he get that information?

    Part 2 (Optional)

14. Explain to students that in the second part of the simulation they try another way to allocate pencils and candy, and then compare the results with the planning ministry method.
    • Tell the former planning ministers that they have inherited a store in the U.S. that sells pencils and candy.
      • (Note: Use the same 2 students because they do not have the information about why the consumer demand for pencils and candy changed. It is important in the debriefing to be able to show that they could make effective market decisions even without this knowledge.)
    • The store is large and employs 4 checkout clerks. (Appoint students to take these roles.) The former owner of the store had set the price of candy at 5$ and the price of pencils at 15$.
    • Tell the owners that you will give them 5 pencils, 10 pieces of candy, and 15 production chips that can be turned into the warehouse (you) for more products. (Reduce these numbers for classes smaller than 25 students.)

    One production chip = 1 pencil or 2 pieces of candy.

    • Tell the store owners that you will decide how successful they are by observing 2 criteria:
      • whether consumers are upset because they have to wait in long and/or slow lines, and
      • whether they have shortages or surpluses of candy and pencils.
    • If their store is well run, they will be rewarded at the end of the simulation.
15. While the owners are setting up their checkout clerks in the front of the room, distribute 20-dollar cards to the rest of the students.
16. When the store is ready and all the consumers have their dollars, explain that when the store is open, the owners can come to you at any time during the round and exchange their production chips for more products.
    • Also, it is very important to let the owners know that they can change the prices of their products at any time during the round.
      • Explain that because the selling round might be chaotic, the owners may call a “time out” to make production and pricing adjustments.
17. Run 2 or 3 rounds.
    • Give consumers a $20 card at the beginning of each round, and give the store owners 25 production chips at the beginning of each round.
    • Ask consumers to keep track of the prices of their purchases on the back of their dollar cards.
    • At the end of each round, record quantities purchased (and prices) by tabulating a show of hands from the consumers.
18. At the beginning of one round, ask the consumers to pretend that it’s the “university situation” from the last simulation again.
    • (Don’t tell the store owners what this means and don’t let other students tell them. We want to see if they adjust, even though they don’t know why consumers’ demand changed.)
19. At the beginning of another round, ask the consumers to pretend it’s the “congratulations situation” from the last simulation.
    • (Again, don’t tell the store owners what this means.)
20. End the simulation.
    • (Don’t forget to pay the clerks and observer with candy.)

Debrief:

• How did the owners of the store make their decisions about the numbers of pieces of candy and pencils (allocation of resources)?
  • How did they know what to turn in their production chips for?
• How did the owners of the store decide what price to charge for pencils and for candy?
• Did the allocation and/or pricing decisions change over the rounds, or even during the rounds? Give examples of how it changed.
  • Store owners – Why did you make that change?
• Was there information that the store owners could use in their decisions that was not available in the planned rounds?
  • What was this information and where did it come from?
  • Why was this information available to the store owners and not to the planners?
  • Would it have helped the planners to know about the university entrance exams and the celebration parties?
    • (yes, although they still might not have been able to adjust very quickly and/or very accurately)
• Did the store owners need the information about the university entrance exams or the celebration parties to make effective decisions? Why?
  (no – all they had to know was that there were long lines for one or the other product. It was of no importance to them why the lines occurred.)
  • Refer to the blackboard and the records of sales and prices from the 2 parts of the simulation. What do they reveal about the importance of the feedback loop of information in enabling producers to adjust to consumers’ demands?
    • Were you, as consumers, more or less satisfied in the store phase or in the central planning phase of the simulation? Why?

  Did the store owners run the store successfully – that is, did they keep lines to a minimum and have the right mix of goods on hand? (Have class decide whether store owners deserve their rewards.)

  • Store owners / central planners – were you more or less satisfied in the store phase or in the central planning phase? Why?
  • Which method is better for making allocation and pricing decisions? Defend your choice in terms of benefits and costs of 2 alternatives.
    • Hint: Think back to the activity we did on the “Journey of Choices.” Suppose the 2 alternatives are a market system of allocation and a centrally planned system of allocation.
    • List the benefits of each.
    • What is the opportunity cost of choosing a centrally planned economy?
    • From your experience is this simulation, who would you say bears that cost?
  • Write a generalization that compares or contrasts markets and central planning systems of allocation in terms of “information” and “consumer satisfaction.”

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