|
|
|
You are here: Home > Current Topics > Mind your Business > 02 May 2005 |
|
|
|
|
Image: Pope John Paul II. His death led to the election of a new Pope - Joseph Ratzinger became Pope Benedict VI. Ratzinger was one of 115 potential candidates but could you have predicted who it would eventually be? The markets did!
The death of Pope John Paul II on April 2nd 2005 prompted the process of a conclave at which a new Pope would be elected. 115 cardinals entered the Sistine Chapel in Rome for secret discussions and a series of ballots that would determine who was to be the next Pope. In theory, any one of the 115 cardinals could have been candidates but only one of their numbers would emerge. On May 5th 2005, the UK will have a general election. The winner of the election will be one of the three major political parties - Labour, Conservative or Liberal Democrat. In reality, the race will really only be between two of these - the Conservatives and Labour. 4 weeks before the actual election could you have predicted who would win? In these two situations there is an outcome. The outcome in each case is uncertain but subject to some element of certainty that can be identified. In the case of the Pope, either Cardinal Ratzinger would be elected Pope or he would not; Cardinal Scola, the Patriarch of Venice and the subject of thousands of jokes, would also either become Pope or he would not. Labour will win the general election or it will not. The Conservatives will win the general election or it will not and so on. Each of these events has an unambiguous outcome. As such, a contract can be issued on this outcome. There are now a series of markets called Trade Exchange Networks that exist to enable individuals to buy and sell contracts on the outcome of such events. It appears that these markets are highly efficient in predicting the future. Their efficiency is such that the Pentagon, the United States Defence Department, floated the idea of using such markets to get information on politically sensitive outcomes like the possibilities of the US president being assassinated or the likelihood of a terrorist attack on the Houses of Parliament. Their plans were withdrawn after it was feared that assassins or terrorists with inside information could use the markets! One of the main principles of these markets is that those who trade in them are not party to inside information which would distort the whole workings of the market. 
Image: Some of these markets were extremely efficient in predicting the winner of the US presidential election in 2004; in some cases they were able to predict accurately which party would win which state and even the proportion of votes the parties gained!
What these markets are doing, therefore, is bringing together thousands, if not more, individuals all seeking to make a profit. They make a profit by buying and selling the contracts at different prices. The prices will rise and fall depending on the perceived outcome of the contract. A contract, therefore, could be announced that Michael Howard will win the election. If he does, then the contract will pay out £10. If not, it will pay out nothing. In the time up to the outcome, the contracts can be traded by the buyers and sellers in this market. If, as the election approaches, it looks as though Michael Howard will win the election then demand for the contract will rise and the price will also rise. If I bought the contract at the start of the period, I may have paid £4.20, as the election approaches and the price rises I might decide to sell it at £8.90 thus making a profit of £4.50 for each contract I own. The person buying the contract at £8.90 will, if Michael Howard does win the election, get £10 thus making a profit of £1.10. If the market feels the chances of Michael Howard winning are receding then they will try to sell and the price will fall. They will want to sell because holding on to the contract will mean they get nothing at the maturity of the contract period. Buyers will, therefore, either buy thinking the price is going to rise or sell thinking the price is going to fall. For each trade, the Exchange charges a small commission. The traders who are successful are the ones who correctly predict the outcome. To help them in their decision making they may well be watching polls, signs, news items, etc. very carefully. What happens, therefore, is that the combined wisdom of thousands of individuals is brought together through this trading process. The market can be very accurate in predicting outcomes. |
A market is any place that brings together buyers and sellers with a view to agreeing a price for exchange. This means that markets could be anything from a street market to a supermarket to e-Bay, a pub, club, the London Metal Exchange, or a drugs transaction on a street corner. Whether legal or not, each of these examples has the characteristics of a buyer, a seller and a price.
The 'market' is often spoken of as being an entity in itself, something tangible that exists somewhere out there in the world. We hear people saying things like, 'the market needs to cater for those less able to help themselves' or 'the market must take into account the effects on the environment'.
The market, however, is not a physical identity. It is made up of people. In some cases, the number in 'the market' can be very small, in other instances there are millions of people who make up the market.
As an individual, you are part of hundreds of markets but to illustrate the point we are going to assume you are walking into HMV or Virgin, or similar retail store, to buy a CD. This example is going to refer to the market for CDs. Within this overall market, however, there are thousands of sub-markets - such markets will depend on the type of music - rock, blues, jazz, garage, drum 'n' bass, classical, world, etc. You have no particular CD in mind but want to spend some time browsing the shelves. You have £30 to spend.
You represent the buyer, the demand for CDs. However, you bring to the market a peculiar set of individual and unique characteristics. As a potential buyer of CDs you have a certain demand schedule - a demand function. We express this function in the following manner.
This means: the level of demand (D) is dependent upon (is a function of (f)) Price (Pn), the prices of other goods (Pn... Pn-1) - substitutes and complements, Incomes (Y), Tastes (T), the level and structure of the population (P) and the level of advertising (A).
As you walk into the store, therefore, you are bringing with you a set of characteristics based on each of these factors which will determine ultimately what or whether you buy anything.
You might be swayed by the price of the range of CDs on offer, for example, some offers might mean you could buy 3 for £20 as opposed to two for £15 each; there might be a sales rack with CDs priced at £5.99 but they might not be ones that you would necessarily buy at full price. You have a limited income - most people do - so you want to make sure you get value for money.
This is termed 'utility' - the measure of satisfaction gained from a product. Utility is impossible to measure in the same way we measure length or volume. It is entirely subjective yet it is vitally important in guiding our spending decisions.
Image: Buyers and sellers coming together in a market. What will determine the final decision of the buyer and how does the seller try to anticipate this?
Title: Music Industry Hunts Illegal File Swappers. Copyright: Getty Images, available from Education Image Gallery
You are also going to be affected by the range of other goods available - there might be a CD of a band you like but also a DVD of a live performance. The DVD would be referred to as a substitute - something that can be used instead of another good but which effectively does the same job. Your decision on the CD or the DVD might depend on whether you have a DVD player. The DVD player would be referred to as a complement - something that tends to be bought along with another good or service.
Your age might also affect your spending decisions. You will be wandering around the store with hundreds of other people of all different ages. Age might be an important factor in determining the type of demand for a product; you might not find too many teenagers crushed around the 'easy listening' section of the store but neither are you likely to find too many pensioners rooting through the gangster rap CDs. The age structure and the size of the population are important determinants of demand.
Finally, the other major determinant of demand is advertising. This will be advertising that is not only in the store itself but also from the TV, radio, magazines and so on. You might go into a store, hear a track playing on the in-store radio and really like it and decide to buy it for that reason. Such facilities are simply a form of advertising for the store.
Facing you as you walk into the store are hundreds of CDs, store assistants, artists, producers, recording engineers, marketing people and others screaming out at you to buy their product. They have used all manner of methods to try to get you to select their particular CD amongst the thousands that are on offer. There might be 50,000 CDs for sale in the store but you might leave having bought only two of them or even none at all!
Supply, like demand, is dependent on a number of factors. Supply is completely independent of demand; supply does not depend on demand any more than demand is dependent on supply. There might be some relationship between the two but they are not dependent on each other. This is very important to remember and is often a source of confusion in student answers.
Supply is represented, like demand, as a function:
This says the level of supply (S) is dependent on (is a function of (f)) the price of the good (Pn), the prices of goods in joint or complementary supply (Pn... Pn-1), the level of technology (H), natural factors (N) - the climate, weather, availability of natural resources, etc., the expectations of producers (E) and the cost of factors of production in producing the good/service (F1... Fm).
The supply of CDs may be determined by some or all of these factors. CD producers and the retail store will certainly be influenced by the price they think they can get for the CD, the level of technology will play a part in how many CDs can be produced and the efficiency with which they can be produced in addition to the quality of the product.
The expectations of producers may involve how successful they think a particular artist or band will be, the quality of the judgment by the record companies in this respect may be crucial in anticipating the market reaction. The costs of production will include the cost of manufacturing, the capital equipment involved, the salaries of all the human resources involved in the process right down to the sales assistants, the profit margin required, the cost of land and raw materials, etc. The rental costs to locate a major store in London's Oxford Street, for example, are likely to be very high.
The market, therefore, consists of these two groups of people. For the most part, they do not know each other although the supplier may engage in market research to try to find out more about the people who buy their products (or who might buy them) but what is happening is that the seller is offering thousands of CDs for sale in the hope of persuading you, the buyer, to part with your money.
You may not think, as a single individual, that you have much power in these markets. That may be the case, but remember the market is made up of millions of individuals each bringing their own set of characteristics to the market. Your individual decision is but one that sends a message to the suppliers about the product they are offering for sale.
Image: Markets - any place bringing together buyers and sellers.
Title: Kashmiris Experience A Fragile Peace. Copyright: Getty Images, available from Education Image Gallery
Let's take the case of two artists in the music industry. U2 are an international music phenomenon; sales of their CDs run into millions. When they release a new album, there is a good chance that it is going to sell well, they are proven artists. The record producers might allow the band a good deal of freedom in the planning, production and content of the new release because they are trusted artists.
Images: Who would you choose? The Edge, guitarist with U2 - one of the most successful rock acts of the past twenty years, and Jan Akkerman during a sound check on tour in the UK, March 2005.
Copyright - The Edge. Title: The Edge Attends New Year's Eve Celebration In Dublin. Getty Images, available from Education Image Gallery.
Copyright - Jan Akkerman. Reproduced by kind permission of Clive Woodley, and the Jan Akkerman official site.
Jan Akkerman is a Dutch guitarist. During the early 1970s, Akkerman was in a band called Focus who achieved international fame and recognition. Akkerman quit the band in the late 1970s and since then has pursued a solo career. He is a highly talented and well respected guitarist but whilst he has a devoted fan base, he has not sold anything like the number of CDs that U2 have. His desire to be independent and pursue his own musical direction means he is not necessarily someone who a mainstream record company is likely to invest money in - the extent of the returns will not, from their point of view, justify such an investment regardless of his talent.
The number of U2 CDs available in the store is gong to be much higher than those of Jan Akkerman. The 'market' for U2 is much bigger, i.e. the number of people who are willing and able to buy their CDs. However, the record store will consider it important to cater for other tastes even if they are not as high profile.
Jan Akkerman is not likely to get his music played on national radio - he is not backed by the marketing budgets of the likes of Sony BMG or EMI. Many people who are potential music buyers, therefore, will never have heard of Jan Akkerman but the record companies may feel that the risk involved in investing in this artist is too risky.
So here you are in the record store. You spend your time browsing round the aisles sifting through the CDs. Some catch your eye and others look interesting but you are not convinced - maybe you have not heard them before but a friend has suggested the band are good, some CDs you will skip over because you have never heard of them!
Your decision will, therefore, be based on a variety of factors. You eventually select two CDs priced at £15 each. Your choice has sent a message to the store. Your choice says I think that the CDs I have chosen represent value for money - I will get at least £15 worth of value out of listening to each of them and I did not find anything else that represented better value for money at this time.
You also send a message that all the other CDs in the store were not considered worth buying. The numbers of people who make these totally individual choices determine the success and failure of the goods and services in a market. If you chose the U2 CD, you help to confirm their status as a top rock act, if you did not choose the Jan Akkerman CD you are sending the message 'I don't like this artist' or 'I do not know enough about them to persuade me to give up my limited resources to take the risk' or you are saying 'this style of music is not my style'. It might be that for some reason the packaging put you off, the design of the cover, or which section it was classified in.
To understand how the market works is to try to piece together all these millions of individual decisions and try to make sense of them. It is generally felt that the combined wisdom of the market tends to get things right but only when buyers and sellers have enough information on which to make informed choices. You may have really enjoyed the Jan Akkerman CD but the fact that you have probably never heard of him or what his music is like means you are not able to make an informed choice.
This is where the efficiency of markets is called into question. Many markets simply do not have informed buyers and sellers. To make 'the market' work more efficiently the quality and availability of information needs to be improved. You might like music but cannot devote sufficient time to be able to listen to every artist out there to help you make a really informed choice.
The network exchange markets however are another thing. They bring together individuals who devote such time to building their information about the market they are entering into. As a result of bringing together a large number of buyers and sellers with high quality information, the efficiency of the market in getting accurate predictions is more likely. Each of those individuals will not be entering the market with the aim of helping everyone else but in so doing are in fact contributing to that outcome.
This, in essence, is what Adam Smith was referring to by the notion of the 'invisible hand'. Each person goes about their daily business seeking to maximise their own welfare given their limited resources. In so doing they, of necessity, contribute to the welfare of the community at large. This fundamental principle is what drives the belief that the market is the most efficient and effective way of allocating scarce resources.
You are going to experiment with this by setting up your own market. Select something appropriate - the outcome of a football match, the rise or fall of the Stock Exchange, foreign exchange market or similar.
One person (or a small group) will have to act as the market makers and monitor the actions of the market - the rest of the group or the whole institution can be invited to take part if you wish!
Set up a contract for the event and mark out the contract on some paper. The group will then buy and sell the contract in the period up to the event occurring. One person will have to take responsibility for recording the transactions - you could even set this up on the college network!
The proviso here is that for each trade, you must write a short sentence explaining your reasoning for your decision. If demand is rising for the contract the price will rise - 10 units for each extra trader wanting to buy. So if you set the initial price at £5 and someone asks to buy a contract, the price will go up to £5.10. If a trader wishes to sell the price falls by 10 and so on. If there is a large number of people taking part you can reduce this increment to somethng more appropriate. Remember the price cannot rise above £10. Make sure the reasons are available for anyone wanting to get more information on the way the market is thinking.
Traders can buy more than one contract but each trader will have a maximum of an imaginary £50 to spend. When the outcome is known, pay out the contract to those who hold them and calculate the winners and losers of all the trades.
Biz/ed has produced the following resources to use in the activity:
You can carry the activity using purely paper based accounting.
