5.1 Stock values button
5.2 Public goods button

5.1 Stock values button

In the 1990s the stock prices of many new Internet firms skyrocketed even though these businesses had, up to that point, not earned any profits. Did that make any sense? Supply and demand in the stock market, of course, determine a firm’s stock price (or share price.) At any given moment individual share prices are equilibrium prices, at which quantity demanded equals quantity supplied. Changes in supply and demand drive stock prices up or down to establish new equilibriums. In general, when the majority of stock market participants expect greater profit in the future, the demand for its stock rises, boosting that stock’s equilibrium share price. The stock market is future oriented, not past or present oriented. Consider the Internet retailer Amazon.com, which began selling books and expanded to selling many other products. Although it had yet to earn a profit in any year, its share price exceeded $100 a share in late 1999. Stock market participants were betting on the future profitability of Amazon.com, believing that its head start in Internet retailing and innovative management eventually would make it one of the "big winners" in on-line commerce. So people bought Amazon.com stock on the expectation of future profitability and future higher share prices. The result of the former would be high dividends; the result of the latter would be large capital gains—the financial gain realized when securities or properties are sold for more than the price paid for them. In late 1999, many people who had bought the stock at very low share prices had obtained large unrealized capital gains or so-called "gains on paper." But that was not the end of the story. By late 2000, Amazon’s share price had declined from $100 to around $10. Stock market investors had soured on Internet firms in general and Amazon.com in particular. The expectations of huge future profitability gave way to the prognosis of long-term continuing losses. A few analysts even hinted at future bankruptcy. If Amazon eventually turns out to be "loser" rather than a highly profitable Internet "winner," its stock price will fall even more. Then people who bought the stock at high shares price will suffer very large capital losses. While expectations of profit can drive up stock prices, profitability ultimately sustains high share values. We encourage students to update the Amazon.com story via the Internet. Is Amazon earning a profit now? What is its current stock price?

Photograph courtesy of: www.amazon.com;

Street entertainers are often found in tourist areas of major cities. Some play violins, tubas, harmonicas, accordions, or other instruments, while others team up to sing songs or juggle various objects. Some street entertainers are highly creative and talented; others "need more practice." But, regardless of talent level, these entertainers illuminate the concepts of free riders and public goods. Most street entertainers have a hard time earning a living from their activities (unless event-organizers pay them). Their problem is that they have no way of excluding nonpayers from the benefits of their entertainment. They essentially are providing public, not private, goods and must rely on voluntarily payments. The result is a significant free-rider problem. Only a few in the audience put money in the container or instrument case, and many who do contribute only token amounts. The rest are free riders. Because they did not ask the entertainers to perform, they rightfully feel no obligation to pay for the performances. Free riders obtain the benefits of the street entertainment and retain their money for purchases that they initiate. Street entertainers are acutely aware of the free-rider problem and some have found creative ways to lessen it. For example, some entertainers involve the audience directly in the act. This usually creates a greater sense of audience willingness (or obligation) to contribute money at the end of the performance. "Pay for performance" is another creative approach to lessening the free-rider problem. A good example is the street entertainer painted up to look like a statue. When people drop coins into the container, the "statue" makes a slight movement. The greater the contributions, the greater the movement. But these human "statues" still face a free-rider problem: Nonpayers also get to enjoy the acts. A relatively few street entertainers supplement their earnings by selling CDs of their music to appreciative audience members. Unlike their public performances, the CDs are private goods. Only consumers who pay for the CDs obtain the benefits. Finally, because talented street entertainers create a festive street environment, cities or retailers sometimes hire them to perform. The "free entertainment" attracts crowds of shoppers who buy goods from nearby retailers. In these instances the cities or retailers use tax revenue or commercial funds to pay the entertainers, in the former case validating them as public goods.

Photograph courtesy of: (c)Richard List/Corbis;