AP Microeconomics

5.3 Understanding Futures Contracts Assignment

Introduction
Farmers and their agricultural products such as corn, wheat, livestock, etc... are good examples of the
type of firm and good that operate within a perfectly competitive market structure. One important
concept that provides insight into how farmers operate within their market structure is the futures
contract. While this concept will not necessarily be on an AP test, it is important for anyone interested
in finance, politics, or risk management to understand.

Assignment
Read the first three sections of the following article and watch both video #1 and video #2. Then answer
the questions below. This assignment will be graded out of 8 points, with 2 points possible for each
question.

1) Explain what a futures contract is.

A futures contract is a type of financial contract that makes one party either promise to sell a particular
asset or purchase a particular asset at a certain date for a certain price.

2) Explain the benefit that futures contracts can provide.

Futures contracts can allow investors to speculate on whether a security, commodity or financial
instrument will increase in the future. Companies can also use futures to modify the price of particular
materials or products to help their business.

3) Futures contracts provide farmers with an increased chance at making a profit. Identify and explain
the characteristic of the perfectly competitive market structure that causes futures contracts to be so
important to farmers making a profit or a loss.

One of the important characteristics of a perfectly competitive market is that there is perfect
information about the price. Because this is never met in reality, there are instead approximations for
perfect information – and futures allow the market to get approximations to the perfect information on
the price of a good.
4) Agricultural products are bought and sold with futures contract. Cell phones and cars are not.
Identify and explain the characteristic of the perfectly competitive market structure that causes this to
be true.
Perfectly competitive markets have undifferentiated products – cars and cell phones are not
undifferentiated in any sense – brands command a very large power in those markets. In contrast, most
agricultural products are largely interchangeable and as such can be considered approximately
undifferentiated, making it possible for them to be bought and sold via futures contracts.