1. The Market Economy Fall 2008 Outline



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1. The Market Economy

  • Fall 2008

Outline

  • A. Introduction: What is Efficiency?
  • B. Supply and Demand (1 Market)
  • C. Efficiency of Consumption (Many Markets)
  • D. Production Efficiency (Many Markets)

A. Introduction

  • Economics is based on assumptions of maximization and equilibrium:
  • Individuals taking decisions to maximize profit or utility. (individualistic)
  • These decisions interact in markets and we use the notion of equilibrium to predict what is the outcome.
  • We build models who gets what and why they get it. (How resources are allocated.)
  • These have testable implications.

Key themes

  • Incentives: Why do optimizers do what they do?
  • Information: What do individuals know and is this useful?
  • Surprising idea: Individual optimization can promote the common good. (In certain cases.)
  • Markets and other domains where individuals interact aggregate individual’s decisions and information.

Pareto Efficiency

  • Definition: An allocation of resources is Pareto Efficient if it is not possible to reallocate resources to make everyone better off.
  • How do we measure better off?
  • We use Utility to measure welfare/happiness.

Utility Possibilities: What is Feasible

  • 1’s Utility
  • 2’s Utility

Utility Possibilities: What is Feasible

  • 1’s Utility
  • 2’s Utility
  • Allocations

Pareto efficiency: There is no waste

  • 1’s Utility
  • 2’s Utility
  • Pareto efficient Allocation

Equity: equal shares

  • 1’s Utility
  • 2’s Utility
  • U1 = U2

Utilitarianism: Maximize U(1)+U(2)

  • 1’s Utility
  • 2’s Utility

Rawls: Maximize min{U(1),U(2)}

  • 1’s Utility
  • 2’s Utility

Example: Efficiency in Exchange

  • A buyer values the good at 4 (and gets 0 otherwise).
  • A seller who values the good at 2 (and gets 0 otherwise).
  • They can trade at the price p.
  • Buyer Seller
  • Seller keeps the good no trade 0 2
  • Buyer pays seller p and 4-p p
  • buyer gets the good
  • Q: What values of p is trade better than no trade?

B. The Supply and Demand Fable

  • Suppose you have:
  • 100 people each wanting a cup of coffee, but valuing the coffee different amounts.
  • 80 people willing to make a cup, but with different costs.
  • Your job is to decide who should get a cup and who should make it.
  • What do you want to avoid:
  • (1) A $5 buyer not getting a coffee but a $1 buyer getting one.
  • (allocative inefficiency)
  • (2) A $1 seller not making a coffee but a $5 seller getting one.
  • (production inefficiency)
  • (3) A $3 seller providing coffee to a $2 buyer. (over provision)
  • (4) A $4 buyer not getting a coffee although there are sellers with $2 costs not making coffees. (under provision)
  • (5) Some coffee not being consumed by anyone.

Possible mechanisms

  • (1) Central Planning/Fiat: (Centralized)
  • Tell people what to do. (After first having tried to find out what people want.) Likely to fail all the above tests.
  • (2) Organize an Auction (Centralized)
  • Tell buyers and sellers to submit bids – likely to fail all tests.
  • (3) Organize a Market (Centralized & Decentralized)
  • Call out a price for coffee.
  • (4) Put them all in a room and let them get on with it!
  • (Decentralized)
  • P
  • Q of Coffee
  • Demand (100)
  • P
  • Q of Coffee
  • Supply (80)
  • P
  • Q of Coffee
  • Demand
  • Supply
  • P
  • Q of Coffee
  • Demand
  • Supply
  • P
  • Q of Coffee
  • Demand
  • Supply
  • P
  • Q of Coffee
  • Demand
  • Supply
  • P
  • Q of Coffee
  • Demand
  • Supply

Conclusions

  • If
  • a market is organized,
  • the market is perfectly competitive,
  • price is at the equilibrium,
  • then
  • full efficiency is achieved.

C. Efficiency of Economies with Many Goods (No Production)

  • Consumer Behaviour with Many Goods
  • Quantity of A

C. Efficiency with Many Goods

  • Indifference Curves
  • Quantity of A
  • Quantity of B
  • utility =2

C. Efficiency with Many Goods

  • Indifference Curves
  • Quantity of A
  • Quantity of B
  • utility =3

C. Efficiency with Many Goods

  • indifference curves
  • Quantity of A
  • Quantity of B
  • utility =4

C. Efficiency with Many Goods

  • Indifference Curves
  • Quantity of A
  • Quantity of B
  • Higher Utility

Budget Constraints

  • Quantity of A
  • Quantity of B
  • With $10 can afford 10 = pAX(Units of A) + pBX(Units of B)
  • 10 = pAQA + pB QB

Budget Constraints

  • Quantity of A
  • Quantity of B
  • With $10 can afford 10 = pAX(Units of A) + pBX(Units of B)

Budget Constraints

  • Quantity of A
  • Quantity of B
  • With $10 can afford 10 = pAX(Units of A) + pBX(Units of B)

Consumer Optimum

  • Quantity of A
  • Quantity of B

Consumer Optimum

  • Quantity of A
  • Quantity of B
  • Here Slopes are equal

Equal Slopes

  • Slope of Budget Line:
  • = - pA /pB
  • Slope of Indifference Curve
  • = - MUA / MUB

Equal Slopes

  • Slope of Budget Line:
  • = - pA /pB
  • Slope of Indifference Curve
  • = - MUA / MUB
  • This is called:
  • “The Marginal Rate of Substitution”

Equal Slopes

  • Slope of Budget Line:
  • = - pA /pB
  • Slope of Indifference Curve
  • = - MUA / MUB
  • Equality Implies
  • MUA / MUB = pA /pB
  • Or
  • MUB/ pB = MUB /pB
  • Interpretation:
  • Extra utility from $1 = Extra utility from $1
  • spent on A spent on B

At Last: Efficiency with Many Goods

  • Imagine 2 people: person I (she) and person II (he).
  • They begin life with:
  • Good A Good B
  • Person I 5 units 1 unit
  • Person II 1 unit 5 units
  • These are called endowments.
  • They want to trade to achieve better bundles.

Their Resources

  • I’s Quantity of A
  • I’s Quantity of B
  • II’s Quantity of B
  • II’s Quantity of A

Their Endowment

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

I’s Preferences

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

II’s Preferences

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

Putting Preferences together

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

Pareto efficiency: Is where cannot make I better off with out making II worse off.

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

Pareto efficiency: Is where cannot make I better off with out making II worse off.

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

Pareto efficiency: Is where cannot make I better off with out making II worse off.

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

Pareto efficiency: Is where cannot make I better off with out making II worse off.

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

Pareto efficiency: Is where cannot make I better off with out making II worse off.

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

Allocation of Resources is efficient if

  • Slope of I’s Indifference = Slope of II’s Indifference Curve Curve
  • I’s MRS = II’s MRS
  • MU(I)A / MU(I)B = MU(II)A / MU(II)B
  • Or
  • MU(I)A / MU(II)A = MU(I)B / MU(II)B
  • Extra utility I gets from Extra utility I gets from
  • small increase in A at the = small increase in B at the
  • expense of II’s small decrease expense of II’s small decrease
  • in A. in B.

All the Pareto efficient places

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

These join to give the Contract Curve

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

Pareto efficiency: Utility Possibilities

  • I’s Utility
  • II’s Utility
  • Pareto efficient Allocation

D. Production Efficiency

  • One firm uses inputs:
  • Land and Labour to produce good A
  • Another firm:
  • uses Land and Labour to produce good B.

Production Functions & Isoquants

  • Quantity of land

Production Functions & Isoquants

  • Quantity of Labour
  • Quantity of land
  • Output = 1 Unit of A
  • Output = 2 Unit of A

Production Functions & Isoquants

  • Quantity of Labour
  • Quantity of land
  • Output = 1 Unit of A
  • Output = 3 Unit of A
  • Output = 2 Unit of A

Production Functions & Isoquants

  • Quantity of Labour
  • Quantity of land
  • Output = 1 Unit of A
  • Output = 3 Unit of A
  • Output = 2 Unit of A
  • Output = 5 Unit of A
  • Output = 4 Unit of A

Most Efficient way of producing Output =3

  • Quantity of Labour
  • Quantity of land
  • $8 = PL QL+ PN PN

Most Efficient way of producing Output =3

  • Quantity of Labour
  • Quantity of land
  • $9 = PL QL+ PN PN
  • $8 = PL QL+ PN PN

Most Efficient way of producing Output =3

  • Quantity of Labour
  • Quantity of land
  • $10 = PL QL+ PN PN
  • $9 = PL QL+ PN PN
  • $8 = PL QL+ PN PN

Most Efficient way of producing Output =3

  • Quantity of Labour
  • Quantity of land
  • Output = 3 Unit of A

Most Efficient way of producing Output =3

  • Quantity of Labour
  • Quantity of land
  • Output = 3 Unit of A

Most Efficient way of producing Output =3

  • Quantity of Labour
  • Quantity of land
  • Here Slopes are equal
  • Output = 3 Unit of A

SLOPES ARE EQUAL SO:

  • Slope of Isoquant
  • = - MPN /MPL
  • = “Marginal rate of technical substitution”
  • Slope of Cost Line
  • = - PN /PL
  • Equal Slopes MPN /MPL = PN /PL
  • or
  • MPN /PN = MPL /PL

Production Functions & Isoquants

  • Quantity of Labour
  • Quantity of land
  • Here Slopes are equal
  • Output = 1 Unit of A
  • Output = 3 Unit of A
  • Output = 2 Unit of A
  • Output = 5 Unit of A
  • Output = 4 Unit of A

Many Firms Producing

  • Firm 1’s Labour
  • Firm 1’s Land
  • Firm II’s Land
  • Firm II’s Labour

Many Firms Producing

  • Firm 1’s Labour
  • Firm 1’s Land
  • Firm II’s Land
  • Firm II’s Labour

Many Firms Producing: Efficient Production

  • Firm 1’s Labour
  • Firm 1’s Land
  • Firm II’s Land
  • Firm II’s Labour

SLOPES ARE EQUAL SO:

  • Slope of Isoquant Firm I
  • = - MP(I)N /MP(I)L
  • = “Marginal rate tech substitution (I)”
  • Slope of Isoquant Firm II
  • = - MP(II)N /MP(II)L
  • = “Marginal rate tech substitution (I)”
  • Equal Slopes MP(I)N /MP(I)L = MP(II)N /MP(II)L
  • or
  • MP(I)N /MP(II)N = MP(I)L /MP(II)L

Many Firms Producing: Efficient Production

  • Firm 1’s Labour
  • Firm 1’s Land
  • Firm II’s Land
  • Firm II’s Labour

Production Possibility Frontier

  • Firm 1’s Labour
  • Firm 1’s Land
  • Firm II’s Land
  • Firm II’s Labour

Production Possibilities: What is Feasible

  • Firm 1’s Output
  • Firm 2’s Output

Production Possibilities: What is Feasible

  • Firm 1’s Output
  • Firm 2’s Output
  • Slope of this line represents how economy is able to move from production of 2 into 1 =
  • Marginal Rate of Transformation

At Last: Production Efficiency with Many Goods and One Consumer

  • Quantity of A
  • Quantity of B
  • Higher Utility

What can be produced

  • Firm 1’s Output
  • Firm 2’s Output

Maximizing Utility given Production

  • Quantity of A
  • Quantity of B
  • Higher Utility
  • How the consumer values goods

Slope of Indifference = Slope of Production Possibilities = Ratio of Prices

  • Quantity of A
  • Quantity of B
  • Higher Utility
  • How the consumer values goods

Efficiency with Many Goods and Production

  • Slope of Indifference = Marginal Rate of Substitution
  • Equals
  • Slope of Production Possibilities = Marginal Rate of Transformation
  • Equals
  • Ratio of Prices

Efficiency with Many Goods and Production

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

Many Firms Producing: What is produced is determined by input prices

  • Firm 1’s Labour
  • Firm 1’s Land
  • 1
  • 5
  • Firm II’s Land
  • Firm II’s Labour
  • 1
  • 5

Their Preferences

  • Quantity of A
  • Quantity of B
  • 1
  • 5
  • II’s Quantity of B
  • II’s Quantity of A
  • 1
  • 5

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