1. The Market Economy Fall 2008 Outline

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

• Quantity of B

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 Labour

• Quantity of land

• Output = 1 Unit of A

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

• How the consumer values goods

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