1 Market Economies

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1. The Market Economy

Fall 2008


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Outline

A. Introduction: What is Efficiency?

B. Supply and Demand (1 Market)

C. Efficiency of Consumption (Many Markets)

D. Production Efficiency (Many Markets)


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A. Introduction

Economics is based on assumptions of maximizationandequilibrium:

Individuals taking decisions to maximizeprofit or utility.(individualistic)

These decisions interact in markets and we use the notionof equilibrium to predict what is the outcome.

We build modelswho gets what and why they get it. (How

resources are allocated.)These have testable implications.


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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 thecommon good. (In certain cases.)

Markets and other domains where individuals interact

aggregate individuals decisions and information.


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Pareto Efficiency

Definition: An allocationof resources is Pareto Efficientif it isnot possible to reallocate resources to make everyone

better off.

How do we measure better off?

We use Utilityto measure welfare/happiness.


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Utility Possibilities: What is Feasible

1s Utility

2s Utility


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Utility Possibilities: What is Feasible

1s Utility

2s Utility

Allocations


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Pareto efficiency: There is no waste

1s Utility

2s Utility

Pareto efficient Allocation


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Equity: equal shares

1s Utility

2s Utility U1= U2


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

1s Utility

2s Utility


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

1s Utility

2s Utility


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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 pricep.

Buyer Seller

Seller keeps the good no trade 0 2

Buyer pays sellerp and 4-p p

buyer gets the good

Q: What values ofpis trade better than no trade?


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B. The Supply and Demand Fable

Suppose you have: 100 people each wanting a cup of coffee, but valuing the coffee differentamounts.

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 costsnot making coffees. (under provision)

(5) Some coffee not being consumed by anyone.


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Possible mechanisms

(1) Central Planning/Fiat: (Centralized)

Tell people what to do. (After first having tried to find out whatpeople 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)


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P

Q of Coffee

Demand (100)


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P

Q of Coffee

Supply (80)


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P

Q of Coffee

Demand Supply


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P

Q of Coffee

Demand Supply


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P

Q of Coffee

Demand Supply


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P

Q of Coffee

Demand Supply


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P

Q of Coffee

Demand Supply


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Conclusions

If

(1) a market is organized,

(2) the market is perfectly competitive,

(3) price is at the equilibrium,

then

full efficiency is achieved.


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C. Efficiency of Economies with ManyGoods (No Production)

Consumer Behaviour with Many Goods

Quantity of A

Quantity of B


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C. Efficiency with Many Goods

Indifference Curves

Quantity of A

Quantity of B

utility =2


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Indifference Curves

Quantity of A

Quantity of B

utility =3


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indifference curves

Quantity of A

Quantity of B

utility =4


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Indifference Curves

Quantity of A

Quantity of BHigher Utility


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Budget Constraints

Quantity of A

Quantity of B

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

10 = pAQA+ pBQB


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Budget Constraints

Quantity of A

Quantity of B



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Budget Constraints

Quantity of A

Quantity of B



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Consumer Optimum

Quantity of A

Quantity of B


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Consumer Optimum

Quantity of A

Quantity of B Here Slopes areequal


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Equal Slopes

Slope of Budget Line:

= - pA/pB

Slope of Indifference Curve

= - MUA / MUB


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Equal Slopes


= - pA/pB


= - MUA / MUB

This is called:

The Marginal Rate of Substitution


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Equal Slopes


= - pA/pB


= - MUA / MUB

Equality ImpliesMUA / MUB = pA/pB

Or

MUB/ pB = MUB/pB

Interpretation:Extra utility from $1 = Extra utility from $1

spent on A spent on B


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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 unitPerson II 1 unit 5 units

These are called endowments.

They want to trade to achieve better bundles.


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Their Resources

Is Quantity of A

Is Quantity of B

IIs Quantity of B

IIs Quantity of A


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Their Endowment

Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5


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Is Preferences

Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5


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IIs Preferences

Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5


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Putting Preferences together

Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5


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

Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5


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Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5


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Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5


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Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5


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Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5


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Allocation of Resources is efficient ifSlope of Is Indifference = Slope of IIs Indifference

Curve Curve

Is MRS = IIs 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 theexpense of IIs small decrease expense of IIs small decrease

in A. in B.


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All the Pareto efficient places

Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5


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These join to give the Contract Curve

Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5


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Pareto efficiency: Utility Possibilities

Is Utility

IIs Utility

Pareto efficient Allocation


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D. Production Efficiency

One firm uses inputs:

Land and Labour to produce good A

Another firm:uses Land and Labour to produce good B.


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Production Functions & Isoquants

Quantity of

Labour

Quantity ofland

Output = 1 Unit of A


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Quantity of

Labour

Quantity ofland




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Quantity of

Labour

Quantity ofland





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Quantity of

Labour

Quantity ofland







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Most Efficient way of producing Output =3

Quantity of

Labour

Quantity ofland

$8 = PL QL+ PNPN


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Quantity of

Labour

Quantity ofland

$9 = PL QL+ PNPN

$8 = PL QL+ PNPN


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Quantity of

Labour

Quantity ofland

$10 = PL QL+ PNPN

$9 = PL QL+ PNPN

$8 = PL QL+ PNPN


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Quantity of

Labour

Quantity ofland



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Quantity of

Labour

Quantity ofland



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Quantity of

Labour

Quantity ofland

Here Slopes areequal



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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


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Quantity of

Labour

Quantity ofland

Here Slopes areequal







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Many Firms Producing

Firm 1s Labour

Firm 1s Land

Firm IIs Land

Firm IIs Labour


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Many Firms Producing

Firm 1s Labour

Firm 1s Land

Firm IIs Land

Firm IIs Labour


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Many Firms Producing: Efficient Production

Firm 1s Labour

Firm 1s Land

Firm IIs Land

Firm IIs Labour


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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)Lor

MP(I)N/MP(II)N = MP(I)L/MP(II)L


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Many Firms Producing: Efficient Production

Firm 1s Labour

Firm 1s Land

Firm IIs Land

Firm IIs Labour


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Production Possibility Frontier

Firm 1s Labour

Firm 1s Land

Firm IIs Land

Firm IIs Labour


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Production Possibilities: What is Feasible

Firm 1s Output

Firm 2s Output


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Production Possibilities: What is Feasible

Firm 1s Output

Firm 2s OutputSlope of this line represents howeconomy is able to move fromproduction of 2 into 1 =

Marginal Rate of Transformation

At Last: Production Efficiency with Many


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At Last: Production Efficiency with ManyGoods and One Consumer

Quantity of A


How the consumer values goods


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What can be produced

Firm 1s Output

Firm 2s Output


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Maximizing Utility given Production

Quantity of A



Slope of Indifference = Slope of Production


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Slope of Indifference = Slope of ProductionPossibilities = Ratio of Prices

Quantity of A




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Efficiency with Many Goods and Production

Slope of Indifference = Marginal Rate of Substitution

Equals

Slope of Production Possibilities = Marginal Rate ofTransformation

Equals

Ratio of Prices


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Efficiency with Many Goods and Production

Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5

Many Firms Producing: What is produced is


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Many Firms Producing: What is produced isdetermined by input prices

Firm 1s Labour

Firm 1s Land

1

5

Firm IIs Land

Firm IIs Labour 1

5


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Their Preferences

Quantity of A

Quantity of B

1

5

IIs Quantity of B

IIs Quantity of A 1

5


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Documents

1 Market Economies