The Market Economy
Outline
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A.
B.
C.
D.
Introduction: What is Efficiency?
Supply and Demand (1 Market)
Efficiency of Consumption (Many Markets)
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
2’s Utility
1’s Utility
Utility Possibilities: What is Feasible
2’s Utility
Allocations
1’s Utility
Pareto efficiency: There is no waste
2’s Utility
Pareto efficient Allocation
1’s Utility
Equity: equal shares
2’s Utility
U1 = U2
1’s Utility
Utilitarianism: Maximize U(1)+U(2)
2’s Utility
1’s Utility
Rawls: Maximize min{U(1),U(2)}
2’s Utility
1’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.
Seller keeps the good no trade
Buyer pays seller p and
buyer gets the good
Buyer
0
4-p
Seller
2
p
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
Call out a price for coffee.
(Centralized & Decentralized)
(4) Put them all in a room and let them get on with it!
(Decentralized)
P
Demand (100)
Q of Coffee
P
Supply (80)
Q of Coffee
P
Demand
Supply
Q of Coffee
P
Demand
Supply
Q of Coffee
P
Demand
Supply
Q of Coffee
P
Demand
Supply
Q of Coffee
P
Demand
Supply
Q of Coffee
Conclusions
If
(1) a market is organized,
(2) the market is perfectly competitive,
(3) 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 B
Quantity of A
C. Efficiency with Many Goods
Indifference Curves
Quantity of B
utility =2
Quantity of A
C. Efficiency with Many Goods
Indifference Curves
Quantity of B
utility =3
Quantity of A
C. Efficiency with Many Goods
indifference curves
Quantity of B
utility =4
Quantity of A
C. Efficiency with Many Goods
Indifference Curves
Quantity of B
Higher Utility
Quantity of A
Budget Constraints
With $10 can afford 10 = pAX(Units of A) + pBX(Units of B)
Quantity of B
10 = pAQA + pB QB
Quantity of A
Budget Constraints
With $10 can afford 10 = pAX(Units of A) + pBX(Units of B)
Quantity of B
Quantity of A
Budget Constraints
With $10 can afford 10 = pAX(Units of A) + pBX(Units of B)
Quantity of B
Quantity of A
Consumer Optimum
Quantity of B
Quantity of A
Consumer Optimum
Quantity of B
Here Slopes are
equal
Quantity of A
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
II’s Quantity of A
I’s Quantity of B
II’s Quantity of B
I’s Quantity of A
Their Endowment
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A
I’s Preferences
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A
II’s Preferences
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A
Putting Preferences together
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A
Pareto efficiency: Is where cannot make I
better off with out making II worse off.
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A
Pareto efficiency: Is where cannot make I
better off with out making II worse off.
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A
Pareto efficiency: Is where cannot make I
better off with out making II worse off.
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A
Pareto efficiency: Is where cannot make I
better off with out making II worse off.
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A
Pareto efficiency: Is where cannot make I
better off with out making II worse off.
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A
Allocation of Resources is efficient if
Slope of I’s Indifference
Curve
I’s MRS
=
Slope of II’s Indifference
Curve
=
II’s MRS
MU(I)A / MU(I)B
=
MU(II)A / MU(II)B
MU(I)A / MU(II)A
=
MU(I)B / MU(II)B
Or
Extra utility I gets from
small increase in A at the
expense of II’s small decrease
in A.
=
Extra utility I gets from
small increase in B at the
expense of II’s small decrease
in B.
All the Pareto efficient places
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A
These join to give the Contract Curve
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A
Pareto efficiency: Utility Possibilities
II’s Utility
Pareto efficient Allocation
I’s Utility
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
Output = 1 Unit of A
Quantity of
Labour
Production Functions & Isoquants
Quantity of
land
Output = 2 Unit of A
Output = 1 Unit of A
Quantity of
Labour
Production Functions & Isoquants
Quantity of
land
Output = 3 Unit of A
Output = 2 Unit of A
Output = 1 Unit of A
Quantity of
Labour
Production Functions & Isoquants
Quantity of
land
Output = 5 Unit of A
Output = 4 Unit of A
Output = 3 Unit of A
Output = 2 Unit of A
Output = 1 Unit of A
Quantity of
Labour
Most Efficient way of producing Output =3
Quantity of
land
$8 = PL QL+ PN PN
Quantity of
Labour
Most Efficient way of producing Output =3
Quantity of
land
$9 = PL QL+ PN PN
$8 = PL QL+ PN PN
Quantity of
Labour
Most Efficient way of producing Output =3
$10 = PL QL+ PN PN
Quantity of
land
$9 = PL QL+ PN PN
$8 = PL QL+ PN PN
Quantity of
Labour
Most Efficient way of producing Output =3
Quantity of
land
Output = 3 Unit of A
Quantity of
Labour
Most Efficient way of producing Output =3
Quantity of
land
Output = 3 Unit of A
Quantity of
Labour
Most Efficient way of producing Output =3
Quantity of
land
Here Slopes are
equal
Output = 3 Unit of A
Quantity of
Labour
SLOPES ARE EQUAL SO:
Slope of Isoquant
=
- MPN /MPL
= “Marginal rate of technical substitution”
Slope of Cost Line
=
Equal Slopes
or
- PN /PL
MPN /MPL
=
PN /PL
MPN /PN
=
MPL /PL
Production Functions & Isoquants
Quantity of
land
Here Slopes are
equal
Output = 5 Unit of A
Output = 4 Unit of A
Output = 3 Unit of A
Output = 2 Unit of A
Output = 1 Unit of A
Quantity of
Labour
Many Firms Producing
Firm II’s Labour
Firm 1’s Land
Firm II’s Land
Firm 1’s Labour
Many Firms Producing
Firm II’s Labour
Firm 1’s Land
Firm II’s Land
Firm 1’s Labour
Many Firms Producing: Efficient Production
Firm II’s Labour
Firm 1’s Land
Firm II’s Land
Firm 1’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
or
MP(I)N /MP(I)L
= MP(II)N /MP(II)L
MP(I)N /MP(II)N
= MP(I)L /MP(II)L
Many Firms Producing: Efficient Production
Firm II’s Labour
Firm 1’s Land
Firm II’s Land
Firm 1’s Labour
Production Possibility Frontier
Firm II’s Labour
Firm 1’s Land
Firm II’s Land
Firm 1’s Labour
Production Possibilities: What is Feasible
Firm 2’s Output
Firm 1’s Output
Production Possibilities: What is Feasible
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
Firm 1’s Output
At Last: Production Efficiency with Many
Goods and One Consumer
Quantity of B
Higher Utility
How the consumer values goods
Quantity of A
What can be produced
Firm 2’s Output
Firm 1’s Output
Maximizing Utility given Production
Quantity of B
Higher Utility
How the consumer values goods
Quantity of A
Slope of Indifference = Slope of Production
Possibilities = Ratio of Prices
Quantity of B
Higher Utility
How the consumer values goods
Quantity of A
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
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A
Many Firms Producing: What is produced is
determined by input prices
Firm II’s Labour
1
Firm 1’s Land
5
Firm II’s Land
1
Firm 1’s Labour
5
Their Preferences
II’s Quantity of A
1
Quantity of B
5
II’s Quantity of B
1
5
Quantity of A