1. the market economy fall 2008. outline a. introduction: what is efficiency? b. supply and demand...
TRANSCRIPT
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 SellerSeller keeps the good no trade 0 2Buyer pays seller p and 4-p pbuyer gets the good
Q: What values of p is trade better than no trade?
B. The Supply and Demand FableSuppose 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(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 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 BHigher 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 SlopesSlope 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 BPerson I 5 units 1 unitPerson 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 ifSlope 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
OrMU(I)A / MU(II)A = MU(I)B / MU(II)B
Extra utility I gets from Extra utility I gets fromsmall increase in A at the = small increase in B at theexpense of II’s small decrease expense of II’s small
decreasein 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
orMPN /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 OutputSlope 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 BHigher 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 BHigher Utility
How the consumer values goods
Slope of Indifference = Slope of Production Possibilities = Ratio of
Prices
Quantity of A
Quantity of BHigher 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
