1. the market economy fall 2008. outline a. introduction: what is efficiency? b. supply and demand...

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