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 U 1 = U 2

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 trade02 Buyer pays seller p and4-pp 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 (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 B Higher Utility

Budget Constraints Quantity of A Quantity of B With $10 can afford 10 = p A X(Units of A) + p B X(Units of B) 10 = p A Q A + p B Q B

Budget Constraints Quantity of A Quantity of B With $10 can afford 10 = p A X(Units of A) + p B X(Units of B)

Budget Constraints Quantity of A Quantity of B With $10 can afford 10 = p A X(Units of A) + p B X(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: = - p A /p B Slope of Indifference Curve = - MU A / MU B

Equal Slopes Slope of Budget Line: = - p A /p B Slope of Indifference Curve = - MU A / MU B This is called: “The Marginal Rate of Substitution”

Equal Slopes Slope of Budget Line: = - p A /p B Slope of Indifference Curve = - MU A / MU B Equality Implies MU A / MU B = p A /p B Or MU B / p B = MU B /p B 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 AGood B Person I5 units1 unit Person II1 unit5 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 A1 5

I’s Preferences Quantity of A Quantity of B 1 5 II’s Quantity of B II’s Quantity of A1 5

II’s Preferences Quantity of A Quantity of B 1 5 II’s Quantity of B II’s Quantity of A1 5

Putting Preferences together Quantity of A Quantity of B 1 5 II’s Quantity of B II’s Quantity of A1 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 A1 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 A1 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 A1 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 A1 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 A1 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 small increase in A at the= small increase in B at the 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 A1 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 A1 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 = P L Q L + P N P N

Most Efficient way of producing Output =3 Quantity of Labour Quantity of land $9 = P L Q L + P N P N $8 = P L Q L + P N P N

Most Efficient way of producing Output =3 Quantity of Labour Quantity of land $10 = P L Q L + P N P N $9 = P L Q L + P N P N $8 = P L Q L + P N P N

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 =- MP N /MP L = “Marginal rate of technical substitution” Slope of Cost Line = - P N /P L Equal Slopes MP N /MP L = P N /P L or MP N /P N = MP L /P L

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 A1 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 Labour1 5

Their Preferences Quantity of A Quantity of B 1 5 II’s Quantity of B II’s Quantity of A1 5