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 individuals 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

1s Utility
2s Utility
Utility Possibilities: What is Feasible

1s Utility
2s Utility
Allocations
Pareto efficiency: There is no waste

1s Utility
2s Utility
Pareto efficient Allocation
Equity: equal shares

1s Utility
2s Utility
U
1
= U
2
Utilitarianism: Maximize U(1)+U(2)

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

1s Utility
2s 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 trade 0 2
Buyer pays seller p and 4-p p
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 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

Is Quantity of A
Is Quantity of B
IIs Quantity of B
IIs Quantity of A
Their Endowment

Quantity of A
Quantity of B
1
5
IIs Quantity of B
IIs Quantity of A 1
5
Is Preferences

Quantity of A
Quantity of B
1
5
IIs Quantity of B
IIs Quantity of A 1
5
IIs Preferences

Quantity of A
Quantity of B
1
5
IIs Quantity of B
IIs Quantity of A 1
5
Putting Preferences together

Quantity of A
Quantity of B
1
5
IIs Quantity of B
IIs 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
IIs Quantity of B
IIs 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
IIs Quantity of B
IIs 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
IIs Quantity of B
IIs 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
IIs Quantity of B
IIs 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
IIs Quantity of B
IIs Quantity of A 1
5
Allocation of Resources is efficient if
Slope 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 the
expense of IIs small decrease expense of IIs small decrease
in A. in B.
All the Pareto efficient places

Quantity of A
Quantity of B
1
5
IIs Quantity of B
IIs Quantity of A 1
5
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
Pareto efficiency: Utility Possibilities

Is Utility
IIs 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 1s Labour
Firm 1s Land
Firm IIs Land
Firm IIs Labour
Many Firms Producing

Firm 1s Labour
Firm 1s Land
Firm IIs Land
Firm IIs Labour
Many Firms Producing: Efficient Production

Firm 1s Labour
Firm 1s Land
Firm IIs Land
Firm IIs 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 1s Labour
Firm 1s Land
Firm IIs Land
Firm IIs Labour
Production Possibility Frontier

Firm 1s Labour
Firm 1s Land
Firm IIs Land
Firm IIs Labour
Production Possibilities: What is Feasible

Firm 1s Output
Firm 2s Output
Production Possibilities: What is Feasible

Firm 1s Output
Firm 2s 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 1s Output
Firm 2s 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
IIs Quantity of B
IIs Quantity of A 1
5
Many Firms Producing: What is produced is
determined by input prices

Firm 1s Labour
Firm 1s Land
1
5
Firm IIs Land
Firm IIs Labour 1
5
Their Preferences

Quantity of A
Quantity of B
1
5
IIs Quantity of B
IIs Quantity of A 1
5