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1. The Market Economy

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 :

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1. The Market Economy

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  1. 1. The Market Economy Fall 2008

  2. Outline • A. Introduction: What is Efficiency? • B. Supply and Demand (1 Market) • C. Efficiency of Consumption (Many Markets) • D. Production Efficiency (Many Markets)

  3. 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.

  4. 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.

  5. 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 Utilityto measure welfare/happiness.

  6. Utility Possibilities: What is Feasible 2’s Utility 1’s Utility

  7. Utility Possibilities: What is Feasible 2’s Utility Allocations 1’s Utility

  8. Pareto efficiency: There is no waste 2’s Utility Pareto efficient Allocation 1’s Utility

  9. Equity: equal shares U1 = U2 2’s Utility 1’s Utility

  10. Utilitarianism: Maximize U(1)+U(2) 2’s Utility 1’s Utility

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

  12. 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?

  13. 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.

  14. 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)

  15. P Demand (100) Q of Coffee

  16. P Supply (80) Q of Coffee

  17. P Supply Demand Q of Coffee

  18. P Supply Demand Q of Coffee

  19. P Supply Demand Q of Coffee

  20. P Supply Demand Q of Coffee

  21. P Supply Demand Q of Coffee

  22. Conclusions If • a market is organized, • the market is perfectly competitive, • price is at the equilibrium, then full efficiency is achieved.

  23. C. Efficiency of Economies with Many Goods (No Production) Consumer Behaviour with Many Goods Quantity of B Quantity of A

  24. C. Efficiency with Many Goods Indifference Curves Quantity of B utility =2 Quantity of A

  25. C. Efficiency with Many Goods Indifference Curves Quantity of B utility =3 Quantity of A

  26. C. Efficiency with Many Goods indifference curves Quantity of B utility =4 Quantity of A

  27. C. Efficiency with Many Goods Indifference Curves Quantity of B Higher Utility Quantity of A

  28. 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

  29. Budget Constraints With $10 can afford 10 = pAX(Units of A) + pBX(Units of B) Quantity of B Quantity of A

  30. Budget Constraints With $10 can afford 10 = pAX(Units of A) + pBX(Units of B) Quantity of B Quantity of A

  31. Consumer Optimum Quantity of B Quantity of A

  32. Consumer Optimum Here Slopes are equal Quantity of B Quantity of A

  33. Equal Slopes Slope of Budget Line: = - pA /pB Slope of Indifference Curve = - MUA / MUB

  34. Equal Slopes Slope of Budget Line: = - pA /pB Slope of Indifference Curve = - MUA / MUB This is called: “The Marginal Rate of Substitution”

  35. 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

  36. 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.

  37. Their Resources II’s Quantity of A I’s Quantity of B II’s Quantity of B I’s Quantity of A

  38. Their Endowment II’s Quantity of A 1 Quantity of B 5 1 II’s Quantity of B 5 Quantity of A

  39. I’s Preferences II’s Quantity of A 1 Quantity of B 5 1 II’s Quantity of B 5 Quantity of A

  40. II’s Preferences II’s Quantity of A 1 Quantity of B 5 1 II’s Quantity of B 5 Quantity of A

  41. Putting Preferences together II’s Quantity of A 1 Quantity of B 5 1 II’s Quantity of B 5 Quantity of A

  42. 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 1 II’s Quantity of B 5 Quantity of A

  43. 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 1 II’s Quantity of B 5 Quantity of A

  44. 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 1 II’s Quantity of B 5 Quantity of A

  45. 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 1 II’s Quantity of B 5 Quantity of A

  46. 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 1 II’s Quantity of B 5 Quantity of A

  47. 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 Extra utility I gets from small increase in A at the = small increase in B at the expense of II’s small decrease expense of II’s small decrease in A. in B.

  48. All the Pareto efficient places II’s Quantity of A 1 Quantity of B 5 1 II’s Quantity of B 5 Quantity of A

  49. These join to give the Contract Curve II’s Quantity of A 1 Quantity of B 5 1 II’s Quantity of B 5 Quantity of A

  50. Pareto efficiency: Utility Possibilities II’s Utility Pareto efficient Allocation I’s Utility

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