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PPS231S.01 Law, Economics, and Organization. Spring 2012 I.1. Markets and Resource Allocations. Introduction: Three Fundamental Concepts. As is common in these courses, we begin by a review of some basic – but important – economic concepts.

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Pps231s 01 law economics and organization

PPS231S.01Law, Economics, and Organization

Spring 2012

I.1. Markets and Resource Allocations

Introduction three fundamental concepts
Introduction: Three Fundamental Concepts

As is common in these courses, we begin by a review of some basic – but important – economic concepts.

Definition: Economics is the study of rational choice in the face of scarcity.

This definition encompasses both micro and macro, and both theoretical and empirical economics.

Introduction three fundamental concepts1
Introduction: Three Fundamental Concepts

More importantly, the definition embodies the behavior of individuals, households, and firms.

The cornerstone of modern social science (and thus of economics) is the assumption of individual rationality. Two objections:

(i) Bounded rationality  Agent-based models

(ii) Behavioral anomalies  Behavioral economics

Introduction three fundamental concepts2
Introduction: Three Fundamental Concepts

The main implication is that economics assumes individuals maximize in all areas of life.

Examples: Sex, marriage, crime, fertility, sports, suicide, etc.

When a commodity does not have an actual (monetary) price, economists talk about “shadow prices,” which is usually derived from people’s willingness to pay for that commodity.

Introduction three fundamental concepts3
Introduction: Three Fundamental Concepts

The Law of Demand

The (generally) inverse relationship between the price of a good and the quantity demanded of the same good.

Two things to note:

1. Causality runs both ways.

2. Wealth or income effects are assumed away.








Introduction three fundamental concepts4
Introduction: Three Fundamental Concepts

Opportunity Cost and Sunk Costs

The opportunity cost of a decision is the value of the next best thing given up when taking that decision.

Examples: Graduate school, marriage, additional child, etc.

Thus, economics is not “just about money,” as many people are so fond of claiming.

Introduction three fundamental concepts5
Introduction: Three Fundamental Concepts

Opportunity Cost and Sunk Costs (continued)

Thus, to an economist, the concept of cost is forward-looking, i.e., incurred and irrecoverable costs do not matter at the margin.

Example: A life-sized white porcelain elephant costs $1,000 to make; most anyone would be willing to pay is $10. Should the builder sell it for $10?

Introduction three fundamental concepts6
Introduction: Three Fundamental Concepts

Opportunity Cost and Sunk Costs (continued)

Competition tends to make the opportunity cost the maximum and the minimum price anyone would pay for something. The supply curve, after all, is the industry-level marginal cost curve, and the marginal cost is the opportunity cost in this case.

The following figure illustrates this point.







Introduction three fundamental concepts7
Introduction: Three Fundamental Concepts

Resources Gravitate to their Most Valuable Use

With voluntary exchange, resources are simply shifted around until they end up in their most valuable use to consumers. When no reallocation of resources would increase their value, we talk about efficiency (much more on this soon enough…)

Value utility and efficiency
Value, Utility, and Efficiency


The economic value of something is someone’s willingness to pay (WTP) for it if they do not already have it, and their willingness to accept money (WTA) for it if they already have it.

In economic theory, WTP should equal WTA. In practice, there is often an endowment effect, i.e., WTA > WTP – something is worth a lot more to you when you have it than before you had it (e.g., Cornell mug experiment.)

Value utility and efficiency1
Value, Utility, and Efficiency

Utility vs. Expected Utility

Utility denotes the level of welfare, well-being, or satisfaction that individuals and households attain. It is what they maximize when making decisions.

Expected utility, however, denotes the utility one derives from uncertain costs and/or benefits, i.e., from “gambles.”

Value utility and efficiency2
Value, Utility, and Efficiency

Utility vs. Expected Utility

Suppose you are offered the following gamble L. Toss a fair die. You roll a 6, you get $10. You roll anything other than a 6, you pay me $2. Who takes the gamble?

The expected value of the lottery is:

Value utility and efficiency3
Value, Utility, and Efficiency

Utility vs. Expected Utility

There is no right or wrong answer – it all depends on your expected utility from L:

Whether this expression is positive or negative – so whether one accepts or rejects the gamble – depends on the shape of U().





EU = pU(w1)+ (1-p)U(w2)





Value utility and efficiency4
Value, Utility, and Efficiency

Utility vs. Expected Utility

A few things:

1. Most individuals are risk-averse. Some are risk-neutral. Rarely are they risk-loving.

2. Risk-aversion is identical to assuming that the utility one derives from wealth is decreasing at the margin. Why is that?

Value utility and efficiency5
Value, Utility, and Efficiency


An allocation is said to be Pareto efficient iff there does not exist another allocation that would make some better without leaving anyone worse off.

This says nothing about equity, and it says nothing about initial conditions (e.g., initial distribution of wealth, of abilities, etc.)

The role of prices
The Role of Prices

“The last premier of the Soviet Union, Mikhail Gorbachev, is said to have asked British Prime Minister Margaret Thatcher: How do you see to it that people get food? The answer was that prices did that.” – Sowell (2004)

The role of prices1
The Role of Prices

Coordination and Incentives

We know from Adam Smith that the division of labor is efficient. Recall Smith’s pin factory example.

Gorbachev’s question, although seemingly naïve, gets at a crucial role of prices, i.e., coordination and motivation.

The role of prices2
The Role of Prices

First Fundamental Theorem of Welfare Economics

This theorem formalizes Adam Smith’s “invisible hand,” i.e., under certain conditions, a competitive equilibrium is Pareto efficient.

To understand this, we first need to define what an economy is.

The role of prices3
The Role of Prices

Suppose there are many consumers. Each consumer supplies his or her labor to firms for a wage, and each consumer is endowed with a vector E of the G goods in the economy.

An individual consumer’s endowment vector is thus E = (E1, E2, E3,…, EG).

Of course, many of these cells will equal zero – no one has a positive quantity of each possible good.

The role of prices4
The Role of Prices

Individuals sell some of their endowments to firms. Thus, S1≤ E1 is the amount of good 1 sold by an individual, so that S = (S1, S2, S3,…, SG) denotes the sales of that individual.

Likewise, B = (B1, B2, B3,…, BG) denotes the purchases of that individual.

Obviously, there is a vector P = (P1, P2, P3,…, PG) that denotes prices.

The role of prices5
The Role of Prices

Each individual also owns a fraction Fj of firm j, which pays dividend Dj .

The value of an individual’s purchases cannot exceed the value of his or her sales plus dividends. Thus, for any individual consumption plan (B, S), it must be true that

The role of prices6
The Role of Prices

We shorthand the three sums above as PB, PS, and FD. In addition, individual utility is denoted U(C), where U( · ) is the individual’s utility function, i.e., a mathematical representation of the individual’s preferences, and C is the list of goods consumed by the individual and their quantity.

Thus, C = E + B – S, and we assume without loss of generality that PB = PS + FD, i.e., that the equation on the previous slide holds with equality (Why?)

The role of prices7
The Role of Prices

There are J firms in the economy. Each firm produces an output vector O using the input vector I. The set of technically feasible (I, O) production plans is denoted by T, and firms maximize profit, i.e., Π = PO – PI.

Note: Firms can, in principle, produce any or all of the G goods in the economy.

The role of prices8
The Role of Prices

Let’s now denote consumers by n and assume there are N consumers in the economy. Then, an economy consists of

  • N consumers, each with a utility function Un( · ) and an endowment En; and

  • J firms, each with a technically feasible set Tj and ownership shares Fnj for each consumer n and firm j.

The role of prices9
The Role of Prices

An allocation is a consumption plan for each consumer and a production plan for each firm that, together, are feasible. This feasible set of plans has three properties:

1. Each firm’s production plan is part of its technically feasible set;

2. The sales of each consumer are less than or equal to their endowment, or

3. , i.e., supply equal demand for each good.

The role of prices10
The Role of Prices

An allocation is Pareto efficient if there is no other allocation that Pareto dominates it, i.e., if no other allocation is viewed as at least as good by all consumers.

By a process of market-clearing, as long as there is a discrepancy between the quantities supplied and demanded of a commodity, the price will adjust so that these quantities are equal. Once all prices equate the quantities supplied and demanded of all commodities, the economy is in a competitive equilibrium.

The role of prices11
The Role of Prices

A competitive equilibrium for this economy consists of a price vector P, a consumption plan for each consumer, and a production plan for each firm. These vectors must satisfy three conditions:

1. Each consumer’s consumption plan must maximize the individual’s utility.

2. Each firm must maximize its profits.

3. Given P, supply must equal demand.

This leads us to the theorem.

The role of prices12
The Role of Prices

First Fundamental Theorem of Welfare Economics:

If (P, B, S, I, O) are the price list and consumption and production plans of a competitive equilibrium, the resulting allocation is efficient.

In other words,

Competitive equilibrium → Pareto efficient allocation.

The role of prices13
The Role of Prices

Note that prices both

1. Inform the parties as to what they should do; and

2. Motivate consumers and firms.

But the First Fundamental Theorem is a mathematical result. Although it may hold by and large, market failures will introduce inefficiencies, even in the presence of competitive equilibria.

The role of prices14
The Role of Prices

Market Failures

1. Increasing Returns to Scale.

The theorem holds with “well-behaved” production functions. With IRS, however, there may not even exist an equilibrium, i.e., a vector of prices such that quantity supplied equals quantity demanded. With IRS, two things can happen: (i) firms consolidate; or (ii) firms simply do not operate. They can also give rise to multiple equilibria. Generally, IRS cause inefficiencies.


Y = F(L)


The role of prices15
The Role of Prices

Market Failures

2. Externalities.

With negative externalities, the production of a good imposes a cost on society which is not taken into account by the producer (e.g., pollution). With positive externalities, the production of a good imposes a benefit on society which is not taken into account by the producer (e.g., vaccines.)

The presence of externalities – either negative or positive – causes inefficiencies.

The role of prices16
The Role of Prices

Market Failures

3. Missing Markets.

This is the strictest requirement of the theorem: markets must exist for all possible goods – this really means all possible goods. In developing countries, many markets are missing (e.g., insurance, credit, inputs, etc.)

Markets do not need to be missing altogether – oftentimes, they are missing for certain individuals or households. Whatever the case, missing markets cause inefficiencies.

The role of prices17
The Role of Prices

Market Failures

4. Search, Matching, and Coordination.

Workers have to look for jobs, firms have to advertise their products, consumers look for firms, landlords look for tenants, principals look for agents, etc.

Searching entails non-negligible costs, and because of these costs, individuals and firms often stop searching before they have found the best possible match. This also causes inefficiencies.

The role of prices18
The Role of Prices

Market Failures and Organization

It should be obvious that the First Fundamental Theorem of Welfare Economics is, sadly, nothing more than a mathematical statement and a conceptual fiction.

This does not mean that it is useless: often, it will making good predictions about the behavior of economies. But market failures need to be taken into consideration.

The role of prices19
The Role of Prices

Market Failures and Organization

Typically, the presence of market failures means that there is scope for government intervention.

For example: subsidize certain productive activities (e.g., national airlines), tax the production of certain goods (e.g., pollution), provide certain goods (e.g., education, health care), intervene to reduce transactions costs (e.g., build roads, policing), and reduce search costs (e.g., public credit bureaus.)

The role of prices20
The Role of Prices

Market Failures and Organization

The response need not come from the government, however. In fact, institutions or organizations often emerge to resolve market failures.


1. Risk Sharing Contracts. These arise to counter the absence of insurance markets, more often than not (e.g., commission sales, sharecropping contracts, etc.)

The role of prices21
The Role of Prices


2. Production Contracts. This form of vertical integration arises to resolve the problem of missing markets for the inputs necessary to produce the output. The principal provides agents with these inputs.

The role of prices22
The Role of Prices


3. Private Credit Bureaus. These arise to reduce the costs of searching for risk information that lenders face. Each lender finds it too costly to gather this information, but by pooling their resources together, all lenders benefit from paying for credit information.

4. Firms. Beyond being a simple production function (as in the framework above), firms arise to obviate coordination problems between economic agents (Coase, 1937).