This is a PowerPoint presentation on market processes.

1. This is a PowerPoint presentation on market processes. A left mouse click or the enter key will add and element to a slide or move you to the next slide. The back space key will take you back an element or slide. If you wish to exit the presentation, the escape key will do it! R. Larry Reynoldsã 1997

2. Markets as Allocative Process • Markets are a social process that allocates scarce resources and goods among alternative uses. • A market exchange is a transfer of property rights based on “quid pro quo” [“I will give you this for that!”] • Market exchange • barter • monetized Principles of Microeconomics

3. Barter • Barter is an market exchange that is a trade of one good for another • Barter can be costly • double coincidence of wants • transaction costs of information and trade • Exchange ratio is the relative amounts of one good given in exchange for another Principles of Microeconomics

4. Monetized Economy • Because the transaction costs of barter can be significant, societies often adopt the use of a numeraire good, “money,” to reduce those costs. • Money as a medium of exchange makes exchange easier • commodity money • fiat money • Exchange ratios expressed in monetary terms Principles of Microeconomics

5. Consider a closed economy with 50 people, each given one case of cola and one case of beer. This distribution does not guarantee that the welfare or utility of the group is maximized. some people like cola but not beer, others like beer but not cola, others might like neither or both. How could these 50 individuals increase their utility? Voluntary exchange! Individuals who do not like beer could trade for cola, those who like cola could trade for beer. What they lack is information about the terms of trade and who will trade with them. To acquire this information they offer to trade a few bottles of what the don’t like for bottles of what they do like. Principles of Microeconomics

6. Through trading and observing others who trade, an “exchange ratio” tends to emerge. On average two colas [2C] seems to trade for one beer [1B]. 2C = 1B. This exchange ratio reflects the initial distribution of cola and beer, the preferences of the individuals and the abilities to acquire information. A different distribution or a group of individuals with different preferences would result in a different exchange ratio. Notice that this example does not explain the process of how to decide “HOW MUCH OF EACH SHOULD BE PRODUCED.” Rather than look for individuals who are willing to trade and then haggling, a numeraire good [money] may be used. The numeraire good is universally acceptable so individuals will accept it in payment even though it is not the good they want. Principles of Microeconomics .

7. The exchange ratio that emerges from the trading determines a set of relative prices. Using the example 2C = 1B, a price of $1 for colas [Pc = 1] implies a price of $2 for beer [Pb= 2] or, [Pb= 1] would imply [Pc = .50] or, [Pc = 2] implies [Pb = 4], These relative prices represent the preferences of the individuals, the initial distribution and abilities to acquire information or bargain [haggle]. It is the relative prices of beer and cola that reflect relevant information! Market exchange is a process that provides information [relative prices] and incentives that coordinates the choices of individuals. Principles of Microeconomics .

8. These relative prices, when established through voluntary exchange reflect the relative value of each good to the group. Relative prices can be altered by changes in: a. the preferences of individuals in the group, b. the distribution of the initial endowment {relative incomes of the group}, c. the relative amounts of the goods, d. the information and bargaining abilities of the individuals, e. or, . . . Each individual engaging in a voluntary exchange is “better off” or “no worse off;” a move toward a Pareto Efficient solution. Utilitarianism is the Philosophy that rationalizes free market economies! Principles of Microeconomics . .

9. Utilitarianism • Utilitarianism is the underlying philosophy of the market system • Jeremy Bentham [1748-1832] • Philosophy of market system is based on each individual attempting to optimize [maximize] their individual welfare or utility • Maximize the welfare or utility of the members of society • utility of individuals is “additive,” [if each person maximizes their welfare it maximizes the welfare of society] Principles of Microeconomics

10. Jeremy Bentham [1748-1832] Jeremy Bentham was trained in the law but became interested in social philosophy. His major contribution to economics is the philosophy of Utilitarianism. It became the basic principle underlying the philosophy of Western, industrial market economies. In one of his major books, An Introduction to the Principles of Morals and Legislation [1789] he attempts to show how the welfare of society can be increased. Principles of Microeconomics

11. Coordination of Individual Actions • Individuals, organizations and society may have competing interests • Markets are one way in which the competing interests and subsequent actions can be coordinated • Market philosophy is based on individuals having information and acting on that information in “rational” ways Principles of Microeconomics

12. Adam Smith[1723 - 1790] • Popularized the idea that markets could be a dominant allocative mechanism in society • “But man has almost constant occasion for the help of his brethren, an it is vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favor, and shew them that it is for their own advantage to do for him what he requires of them. Whoever offers to another a bargain of any kind proposes to do this. Give me that which I want , and you shall have this which you want, is the meaning of every such offer; . . . It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their self interest.” Wealth of Nations, 1776 Principles of Microeconomics

13. Need For Justice • In the book The Theory of Moral Sentiments, Smith argues: • “Justice, on the contrary, is the main pillar that upholds the whole edifice. If it is removed, the great, the immense fabric of human society, that fabric which, to raise and support, seems, in this world, if I may say so, to have been the peculiar and darling care of nature, must in a moment crumble into atoms.”The Theory of Moral Sentiments 1759 Principles of Microeconomics

14. Markets, Justice and Jurisprudence • Adam Smith’s system included three segments; • A Theory of Moral Sentiments [1759] • Argued that Justice was crucial for a society • An Inquiry into the Nature and Causes of the Wealth of Nations [1776] • argued the importance of markets and self interest • A third book, on jurisprudence [Lectures on Jurisprudence], was burned about the time of his death and showed the importance of law Principles of Microeconomics

15. Totals, Averages, Marginals and Optimization • total, average and marginal values are used to describe relationships in benefit, utility, revenue, product, cost,... • There is a mathematical relationship between totals, averages and marginals • These relationships can be used to evaluate alternative choices with respect to different alternatives • These relationships will be demonstrated using revenue. The principles are the same with benefits or utility. Principles of Microeconomics

16. Totals • Total Revenue is defined as Price times Quantity TR = PQ. For 2 goods, X and Y, TR = PxQx +Py Qy. This can be expanded to include as many goods as required. Note that this is also the total expenditure. • Total cost is defined as the total expenditure to produce a given output. TC = PL L + PK K+. . . + PR R, where L = Labour, • K = kapital, R = land [as many inputs as you want can be included. Sometimes inputs are classified as “variable or fixed.” The cost of the variable inputs is VC, the cost of the fixed inputs is FC. In this case; TC = VC + FC Principles of Microeconomics

17. DTR P AR= MR = or, DQ 20 Demand Q MR 10 A relationship between the price of a good [P] and the quantity purchased [Q] is estimated through observation and statistical analysis. Q = 10 - .5P P = 20 - 2Q This can also be expressed: Since we usually identify the horizontal axis as Q [quantity], the equation for the graph that we typically construct is; P = 20 - 2Q Total Revenue can be calculated:TR º PQ, \ TR = (20-2Q)Q, or TR = 20Q- 2Q2 AR = TR/Q, \AR = 20 - 2Q [\AR = P] TR \MR = 20 - 4 Q Demand, AR, TR and MR can also be shown using a table. . . . . Principles of Microeconomics

18. Demand, TR, AR and MR Price Quantity TR AR MR 0 $20 $0 DQ = 1 DTR = 18 $18 Average Revenue, [AR] is calculated, $18 1 $18 $16 2 $32 14 $16 TR AR = $14 $14 $42 10 3 Q 4 $12 $48 6 $12 $10 $50 5 $10 2 $8 $48 6 $8 -2 Marginal Revenue is defined as the change in TR caused by a change in quantity, DTR MR = DQ Given: P=20-2Q TR is calculated TR = PQ 18 18 AR and Price are the same thing! The AR and demand functions are the same thing! The MR associated with the 1stunit of output is 18.This is actually between 0 & 1. Principles of Microeconomics

19. Demand Q P=AR Based on the table from the previous slide The slope of the demand function is, 1 $18 $16 DQ 2 = -.5 DP $14 3 4 $12 $10 5 $8 6 10 -.5 7 $6 The demand equation that is consistent with the table being used as an example can be calculated. Since the slope is -.5, for each $1 change in price, Q will decrease by .5. At P= $0, the quantity would be 10. From $6 to $0, Q increases by .5 for each $1, so when P = 0 then Q = 10 Q = a - m P or, P = 20 - 2Q Is the Demand function being used as an example. Principles of Microeconomics

20. Demand, TR, AR and MR Price Quantity TR AR MR 0 $20 $0 $18 $18 1 $18 $16 2 $32 14 $16 $14 $14 $42 10 3 4 $12 $48 6 $12 $10 $50 5 $10 2 $8 $48 6 $8 -2 MR is the change in TR [DTR]“caused” by a change in Q [DQ]. In principles of econ we will let DQ = 1. MR is then the change in TR that results from a 1 unit change in Q. 18 When the table has DQ in one unit increments, TR can be calculated by s subtraction. as Q increases from 0 to 1, TR increases by 18 [18-0] as Q increases from 1 to 2, TR increases by 14 [32-18] Principles of Microeconomics

21. DTR Demand MR = DQ 18 MR Q P=AR 16 1 $18 14 $18 12 $16 $14 2 10 $14 $10 3 8 4 $12 6 $6 D=AR 4 $10 $2 5 2 $8 $-2 6 1 2 3 4 5 6 7 8 7 $6 $-6 Q/ut MR . P,$ Graph Demand / AR Remember when MR is calculated by subtraction, the value associated with a level of output is actually between that quantity and the next lower quantity. Graph MR . . . . Principles of Microeconomics

22. DTR MR = DQ MR Q 1 14 $18 12 2 $14 10 DTR from firs unit 3 $10 8 DTR from second unit 4 6 $6 DTR from 3 unit 4 5 $2 DTR of 4rth 2 6 5th $-2 7 $-4 MR P, $ as output increases from 0 to 1, TR increases by 18 Given the MR, 18 The red area represents the DTR from each additional unit of Q, this is MR. 16 As the change in quantity becomes smaller, the red columns “fill’ in the area under the MR function. The area under the MR is the sum of the DTR added by each additional unit, \ TR = the sum of DTR’s TR= 50 P = $10, Q = 5 TR = PQ = 50 When MR = 0 TR is a MAX 18 + 14 + 10 + 6+2 The 6th unit reduces TR by 2 1 2 3 4 5 6 7 8 Q/ut If Q is 4, TR is 2 less Principles of Microeconomics . .

23. 18 16 14 TR=PQ . ep = -1 12 at P = $12 Q = 4; TR = $48 10 TR = $10x5=$50 The maximum TR is at the “midpoint” of a linear demand. 16x2= 32=TR 8 At P = $8, Q=6 TR = $48 6 D=AR 4 At a price of $4, Q is 8: TR = PQ = 32 2 1 2 3 4 5 6 7 8 Q/ut P, $ As price increases. TR decreases. TR can also be related to AR or the demand function. ep|> 1; elastic At a price of $16, Q is 2: TR = PQ = 32 Remember that the ep = -1 at the point where TR is a Maximum. As price decreases, TR decreases. |ep| < 1; inelastic Principles of Microeconomics

24. 18 16 14 12 10 3 3 8 6 D=AR 4 2 1 2 3 4 5 6 7 8 Q/ut MR angle, side, angle = angle, side, angle P, $ AR and MR are related; The MR function is 2x as steep as AR or, its slope it twice the slope of AR. It will be half as far away from the Y-axis at every price [it bisects the space between the axis and demand function.] MR= 0 The maximum TR occurred where; TR = PQ TR = $10x5 =50 The area under the MR is TR, by taking a piece of this area, it can be shown that it is the equivalent of the maximum TR as described by PQ = TR [using AR function]. MR=0 [both are right angles, sides are equal, angles are equal] Principles of Microeconomics .

25. 50 = P, $ max TR $10 TR = PQ TR = 50 Sum of DTR’s Q/ut 5 MR TR TR is related to both AR and MR. Where MR = O, TR is a maximum. For out example, this occurs at Q = 5, P=$10. TR is a maximum where, ep = -1 Soooo, if there are no costs, you would want to produce 5 units which you could sell at $10 for a total of $50. ep = -1 TR AR Principles of Microeconomics

26. Consider the choices of picking blackberries. Instead of TR you want to maximize Total utility [TU] or Total Benefit [TB] As more and more blackberries are picked, the marginal benefit [MB] of each additional unit of blackberries decreases. A rational person would pick the easiest blackberries first, therefore as they pick additional units of fruit the marginal cost rises. Marginal Decision Rule: When the objective is to maximize net benefits from an action, MB > MC Do it! [or MR > MC] Net benefits are maximized where MB = MC MB < MC Don’t do it! [or MR < MC] Principles of Microeconomics

27. MC, MC d A MB MC =MB C MB f 1 Picking Blackberries [BB] As more BB are picked, the effort required to pick an additional unit rises. Hence, the MC has a positive slope. To maximize the net benefits, pick BB until MC = MB As the amount of BB available for consumption in a period of time increases, each additional unit adds a smaller amount of utility; the MB function declines. 0 BB/ut The marginal decision rule indicates you should pick the first unit of BB The MB of the first unit exceeds the MC of the first unit, MB > MC The benefit associated with the first unit of BB is the blue area 01Ad. This is the MB associated with the first unit of BB. The cost associated with the first unit of BB is the yellow area 01Cf. This is the MC associated with the first unit of BB The net benefits that result from the first unit of BB is the red area fCAd. Principles of Microeconomics .

28. MC, MB MC MC=MB w t s r MB [X-1] [X+1] If one unit less is picked, [X-1], the net benefit declines. To maximize the net benefits, pick BB until MC = MB e Net benefits are reduced by area ret. 0 X BB/ut If one more unit is picked [X+1], net benefits are reduced by area esw Net benefits are maximized where MC = MB, profits will be maximized where MR = MC. . Principles of Microeconomics

29. TB1 MAX TC1 X TC TB the slope of TR = slope of TC TC Total benefits [TB] tend to increase at a decreasing rate, TB and may decline. Total costs [TC] tend to increase at an increasing rate. NET BENEFITS º TB-TC are maximized where the vertical distance between TB and TC is greatest. Q/ut or, max net benefits is where MB = MC MB MC MB [the slope of TB] decreases, MC and MB becomes negative. max net benefits MC [the slope of TC] increases. The slope of TR = MR, the slope of TC = MC. MB Q/ut X Principles of Microeconomics .

30. Highest Valued Use • An important function of markets is to insure that resources are used in their highest valued use. • markets can be viewed as an “information system” that uses relative prices as a signaling mechanism • individuals react to relative prices in an attempt to optimize the achievement of their objectives Principles of Microeconomics

31. MB MC MC P MB X Q/ut X Net benefits are maximized where MB = MC. As long as the MB > MC, produce the additional unit. Max net benefits If MC > MB, reduce production a unit. At X units of output: the last unit produced has a MB = MC. At a market price of P, buyers will continue to purchase the good so long as they receive a MB > P. Buyers who expect to receive a MB less than the price P would not purchase the good. In this waythe market allocates the good to those who place the greatest “value” on the good. Sellers who can produce the good for a MC less than a price of P will be willing to offer the good for sale. Principles of Microeconomics

32. MB MC MC P MB X Buyers and sellers making independent choices will behave in such a way that resources and goods are allocated to the “highest valued” use. Buyers will buy so long as their MB > P, Sellers will produce and offer for sale so long as the MC is less than P. The value of the last unit produced and sold [bought] will be equal to the price, P. Where MB = P = MC, the results are “optimal,” i.e. those who can produce the good at a MC less than [or equal] P, will have an incentive to supply the good. Buyers who have a MB > P will be able to purchase the units they want. . Principles of Microeconomics .

33. MB MC MC Consumer surplus P producer surplus MB X A Using MB and MC, the distribution of benefits between buyers and sellers can be demonstrated. E At a market price of P, buyers can buy the X units they want. All the units up to X units of the good have a MB in excessive the price. P. This area is called “consumer surplus” [or consumer’s surplus] and is shown in the area PEA. R The sellers can produce the first X units at a MC less than the price, P. Since they can sell at the price P, the earn a surplus on those units; “producer surplus” is shown as area REP. Principles of Microeconomics .

34. MB = P = MC Under ideal circumstances the market will produce the ideal result: The market price [P] will represent the value of the last unit that any buyer is willing to purchase. This same price [P] also represents the cost of producing that last unit! The “ideal” is the benchmark that we use to gauge the performance of the processes that actually occur. When MB ¹ P ¹MC, there is a problem. It is the job of the economic analysis to determine why the market forces have not established a price that reflects the conditions of buyers and sellers. Principles of Microeconomics .

35. Price Distortions • “Noncompetitive markets”i.e buyers or sellers have the power to influence the market price • monopoly, monopsony, oligopoly, oligopsony, imperfect competitive markets,. . . {structure} • collusion, price discrimination,. . . {process or behavior} • Property rights problems • externalities • collective or public goods • common property resources Principles of Microeconomics

36. Noncompetitive Markets • Monopoly -- a single seller of a good with no close substitutes. • Monopsony -- a single buyer of a good. • oligopoly -- a “few” sellers who recognize their interdependence. • oligopsony -- a “few” buyers who recognize their interdependence. • imperfect competition, monopolistic competition • pure competition -- the “ideal” market structure that results in P = MR = MC = AR = ATC Principles of Microeconomics

37. Competition • Pure competition as the ideal -- a structural concept of competition. • large number of buyers and sellers no one of which can influence the market • homogeneous product • relatively free entry and exit • Competition as rivalry -- a process concept of competition. Principles of Microeconomics

38. Property Rights • For markets to produce optimal results, nonattenuated property rights are required • exclusive • transferable • enforceable • “weakened” or “attenuated” property rights result in” • externalities • collective or public goods • common property resources Principles of Microeconomics

39. Externalities -- A market transaction imposes a cost [negative externality] or confers a benefit [positive externality] on another person(s) who is (are) not involved with the market transaction. MC + external costs MB MC MC P’ P MB X0 X When all costs and benefits are recognized by the parties in the transaction, MB = P = MC. A negative externality imposes a cost on a person(s) who is not included as a party to the exchange. these costs must be added to the MC that was recognized as part of the exchange. P is the market price but, the higher price, P’, correctly reflects MB & MC. The parties to the exchange will agree to X amount as optimal, if the externality had been included, only X0 would be optimal. Principles of Microeconomics

40. MB MC MC P1 MB + external benefits P MB X X1 Externalities -- A positive externality confers a benefit on a person(s) who is not included as a party to the exchange. These benefits must be added to the MB that was recognized as part of the exchange. If the external benefits are included, the optimal output is X1, and the price that represents the benefits and costs to society is P1. P is the market price but, the higher price, P1, correctly reflects MB & MC. The parties to the exchange will agree to X amount as optimal, if the positive externality had been included, X1 would be optimal. Principles of Microeconomics

41. Public or Collective Goods When it is impossible to exclude individuals from using a good and their use of that good imposes no opportunity cost, or MC on society, that good is called a collective or public good. National defense is the most often used example of a collective good. After a given level of national defense is provided, a new member of society cannot be excluded from that protection and the additional person protected does not increase the MC of national defense. Since the individual cannot be excluded, the have no incentive to pay for the good even though they benefit from it; they become “free riders.” To pay for the collective good government may tax the individuals and provide the good. In which case individuals may become “forced riders.” A quasi-public good is like a road or park, we could exclude an individual from using the good, but it may not be desirable to do so. Because of the problems associated with collective goods and quasi-public goods, markets do not result in optimal allocations. Principles of Microeconomics

42. Common Property Resources These are resources that are held “in common,” or are “fugitive” resources; whoever captures the resources acquires the right to use it. Unlike collective or public goods, common property resources are subject to a marginal cost for their use. If I get it, you don’t. In the case of exhaustable or depletable resources, individuals tend to capture as much as they can as quickly as they can. Resources such as buffalo. whales, carrier pigeons, oceans, air, [biosphere], common lands, etc. tend to be “overused” and may be driven to extinction or depletion. Principles of Microeconomics . .

43. Summary • Markets are a social institution that will coordinate individuals’ behavior • Problems develop when • lack of competition • property rights are not; • exclusive • enforceable • transferable Principles of Microeconomics