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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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outline
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
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
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
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.

utility possibilities what is feasible
Utility Possibilities: What is Feasible

2’s Utility

1’s Utility

utility possibilities what is feasible1
Utility Possibilities: What is Feasible

2’s Utility

Allocations

1’s Utility

pareto efficiency there is no waste
Pareto efficiency: There is no waste

2’s Utility

Pareto efficient Allocation

1’s Utility

equity equal shares
Equity: equal shares

U1 = U2

2’s Utility

1’s Utility

utilitarianism maximize u 1 u 2
Utilitarianism: Maximize U(1)+U(2)

2’s Utility

1’s Utility

rawls maximize min u 1 u 2
Rawls: Maximize min{U(1),U(2)}

2’s Utility

1’s Utility

example efficiency in exchange
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
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
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)

slide15

P

Demand (100)

Q of Coffee

slide16

P

Supply (80)

Q of Coffee

slide17

P

Supply

Demand

Q of Coffee

slide18

P

Supply

Demand

Q of Coffee

slide19

P

Supply

Demand

Q of Coffee

slide20

P

Supply

Demand

Q of Coffee

slide21

P

Supply

Demand

Q of Coffee

conclusions
Conclusions

If

  • a market is organized,
  • the market is perfectly competitive,
  • price is at the equilibrium,

then

full efficiency is achieved.

c efficiency of economies with many goods no production
C. Efficiency of Economies with Many Goods (No Production)

Consumer Behaviour with Many Goods

Quantity of B

Quantity of A

c efficiency with many goods
C. Efficiency with Many Goods

Indifference Curves

Quantity of B

utility =2

Quantity of A

c efficiency with many goods1
C. Efficiency with Many Goods

Indifference Curves

Quantity of B

utility =3

Quantity of A

c efficiency with many goods2
C. Efficiency with Many Goods

indifference curves

Quantity of B

utility =4

Quantity of A

c efficiency with many goods3
C. Efficiency with Many Goods

Indifference Curves

Quantity of B

Higher Utility

Quantity of A

budget constraints
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

budget constraints1
Budget Constraints

With $10 can afford 10 = pAX(Units of A) + pBX(Units of B)

Quantity of B

Quantity of A

budget constraints2
Budget Constraints

With $10 can afford 10 = pAX(Units of A) + pBX(Units of B)

Quantity of B

Quantity of A

consumer optimum
Consumer Optimum

Quantity of B

Quantity of A

consumer optimum1
Consumer Optimum

Here Slopes are equal

Quantity of B

Quantity of A

equal slopes
Equal Slopes

Slope of Budget Line:

= - pA /pB

Slope of Indifference Curve

= - MUA / MUB

equal slopes1
Equal Slopes

Slope of Budget Line:

= - pA /pB

Slope of Indifference Curve

= - MUA / MUB

This is called:

“The Marginal Rate of Substitution”

equal slopes2
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

at last efficiency with many goods
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
Their Resources

II’s Quantity of A

I’s Quantity of B

II’s Quantity of B

I’s Quantity of A

their endowment
Their Endowment

II’s Quantity of A

1

Quantity of B

5

1

II’s Quantity of B

5

Quantity of A

i s preferences
I’s Preferences

II’s Quantity of A

1

Quantity of B

5

1

II’s Quantity of B

5

Quantity of A

ii s preferences
II’s Preferences

II’s Quantity of A

1

Quantity of B

5

1

II’s Quantity of B

5

Quantity of A

putting preferences together
Putting Preferences together

II’s Quantity of A

1

Quantity of B

5

1

II’s Quantity of B

5

Quantity of A

pareto efficiency is where cannot make i better off with out making ii worse off
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

pareto efficiency is where cannot make i better off with out making ii worse off1
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

pareto efficiency is where cannot make i better off with out making ii worse off2
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

pareto efficiency is where cannot make i better off with out making ii worse off3
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

pareto efficiency is where cannot make i better off with out making ii worse off4
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

allocation of resources is efficient if
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.

all the pareto efficient places
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

these join to give the contract curve
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

pareto efficiency utility possibilities
Pareto efficiency: Utility Possibilities

II’s Utility

Pareto efficient Allocation

I’s Utility

d production efficiency
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
Production Functions & Isoquants

Quantity of land

Output = 1 Unit of A

Quantity of Labour

production functions isoquants1
Production Functions & Isoquants

Quantity of land

Output = 2 Unit of A

Output = 1 Unit of A

Quantity of Labour

production functions isoquants2
Production Functions & Isoquants

Quantity of land

Output = 3 Unit of A

Output = 2 Unit of A

Output = 1 Unit of A

Quantity of Labour

production functions isoquants3
Production Functions & Isoquants

Quantity of land

Output = 5 Unit of A

Output = 4 Unit of A

Output = 3 Unit of A

Output = 2 Unit of A

Output = 1 Unit of A

Quantity of Labour

most efficient way of producing output 3
Most Efficient way of producing Output =3

Quantity of land

$8 = PL QL+ PN PN

Quantity of Labour

most efficient way of producing output 31
Most Efficient way of producing Output =3

Quantity of land

$9 = PL QL+ PN PN

$8 = PL QL+ PN PN

Quantity of Labour

most efficient way of producing output 32
Most Efficient way of producing Output =3

$10 = PL QL+ PN PN

Quantity of land

$9 = PL QL+ PN PN

$8 = PL QL+ PN PN

Quantity of Labour

most efficient way of producing output 33
Most Efficient way of producing Output =3

Quantity of land

Output = 3 Unit of A

Quantity of Labour

most efficient way of producing output 34
Most Efficient way of producing Output =3

Quantity of land

Output = 3 Unit of A

Quantity of Labour

most efficient way of producing output 35
Most Efficient way of producing Output =3

Here Slopes are equal

Quantity of land

Output = 3 Unit of A

Quantity of Labour

slopes are equal so
SLOPES ARE EQUAL SO:

Slope of Isoquant

= - MPN /MPL

= “Marginal rate of technical substitution”

Slope of Cost Line

= - PN /PL

Equal Slopes MPN /MPL = PN /PL

or

MPN /PN = MPL /PL

production functions isoquants4
Production Functions & Isoquants

Here Slopes are equal

Quantity of land

Output = 5 Unit of A

Output = 4 Unit of A

Output = 3 Unit of A

Output = 2 Unit of A

Output = 1 Unit of A

Quantity of Labour

many firms producing
Many Firms Producing

Firm II’s Labour

Firm 1’s Land

Firm II’s Land

Firm 1’s Labour

many firms producing1
Many Firms Producing

Firm II’s Labour

Firm 1’s Land

Firm II’s Land

Firm 1’s Labour

many firms producing efficient production
Many Firms Producing: Efficient Production

Firm II’s Labour

Firm 1’s Land

Firm II’s Land

Firm 1’s Labour

slopes are equal so1
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 production1
Many Firms Producing: Efficient Production

Firm II’s Labour

Firm 1’s Land

Firm II’s Land

Firm 1’s Labour

production possibility frontier
Production Possibility Frontier

Firm II’s Labour

Firm 1’s Land

Firm II’s Land

Firm 1’s Labour

production possibilities what is feasible
Production Possibilities: What is Feasible

Firm 2’s Output

Firm 1’s Output

production possibilities what is feasible1
Production Possibilities: What is Feasible

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

Firm 1’s Output

at last production efficiency with many goods and one consumer
At Last: Production Efficiency with Many Goods and One Consumer

Quantity of B

Higher Utility

Quantity of A

How the consumer values goods

what can be produced
What can be produced

Firm 2’s Output

Firm 1’s Output

maximizing utility given production
Maximizing Utility given Production

Quantity of B

Higher Utility

Quantity of A

How the consumer values goods

slope of indifference slope of production possibilities ratio of prices
Slope of Indifference = Slope of Production Possibilities = Ratio of Prices

Quantity of B

Higher Utility

Quantity of A

How the consumer values goods

efficiency with many goods and production
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 production1
Efficiency with Many Goods and Production

II’s Quantity of A

1

Quantity of B

5

1

II’s Quantity of B

5

Quantity of A

many firms producing what is produced is determined by input prices
Many Firms Producing: What is produced is determined by input prices

Firm II’s Labour

1

Firm 1’s Land

5

1

Firm II’s Land

5

Firm 1’s Labour

their preferences
Their Preferences

II’s Quantity of A

1

Quantity of B

5

1

II’s Quantity of B

5

Quantity of A