The Market System

Ec 201: Principles of Microeconomics
Weeks 1 and 2
Tim Besley
January 2021
TJB (LSE) Ec 201 January 2021 1 / 78

Introduction
Why are we here?

Who am I?
Who are you?
What are my expectations?

Why are we here?
Plausible answer: because this is a requirement for your degree

program

Why are we here?

program
Better answer: because you want to have the tools that are needed to
think about how economies work

Why are we here?

program
Better answer: because you want to have the tools that are needed to
think about how economies work
Best answer: because without understanding how the economy works,
you will be less good at making the world a better place.

Who am I?
I have been an economist for more than 30 years

My main interests are in policy-related issues
particularly interested in political economy
understanding what makes good policy happen
I am predominantly an academic
But have spent time in policy-making such as
Serving on the Bank of England Monetary Policy Committee during the
…nancial crisis
Advising (e.g.) the World Bank, IMF and EBRD on strategic issues
Founding member of the UK National Infrastructure Commission

Who are you?
Will be di¢ cult to get to know you all on a personal basis.

But I am aware that you have di¤erent goals in what you are trying to
get out of this course and your time at LSE
You all have backgrounds which should equip you to access the
material in the course
but you will already have had one term to establish this.
I expect you to have a set of basic quantitative skills which serve to
speed up the learning of economic concepts
And (I hope) that you are all interested in economic ideas can be
applied
tools are important but applications matter most
and I encourage you explore how what you learn in the course applies
to those things that you are passionate about in your personal lives.

What are my expectations?
That you follow the lectures and “attend” all of the classes
I will aim to make the two speak to each other
But that means that you need to prepare for the classes
you will get much less out of them if you do not.
That you pass the exam

This will test
whether you have understood the economic models and ideas that have
been covered in the course
that you have a sense of what is important in the models
Format will be as last year (mix of short and long questions)
Last year’s exam, and sample paper that we also produced, are good
guides to what you will face.
We will also test knowledge of the readings.

Lectures, Classes and Readings
Lectures provide an overview of the material

introduce the main ideas
try to set them in a wider context
introduce the core model structures
but rarely going into detail.
Classes try to complement this

equip you with more speci…c knowedge needed to pass the exam
There are supplementary reading material with links to speci…c
applications

Using our time
Two lectures per week

1pm GMT on Tuesday
11am GMT on Wednesday
12 noon GMT on Wednesday is "Q&A"
Discuss the aims and topics of the class exercises/readings
Maybe …nish o¤ some topics that we cannot cover in lectures
General discussion of applications/ideas

This Term
Two big issues

understanding the market system
looking at both e¢ ciency, well-being and inequality
examining the role of government and the limits of markets
what is the case for intervention?
will intervention be e¤ective in practice?

The Course Outline
Week 1: Lecture 1 & 2: A model of the market system

The market system viewed through the lens of general general equilibrium. Resource allocation
in a decentralized market system; equilibrium prices the distribution of income and consumption.
Week 2: Lecture 3 & 4: Achievements of the market system.

We will explore under what conditions, the outcome in a market system is e¢ cient. It is also
important to realise that the standard economic model makes some quite strong assumptions
about the capacity of government to support a market economy. We use this analysis to
motivate the idea of market failure.
Week 3/4: Lectures 5-7: Who gets what from the market system?
The market system does not guarantee equity. We will discuss di¤erent ways of thinking about
inequality and its measurement. Some simple ethical theories will also be discussed as will some
government interventions which change distribution.

The Course Outline
Week 4/5: Lectures 8-10: Living Interdependently: public goods and
externalities.
Individuals take actions which in‡uence the well-being of others creating public goods when one
individual’s consumption generates a bene…t for someone else or public bads (externalities) when
their actions harm each other. How do standard competitive markets fail to solve externality
problems and produce public goods e¢ ciently?
Week 6: Lectures 11 & 12: How does the market work when people
do not know their own best interests?
Our study of behavioural economics has already allowed us to explore frailty in human decision
making. Here, we will discuss how the case for the market system change when individuals lack
the capacity to understand what is good for them. We will also discuss principles of government
intervention in this world.
Week 7/8: Lectures 13-15: How do governments behave?

Having explored the possibility of policy making markets work better, we will ask whether we
would expect governments to …x market failures and promote equity. This means thinking about
government failure as well as market failure.
The Course Outline
Week 8/9: Lectures 16-18: Limited information

These lectures will explore what happens when people trade with each other in a situation of
imperfect information. We will explore the idea of moral hazard and its implications for equity
and e¢ ciency.
Week 10: Lectures 19 & 20: Innovation.

These lectures will consider models where new products can be created and/or ways can be
found to make things more cheaply. We will explore incentives for innovation in markets and by
government.

The Market System
Something boring

The Market System
Something interesting (?)

The Market System
Adam Smith’s challenge:

"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 own interest."
Two parts:
decentralization – people are not being instructed or explicitly
coordinated
greed – they do not care about the people that they are producing
for/trading with.

The Market System
What we mean by this is a way of producing goods allocating

resources to people using price signals
We refer to a “system” because we are looking at the whole economy
and how it works rather than any speci…c sector or market
There are many grand debates about the merits of markets and what
they achieve
forces us to think about what we value in human welfare
e¢ ciency, equity, freedom etc.
We want our models to give some insight into these issues.

Standard Model
M people labelled by i
N goods labelled by j
Each person has “talents” which can be deployed to generate income
see below
People have preferences
U i xi , Li
where xi = x1i , ...xNi is consumption and Li is labour supply.
Conventional assumption: people like goods and dislike work.
Throughout the course, we will focus on the case of just two goods
and also two people
will su¢ ce to illustrate the main ideas.

What is a good?
Goods may not just be things that we conventionally recognize as

goods
mobile phone services, food, paper, pens etc.
A good can be di¤erent according to where and when I consume it
cake on 18th January 2021 may enter my utility di¤erently to cake on
19th January 2021
so they are distinct goods
and prices could vary if supply and demand for cake need to be
equalized on di¤erent dates
There are complete markets when all possible variants of goods and
services can be traded.

Market Goods
The focus is on those things that are traded at de…ned prices

Statistical agencies collect price data in markets and data on what
people buy and produce
These are used to get measures of aggregate activity in the market
economy
important for guiding policy
The non-market sector is also important

home production
government production
some parts of the non-pro…t sector

Market Goods
What is a market good?

Incomes
An Exchange Economy
Individuals have endowments of goods

Although unrealistic, we will explore some aspects of allocative
e¢ ciency and equity issues in this framework
And allows us to draw the classic “Edgeworth Box”
Total endowment of good j is Zj . Let σij 2 [0, 1] be share of the
endowment of good j 2 individual i with
∑ σij = 1 for all j

i
with σAj + σBj = 1

(Think of σij de…ning the distribution of “property rights”.)
Income of i is
mi = ∑ pj σij Zj .
j

Incomes
A Production Economy
Simple model is one where income is generated by supplying labour.

Suppose that each individual i has a talent for producing one good
denoted by aij
Then income of i is
mi = pj aij Li
We can think of aij pj as an individual’s “wage rate”.

The supply of good j is
Zj = ∑ aij Li
i
where we are using the convention that aij = 0 when individual i has
not talent for producing good j.

The Structure of Production
Crude world breakdown in production into

agriculture: 5.9%
industry: 30.5%
services: 63.6%
But varies a lot across countries:
China: 6.9% 40.1% 52.9%
UK: 0.7% 21% 78.3%
India: 17.4% 25.8% 56.9%
Mexico: 3.7% 34.2% 62.1%

Distribution of Wages

Consumption and Labour Supply
This is standard and follows the approach from last term

An individual will choose their consumption and labor supply to
maximize
U i xi , Li
subject to
∑ xji pj mi = aij pj Li .
j
This yields their demand for each good
x̂ji = f i (p1 , ..., pN , aij )

L̂ij = g i (p1 , ..., pN , aij )
Goods can be complements or substitutes.

The Whole Economy
Demand for a good is just the sum of the demands by all individuals:
M
Xj (p1 , ..., pN , a) = ∑ f i (p1 , ..., pN , aij )
i =1
where a = (a11 , ...., aMN ) is the vector of talents in the economy.

Supply of labor determines the output of each goods
M
Zj (p1 , ..., pN , a) = ∑ g i (p1 , ..., pN , aij ) .
i =1
So now we can ask about resource allocation in the economy as a

whole.
In particular, how prices are determined.

General Equilibrium
Prices are set so as to “clear” all markets simultaneously

Consumers are able to get what they want given these prices
Given the distribution of talents, the market delivers enough goods to
provide for what consumers want.
We will denote the equilibrium prices as p = p1 , ..., pN
The best way to think about this is in terms of “excess demand”
Let
Ej (p1 , ..., pN , a) = Xj (p1 , ..., pN , a) Zj (p1 , ..., pN , a)
be excess demand for good j.

There are N of these equations (one for each good)
When markets clear, all excess demands are zero.

Intuitions about Excess Demand Functions
Suppose that there are more people who are able to produce a
particular good
then excess demand will fall for any given price
we would then expect the market clearing price to fall
but will also a¤ect markets for complements and substitutes for that
good
If a good becomes more popular
then excess demand for that good increases
we would expect the market clearing price to rise
will a¤ect other markets which are complements or substitutes.

Link to Macro Economics
We can think of the aggregate economy as representing the sum of all

activity:
Aggregate demand: ∑ pj Xj p1 , ..., pN , a
Aggregate supply: ∑ pj Zj p1 , ..., pN , a
But the economy can also be looked at in terms of sectoral
aggregates as we did in the last lecture
e.g. agricultural share
∑K 2fagricultural goodsg pK ZK p1 , ..., pN , a

∑k 2fall goodsg pk Zk p1 , ..., pN , a .

Price Normalization and Walras’Law
Price normalization
A general equilibrium can be expressed entirely in terms of a numeraire
good since only relative prices matter
But the choice of numeraire is arbitrary: we can set pk = 1 for any k.
Walras Law
If all but one market is in equilibrium, then so is the last one
To see this, set p1 = 1 and then note that
N N
X1 + ∑ pj Xj = Z1 + ∑ pj Zj
j =2 j =2
so if ∑N N
j =2 pj Xj = ∑j =2 pj Zj , then X1 = Z1 .

An Example
Consider an economy where two individuals A and B consume two

goods labelled 1 and 2.
Let x1A , x2A and x1B , x2B be the consumption of individuals A and
B.
Individual 1 has Z1 units of x1 and individual 2 has Z2 units of x2 .
This is an endowment economy where on individual owns the whole
stock of one good
i.e. σA1 = 1 and σB 2 = 1
Let the price of good 1 be p1 and for good 2 be p2
Preferences for A are q
x1A + 4 x2A
Preferences for B are q
2 x1B + x2B .

What are the equilibrium prices?
Four steps
1 Make life easy by using the fact that we can set p1 = 1
2 Solve for demand functions
3 Set supply equal to demand
4 Solve for prices (using Walras law)

Solve for demand functions
Set p1 = 1
Then use the budget constraint p1 x1A + p2 x2A p1 Z1 to derive
x1A = Z1 x2A p2
Then for person B we use p1 x1B + p2 x2B p2 Z2 to derive
x1B
x2B = Z2
p2

Demand functions for Individual A
Substitute the budget constraint into the utility function to get that
demand for good 2 solves
q
A A
x2 = arg max Z1 x2 p2 + 4 x2A .
The …rst order condition is

1
p2 + 2(x2A ) 2 = 0.
Then demand for good 2 is
2
1
x2A = 4
p2
and demand for good 1 is
4
x1A = Z1 .
p2
Same for Individual B
q
x1B
x1B = arg max 2 x1B + Z2
p2
1 1
First Order Condition : (x1B ) 2 =0
p2
x1B = ( p2 ) 2
! x2B = Z2 p2

Set Supply Equal To Demand and Solve for the price of
good 2
Add demand across both consumers:
Total Demand: x1A + x1B = Z1 : Total Supply
or
4
Z1 + (p2 )2 = Z1
p2
or
1
p2 = 4 3 > 1 = p1 .
(Note that it would not have mattered had we instead set supply for
good 2 equal to supply of good 2
2
1
Z2 p2 + 4 = Z2 )
p2

Three Big Questions About General Equilibrium
Consistency
is there a set of prices at which supply and demand are balanced in all
markets?
E¢ ciency
In what sense, if at all, is the market system e¢ cient?
Distribution
Who gets what from the market system?
Over the next few weeks, we will study each of these.

An interesting issue that we will not discuss:
Stability of the market system

even if market clearing prices exist, then how do they emerge?
this is Adam Smith’s idea of an “invisible hand” guiding the system
towards equilibrium
often couched in terms of there being a “Walrasian auctioneer”
named after Leon Walras (1834-1910)
and there is much discussion (particularly in macro-economics) of
prices not adjusting quickly when there are shocks to the economy

Consistency
Main breakthroughs came in the second half of the 20th century

often called an Arrow-Debreu economy
after Kenneth Arrow (1921-2017) and Gerard Debreu (1921-2004)
Key innovation was to apply "…xed point" reasoning to the market
economy.
many of the issues are deeply technical and so will not be explored here
but basic idea is highly intuitive
To motivate, consider excess demand in a single market.

Excess Demand in a Single Market

Excess Demand in a Single Market
Key features:
High enough price discourages demand and encourages supply
Low enough price encourages demand and discourages supply
No jumps in supply and demand
importance of “convexity assumptions” to make demand and supply
continuous
averaging over people also helps too

Extension to Multiple Markets
Cannot be drawn but the basic idea is the same as a single market
except that all prices are moving to achieve equilibrium across all
markets
However, continuity and what happens in a market as prices become
high and low still play a key role
A set of prices that set all excess demand functions equal to zero
simultaneously is known as a “…xed point”.
A market system in this very stylized world is a set of market-clearing
prices

Next Steps
Discuss the role of government in basic general equilibrium model

develop a diagrammatic representation of general equilibrium using an
Edgeworth Box
see how to represent an economy in terms of a Utility Possibility
Frontier
These are both important tools for understanding many of the ideas
that we will cover this term.
They are textbook ideas so, if you …nd them hard to grasp, you can
read up on them in any decent economics textbook or on line.
but my coverage will be self-contained.

The Role of Government
The general equilibrium model is generally thought of as a "pure

market system"
But this is misleading
Two key things that government might do?
enforce property rights, i.e. ensure that people own what they produce
enforce trades at agreed prices
In practice, there is no guarantee that this happens
many countries have poorly developed court systems and corrupt
governments who do these jobs poorly
widely studied in political economy
creates an impediment to having an e¤ective market economy

The Role of Government
A few years ago, the World Bank started trying to track this through
their "Doing Business
Project"

The Distribution of Property Rights in a Market Economy
Behind a market economy is a distribution of property rights

No slavery assumption: people own their own labour power
But this does not mean that they own the output that they produce
We will consider a distribution of property rights to output which
could be di¤erent to who produces what
changes in the distribution of property rights to output corresponds to
what economists call lump-sum redistribution

Representing General Equilibrium in An Edgeworth Box
Name after Francis Ysidro Edgeworth 1845-1926

Drawing An Edgeworth Box
Two individuals A and B in an exchange economy

Two goods: books (good 1) and food (good 2)
aggregate quantities are Z1 and Z2 (the endowments)
Individual A : σA1 Z1 of food and σA2 Z2 of books
Individual B : σB 1 Z1 of food and σB 2 Z2 of books
Unless they have the amount of books and food that they want to
consumer, it would make sense for them to trade.
let p1 (p2 ) be the price of books (food)

The Edgeworth Box
Two parts:
where you start
depends on the amount of food and books that each individual owns.
as fσA1 , σA2 , σB 1 , σB 2 g vary then we move around inside the box.
where you end up
consumption after trade.
At an equilibrium point prices allocate consumption so that each

consumer gets what they want given the equilibrium prices
We will now build up a picture of a two-person general equilibrium
using this tool

The Edgeworth Box
An “empty” Edgeworth box

The Edgeworth Box
endowments

The Edgeworth Box
an “autarky” consumption allocation

The Edgeworth Box
trade at market prices

The Edgeworth Box
a general equilibrium point

The Utility Possibility Frontier (UPF)
Now ask what level of utility does each consumer obtain in a general
equilibrium?
this is a crucial idea when it comes to thinking about e¢ ciency and
equity.
We allow for the possibility of redistribution between the two
individuals.
imagine a redistribution of property rights to output
Relative prices will change to re‡ect the scarcity of the goods to
achieve a general equilibrium outcome
and each will be associated with a particular level of utility for each
individual.

A single point corresponding to general equilibrium.

A single point corresponding to general equilibrium.

Lump-sum redistribution
What happens if there is a change of property rights so that some of

the food produced by A is transferred to B before trade begins?
This is like varying fσA1 , σB 1 , σA2 , σB 2 g
After the transfer of food, we assume that they trade in markets to
achieve a general equilibrium
Prices may now have to change to clear markets depending on the
preferences of the two individuals
Individual B who now has greater purchasing power may like one good
more than the other.
This results in a new point on the UPF
So the UPF maps out what happens in a market system with di¤erent
levels of purchasing power
important and useful when we think about redistribution

Lump-sum redistribution
a movement around a UPF

Welfare Economics
This is the branch of economics that engages with normative analysis

and moral philosophy
This underpins how we think about the role of government
A cornerstone of the approach is a framework for thinking about
inequality
we will try to think systematically about welfare judgements based on
the distribution of income
We will …rst present some standard ideas
but it is important to examine these critically

Two Big Issues
E¢ ciency of general equilibrium

what if anything is achieved by a market economy?
Who gets what in general equilibrium
Begin to look at the determinants of income distribution
Set up for a proper discussion of markets and inequality

The First Fundamental Welfare Theorem
Go back (momentarily) to an economy with N goods

Consider an equilibrium price vector p = (p1 , ..., pN ).
Is the equilibrium that prevails “good” in any interesting or
meaningful sense?
Key Concept: Pareto E¢ ciency
An allocation of goods and services fx, Lg is Pareto E¢ cient if we
cannot make someone better o¤ without making someone else worse o¤
The …rst fundamental theorem of welfare economics says
Every general competitive equilibrium is Pareto e¢ cient

Is this surprising?
Interest goes back to Smith’s famous quote
the only thing “regulating” interactions between economic actors is the
price vector at which they can trade.
there is nobody directly coordinating economic activity and people are
acting independently and sel…shly
So perhaps it is remarkable that this does not yield chaos?
“Every individual... neither intends to promote the public

interest, nor knows how much he is promoting it... he intends
only his own security; and by directing that industry in such a
manner as its produce may be of the greatest value, he intends
only his own gain, and he is in this, as in many other cases, led
by an invisible hand to promote an end which was no part of his
intention.” Adam Smith: The Wealth Of Nations, Book IV,
Chapter II, p. 456, para. 9.
So why is it true?
The proof is rather trivial
We know that everyone is maximizing given the prices that they face.
Then
n ifothere is a bundle of consumption and labour supply
0 0
xi , Li that a consumer i prefers, it must be “una¤ordable”
0
Equally if there is xi0 , Li such that
0
U xi0 , Li > U f i p , aij , g i p , aij
then it must be infeasible.

Pareto E¢ ciency in an Edgeworth Box
Not every point in an Edgeworth box is Pareto e¢ cient

Pareto E¢ cient Allocations in the Edgeworth Box
This is called a "contract curve"

Competitive Equilibrium in an Edgeworth Box

Should we care about Pareto e¢ ciency?
Amartya Sen —
’A society can be Pareto optimal and still perfectly disgusting.’
Let’s explore this.

A Pareto optimal allocation with highly unequal endowments?

A Pareto optimal allocation with highly unequal endowments?

The Distribution of income in general equilibrium
Determined by four things

1 Distribution of endowments (property rights)
2 Market prices
3 Distribution of talent
4 Distribution of e¤ort (labour supply)
We will now unpack this.

An Exchange Economy
Income is given by
mi = ∑ pj σij Zj .
j
In the two person example economy
mA = Z1
and
mB = p2 Z2 = 41/3 Z2
so even if Z1 = Z2 , the income of B will be higher than A.

A Production Economy
Income of individual i with talent to produce good j is given by
mi = pj aij g i (p, a) .
Now three factors:

productive skill – aij
equilibrium prices – p
extent of e¤ort – g i (p, a)

What about the distribution of utility?
In our example exchange economy:

q
UA = Z1 x2A p2 + 4 x2A
= Z1 + 42/3
and
q
B x1B
U = 2 x1B + Z2
p2
= Z2 + 41/3

What about the distribution of utility?
In a production economy, individual i’s utility is
U i f i (p , a) , g i (p , a)
How does utility distribution di¤er from income distribution?

individuals may have di¤erent tastes for income and goods
some people might dislike work/value consumption more.
BUT, as we shall discuss later there are issues about comparability of
utility between individuals

Next Steps
Start to think systematically about how to do distributional analysis

relate to statistical measures
introduce the idea of social welfare
Dovetails naturally to thinking about the role of government

A Final Thought
Suppose that we are in the very unequal equilibrium illustrated above

Then would you rather be at the Pareto ine¢ cient point?

Market Failure
In the coming lectures, we will look at a range of reasons why

markets can fail
situations in which markets fail to achieve a Pareto optimal outcome
public goods and externalities
imperfect information
internalities (failures to optimize)

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Ec 201: Principles of Microeconomics

TJB (LSE) Ec 201 January 2021 1 / 78

Why are we here?

TJB (LSE) Ec 201 January 2021 2 / 78

Plausible answer: because this is a requirement for your degree

TJB (LSE) Ec 201 January 2021 3 / 78

Plausible answer: because this is a requirement for your degree

TJB (LSE) Ec 201 January 2021 3 / 78

Plausible answer: because this is a requirement for your degree

TJB (LSE) Ec 201 January 2021 3 / 78

I have been an economist for more than 30 years

TJB (LSE) Ec 201 January 2021 4 / 78

Will be di¢ cult to get to know you all on a personal basis.

TJB (LSE) Ec 201 January 2021 5 / 78

That you pass the exam

TJB (LSE) Ec 201 January 2021 6 / 78

Lectures provide an overview of the material

Classes try to complement this

TJB (LSE) Ec 201 January 2021 7 / 78

Two lectures per week

TJB (LSE) Ec 201 January 2021 8 / 78

Two big issues

TJB (LSE) Ec 201 January 2021 9 / 78

Week 1: Lecture 1 & 2: A model of the market system

Week 2: Lecture 3 & 4: Achievements of the market system.

TJB (LSE) Ec 201 January 2021 10 / 78

Week 7/8: Lectures 13-15: How do governments behave?

Week 8/9: Lectures 16-18: Limited information

Week 10: Lectures 19 & 20: Innovation.

TJB (LSE) Ec 201 January 2021 12 / 78

TJB (LSE) Ec 201 January 2021 13 / 78

Something interesting (?)

TJB (LSE) Ec 201 January 2021 14 / 78

Adam Smith’s challenge:

TJB (LSE) Ec 201 January 2021 15 / 78

What we mean by this is a way of producing goods allocating

TJB (LSE) Ec 201 January 2021 16 / 78

TJB (LSE) Ec 201 January 2021 17 / 78

Goods may not just be things that we conventionally recognize as

TJB (LSE) Ec 201 January 2021 18 / 78

The focus is on those things that are traded at de…ned prices

The non-market sector is also important

TJB (LSE) Ec 201 January 2021 19 / 78

TJB (LSE) Ec 201 January 2021 20 / 78

Individuals have endowments of goods

∑ σij = 1 for all j

with σAj + σBj = 1

TJB (LSE) Ec 201 January 2021 21 / 78

Simple model is one where income is generated by supplying labour.

We can think of aij pj as an individual’s “wage rate”.

TJB (LSE) Ec 201 January 2021 22 / 78

Crude world breakdown in production into

TJB (LSE) Ec 201 January 2021 23 / 78

TJB (LSE) Ec 201 January 2021 24 / 78

This is standard and follows the approach from last term

This yields their demand for each good

x̂ji = f i (p1 , ..., pN , aij )

Goods can be complements or substitutes.

TJB (LSE) Ec 201 January 2021 25 / 78

where a = (a11 , ...., aMN ) is the vector of talents in the economy.

So now we can ask about resource allocation in the economy as a

TJB (LSE) Ec 201 January 2021 26 / 78

Prices are set so as to “clear” all markets simultaneously

Ej (p1 , ..., pN , a) = Xj (p1 , ..., pN , a) Zj (p1 , ..., pN , a)