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:
• 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

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

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 Utility to measure welfare/happiness.
Utility Possibilities: What is Feasible

2’s Utility

1’s Utility
Utility Possibilities: What is Feasible

2’s Utility
Allocations

1’s Utility
Pareto efficiency: There is no waste

2’s Utility
Pareto efficient Allocation

1’s Utility
 Equity: equal shares

2’s Utility U1 = U2

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

2’s Utility

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

2’s Utility

1’s Utility
 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
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

(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)
P
Demand (100)

Q of Coffee
P
Supply (80)

Q of Coffee
P
Demand Supply

Q of Coffee
P
Demand Supply

Q of Coffee
P
Demand Supply

Q of Coffee
P
Demand Supply

Q of Coffee
P
Demand Supply

Q of Coffee
 Conclusions

If
(1) a market is organized,
(2) the market is perfectly competitive,
(3) price is at the equilibrium,

then

full efficiency is achieved.

 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

Indifference Curves
Quantity of B

utility =2

Quantity of A
 C. Efficiency with Many Goods

Indifference Curves
Quantity of B

utility =3

Quantity of A
 C. Efficiency with Many Goods

indifference curves
Quantity of B

utility =4

Quantity of A
 C. Efficiency with Many Goods

Indifference Curves
Quantity of B
Higher Utility

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

Quantity of B

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

Quantity of B

Quantity of A
 Consumer Optimum

Quantity of B

Quantity of A
 Consumer Optimum

Quantity of B Here Slopes are

equal

Quantity of A
 Equal Slopes
Slope of Budget Line:
= - pA /pB

Slope of Indifference Curve

= - MUA / MUB
 Equal Slopes
Slope of Budget Line:
= - pA /pB

Slope of Indifference Curve

= - MUA / MUB

This is called:
“The Marginal Rate of Substitution”
 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

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

II’s Quantity of A

I’s Quantity of B

II’s Quantity of B

I’s Quantity of A
 Their Endowment

II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A
 I’s Preferences

II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A
 II’s Preferences

II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A
 Putting Preferences together

II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A
 Pareto efficiency: Is where cannot make I
better off with out making II worse off.
II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A
 Pareto efficiency: Is where cannot make I
better off with out making II worse off.
II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A
 Pareto efficiency: Is where cannot make I
better off with out making II worse off.
II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A
 Pareto efficiency: Is where cannot make I
better off with out making II worse off.
II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A
 Pareto efficiency: Is where cannot make I
better off with out making II worse off.
II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A
 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

II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A
 These join to give the Contract Curve

II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A
Pareto efficiency: Utility Possibilities

II’s Utility
Pareto efficient Allocation

I’s Utility
 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

Quantity of
land

Output = 1 Unit of A

Quantity of
Labour
 Production Functions & Isoquants

Quantity of
land

Output = 2 Unit of A

Output = 1 Unit of A

Quantity of
Labour
 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 & 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

Quantity of
land

$8 = PL QL+ PN PN

Quantity of
Labour
 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 =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 =3

Quantity of
land

Output = 3 Unit of A

Quantity of
Labour
 Most Efficient way of producing Output =3

Quantity of
land

Output = 3 Unit of A

Quantity of
Labour
 Most Efficient way of producing Output =3

Quantity of Here Slopes are

land equal

Output = 3 Unit of A

Quantity of
Labour
 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 & Isoquants

Quantity of Here Slopes are

land equal

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

Firm II’s Labour

Firm 1’s Land

Firm II’s Land

Firm 1’s Labour

 Many Firms Producing

Firm II’s Labour

Firm 1’s Land

Firm II’s Land

Firm 1’s Labour

 Many Firms Producing: Efficient Production

Firm II’s Labour

Firm 1’s Land

Firm II’s Land

Firm 1’s Labour

 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 Production

Firm II’s Labour

Firm 1’s Land

Firm II’s Land

Firm 1’s Labour

 Production Possibility Frontier

Firm II’s Labour

Firm 1’s Land

Firm II’s Land

Firm 1’s Labour

Production Possibilities: What is Feasible

Firm 2’s Output

Firm 1’s Output

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

Quantity of B
Higher Utility

Quantity of A
How the consumer values goods
What can be produced

Firm 2’s Output

Firm 1’s Output

 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

Quantity of B
Higher Utility

Quantity of A
How the consumer values goods
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 Production

II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A
 Many Firms Producing: What is produced is
determined by input prices
Firm II’s Labour 1

Firm 1’s Land

1 5
Firm II’s Land

Firm 1’s Labour 5

 Their Preferences

II’s Quantity of A 1

Quantity of B

1 5
II’s Quantity of B

5 Quantity of A