Chapter Two: Exchange, Efficiency, and Markets

1
Chapter TwoExchange, Efficiency, and Markets

• Basic Concepts
• Overview of the Market System
• Gains from Trade
• The Incentive to Innovate
• Exceptions to the Market
• Competition and Externalities
• The Nature of the Firm
• Market Analysis The Supply and Demand Model

2
Basic Concepts

• Economics - The study of the choices people make
  with respect to scarcity.
• Scarcity - the goods available are too few to
  satisfy individuals desires.
• Marginal Benefits - the additional benefits above
  what have already been derived.
• Cost Concepts
• Marginal cost - additional cost above the costs
  already incurred.
• Sunk cost - costs that have already been incurred
• Opportunity Cost - the value of the next best
  alternative foregone in making a decision.
• The economic decision rule If the relevant
  benefits of doing something exceed the relevant
  costs, do it. If the relevant costs of doing
  something exceed the relevant benefits, dont do
  it.

3
Overview of the Market System

• Why do societies utilize the market system?
• The market system creates economic growth.
• Economic growth Transformation of a nations
  inputs into greater and greater amounts of
  output.
• Extensive growth Growth due to an increase in
  the quantity of a nations factors of production.
• Intensive growth Growth due to an increase in
  the quality of a nations factors of production.
• How does the market system create economic growth
• Gains from Trade
• The Incentive to Innovate

4
Interdependence and the Gains from Trade

• David Ricardo (1772-1823) and the Principle of
  Comparative Advantage
• Absolute advantage - the comparison among
  producers of a good according to their
  productivity.
• Comparative advantage - the comparison among
  producers of a good according to their
  opportunity cost.

5
England may be so circumstanced, that to produce
the cloth may require the labour of 100 men for
one year and if she attempted to make the wine,
it might require the labour of 120 men for the
same time. England would therefore find it her
interest to import wine, and to purchase it by
the exportation of cloth. To produce wine in
Portugal, might require only the labour of 80 men
for one year, and to produce the cloth in the
same country, might require the labour of 90 men
for the same time. It would therefore be
advantageous for her to export wine in exchange
for cloth. Ricardo (1817) as reprinted in
McCulloch (1888, p. 76-77)
6
This exchange might even take place,
notwithstanding that the commodity imported by
Portugal could be produced with less labour than
in England. Though she could make the cloth with
the labour of 90 men, she would import it from a
country where it required the labour of 100 men
to produce it, because it would be advantageous
to her rather to employ her capital in the
production of wine, for which she would obtain
more cloth from England, than she could produce
by diverting a portion of her capital from the
cultivation of vines to the manufacture of
cloth.(Ricardo (1817) as reprinted in McCulloch
(1888, p. 76-77).
7
Ricardo, the numbers

• Hours needed to produce each good
• Nation Wine Cloth
• England 120 100
• Portugal 80 90
• In Ricardos example, Portugal has an absolute
  advantage with respect to both goods. However,
  Portugals comparative advantage only lies in the
  production of wine.

8
Ricardos conclusions

• Comparative advantage, not absolute advantage,
  determines the pattern of trade.
• Free trade benefits every nation by expanding
  each nations consumption possibilities beyond
  its production possibilities.
• What is true for nations is true for individuals.
  The gains from trade is one reason why the
  market system is adopted.

9
Allocation Mechanisms

• The Price Mechanism Goods are allocated
  according a person being both willing and able to
  purchase the commodity.
• Government
• Tradition
• First-come-first-serve
• Random draw
• Other
• What is the advantage of the price system? It
  allocates goods and services to where these are
  valued the highest. More importantly, it
  provides incentives for people to innovate and
  work harder.
• Economic growth can occur when a nations
  increases the quantity and/or quality of its
  factors of production. Diminishing returns tells
  us there is a limit to increasing the quantity of
  a nations inputs. Hence, long term growth can
  only occur if a nation increases quality. Only
  with the market system is this likely to occur.
  Why?

10
Exceptions to the Market

• Competition requires
• A large number of buyers and sellers
• Free entry and exit
• Homogenous goods
• Perfect information
• If these conditions are not met, markets will not
  work efficiently.
• Externalities costs and/or benefits external to
  the buyers and sellers in a given transaction.
• When negative externality exist the market will
  produce more of a good than is socially optimal.
  
• When a positive externality exist the market will
  produce less of a good than is socially optimal.
• The existence of externalities provide a
  motivation for government intervention.

11
Internalizing MarketsThe Nature of the Firm

• A Firm An organization formed to minimize the
  costs inherent in certain market transactions.
• Transaction costs - the expenses of trading with
  others above and beyond the price. i.e. the costs
  of bargaining and negotiating.
• Transaction costs determine whether markets are
  internalized or allowed to remain external to the
  firm.
• Types of integration
• Vertical integration - various stages of
  production of a single product are conducted by a
  single firm.
• Horizontal integration - merging of the
  production of similar products into a single
  firm.
• With each merger a firm is arguing that the cost
  of producing via the market exceeds the cost of
  external production.
• Architecture The firms organization or
  structure. The architecture of a firm is
  determined by efficiency considerations.

12
Market vs. Internal Production

• Labor theory Wages Marginal Revenue Product
• Marginal Revenue Product Marginal Revenue of
  Output (MR) Marginal Product of Labor (MP)
• However, for this to be true for each worker a
  firm would need to measure MP.
• What if a firm cannot measure MP? Then a worker
  can reduce effort an still maintain the same
  wage. When monitoring costs are high, a firm has
  an incentive to sub-contract work.
• Why? For independent workers the wage (profit) is
  closer linked to productivity.

13
History of the Supply and Demand Model or the
Marshallian Cross (part 1)

• The Labor Theory of Value - The price of a good
  is determined by the cost of production, and the
  cost of production is dictated by the quantity
  and quality of labor utilized.
• What about demand?
• In the long-run, assuming competition, price will
  equal the cost of production.
• Marx wished to show that even if capitalism
  worked exactly as Ricardo believed, capitalism
  was still a very poor economic system.
  Consequently, Marx utilized the labor theory of
  value to explain prices. Given this explanation,
  Marx offered the following argument If the value
  of labor determines value, and value mostly is
  given to the owners of capital, is it not the
  case that labor is exploited?
• Response of mainstream economics Labor is not
  exploited because the labor theory of value is
  not correct.

14
History of the Supply and Demand Model or the
Marshallian Cross (part 2)

• Utility - the satisfaction one receives from a
  good.
• The fact is, that labor once spent has no
  influence on the future value of any article it
  is gone and lost forever. In commerce, bygones
  are for ever bygones. W.S. Jevons, 1871
• W.S. Jevons, Carl Menger, and Leon Walras argued
  the price of a good was dictated by the demand
  for the product. If consumers did not want a
  good, regardless of how much labor it takes to
  produce the good, the price would be very low or
  zero.

15
History of the Supply and Demand Model or the
Marshallian Cross (part 3)

• Alfred Marshall and the Issue of Time
• Very Short-run Price determined by demand or
  utility
• Short-run Price determined by supply and demand
• Long-run Price determined by the cost of
  production

16
The Law of Demand

• The quantity of a well-defined good or service
• that people are willing and able to purchase
• during a particular period of time
• decreases as the price of that good or service
  increases
• everything else held constant.

17
Demand

• Utility the satisfaction a person derives from
  a particular action.
• Law of Diminishing Marginal Utility - states that
  for a given time period, the marginal
  (additional) utility or satisfaction gained by
  consuming equal successive units of a good will
  decline as the amount consumed increases.
• Demand curve - a curve relating how much a good
  is demanded at various prices.
• Market Demand - the horizontal sum of all
  individual demand curves.
• Quantity demanded - refers to a specific amount
  that will be demanded per unit of time at a
  specific price, ceteris paribus. This is
  illustrated by a movement along the curve.

18
Demand FactorsA brief list

• Normal good - a good the demand for which rises
  as income rises.
• Inferior goods - a good the demand for which
  falls as income rises.
• Substitutes - two goods that satisfy similar
  needs or desires. If two goods are substitutes
  then as the price of one rises, demand for the
  other good will increase.
• Complements - two goods that are used jointly in
  consumption. If two goods are complements then
  as the price of one rises, demand for the other
  good will decrease.
• Other factors
• Tastes and preferences
• Population
• Changes in demand factors will cause the demand
  curve to shift.

19
Supply

• Supply -To be considered to supply a good you
  must be able and willing to produce (and sell)
  the good in various quantities at various prices.
• Market Supply - The total quantities of a good
  that sellers are willing and able to produce and
  sell.
• Supply curve - a curve relating how much a good
  is supplied at various prices.

20
Equilibrium and Disequilibrium

• Equilibrium Price - The price at which the
  quantity demanded of the good equals the quantity
  supplied.
• Market Surplus - The amount by which the quantity
  supplied exceeds the quantity demanded at a given
  price.
• Market Shortage - The amount by which the
  quantity demanded exceeds the quantity supplied
  at a given price.