1. The Market Economy

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1. The Market Economy
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Outline

• A. Introduction What is Efficiency?
• B. Supply and Demand (1 Market)
• C. Efficiency of Consumption (Many Markets)
• D. Production Efficiency (Many Markets)

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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.

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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 individuals decisions and
  information.

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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.

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Utility Possibilities What is Feasible

2s Utility
1s Utility
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Utility Possibilities What is Feasible

2s Utility
Allocations
1s Utility
8
Pareto efficiency There is no waste

2s Utility
Pareto efficient Allocation
1s Utility
9
Equity equal shares

U1 U2
2s Utility
1s Utility
10
Utilitarianism Maximize U(1)U(2)

2s Utility
1s Utility
11
Rawls Maximize minU(1),U(2)

2s Utility
1s Utility
12
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?

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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.

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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)

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P
Demand (100)
Q of Coffee
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P
Supply (80)
Q of Coffee
17

P
Supply
Demand
Q of Coffee
18

P
Supply
Demand
Q of Coffee
19

P
Supply
Demand
Q of Coffee
20

P
Supply
Demand
Q of Coffee
21

P
Supply
Demand
Q of Coffee
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Conclusions

• If
• a market is organized,
• the market is perfectly competitive,
• price is at the equilibrium,
• then
• full efficiency is achieved.

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C. Efficiency of Economies with Many Goods (No
Production)

• Consumer Behaviour with Many Goods

Quantity of B
Quantity of A
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C. Efficiency with Many Goods

• Indifference Curves

Quantity of B
utility 2
Quantity of A
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C. Efficiency with Many Goods

• Indifference Curves

Quantity of B
utility 3
Quantity of A
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C. Efficiency with Many Goods

• indifference curves

Quantity of B
utility 4
Quantity of A
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C. Efficiency with Many Goods

• Indifference Curves

Quantity of B
Higher Utility
Quantity of A
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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
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Budget Constraints
With 10 can afford 10 pAX(Units of A)
pBX(Units of B)

Quantity of B
Quantity of A
30
Budget Constraints
With 10 can afford 10 pAX(Units of A)
pBX(Units of B)

Quantity of B
Quantity of A
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Consumer Optimum

Quantity of B
Quantity of A
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Consumer Optimum

Here Slopes are equal
Quantity of B
Quantity of A
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Equal Slopes

• Slope of Budget Line
• - pA /pB
• Slope of Indifference Curve
• - MUA / MUB

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Equal Slopes

• Slope of Budget Line
• - pA /pB
• Slope of Indifference Curve
• - MUA / MUB
• This is called
• The Marginal Rate of Substitution

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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

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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.

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Their Resources

IIs Quantity of A
Is Quantity of B
IIs Quantity of B
Is Quantity of A
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Their Endowment

IIs Quantity of A
1
Quantity of B
5
1
IIs Quantity of B
5
Quantity of A
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Is Preferences

IIs Quantity of A
1
Quantity of B
5
1
IIs Quantity of B
5
Quantity of A
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IIs Preferences

IIs Quantity of A
1
Quantity of B
5
1
IIs Quantity of B
5
Quantity of A
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Putting Preferences together

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

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

IIs Quantity of A
1
Quantity of B
5
1
IIs Quantity of B
5
Quantity of A
44
Pareto efficiency Is where cannot make I better
off with out making II worse off.

IIs Quantity of A
1
Quantity of B
5
1
IIs Quantity of B
5
Quantity of A
45
Pareto efficiency Is where cannot make I better
off with out making II worse off.

IIs Quantity of A
1
Quantity of B
5
1
IIs Quantity of B
5
Quantity of A
46
Pareto efficiency Is where cannot make I better
off with out making II worse off.

IIs Quantity of A
1
Quantity of B
5
1
IIs Quantity of B
5
Quantity of A
47
Allocation of Resources is efficient if

• Slope of Is Indifference Slope of IIs
  Indifference Curve Curve
• Is MRS IIs 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 IIs small decrease expense of IIs
  small decrease
• in A. in B.

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All the Pareto efficient places

IIs Quantity of A
1
Quantity of B
5
1
IIs Quantity of B
5
Quantity of A
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These join to give the Contract Curve

IIs Quantity of A
1
Quantity of B
5
1
IIs Quantity of B
5
Quantity of A
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Pareto efficiency Utility Possibilities

IIs Utility
Pareto efficient Allocation
Is Utility
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D. Production Efficiency

• One firm uses inputs
• Land and Labour to produce good A
• Another firm
• uses Land and Labour to produce good B.

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Production Functions Isoquants

Quantity of land
Output 1 Unit of A
Quantity of Labour
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Production Functions Isoquants

Quantity of land
Output 2 Unit of A
Output 1 Unit of A
Quantity of Labour
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Production Functions Isoquants

Quantity of land
Output 3 Unit of A
Output 2 Unit of A
Output 1 Unit of A
Quantity of Labour
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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
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Most Efficient way of producing Output 3

Quantity of land
8 PL QL PN PN
Quantity of Labour
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Most Efficient way of producing Output 3

Quantity of land
9 PL QL PN PN
8 PL QL PN PN
Quantity of Labour
58
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
59
Most Efficient way of producing Output 3

Quantity of land
Output 3 Unit of A
Quantity of Labour
60
Most Efficient way of producing Output 3

Quantity of land
Output 3 Unit of A
Quantity of Labour
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Most Efficient way of producing Output 3

Here Slopes are equal
Quantity of land
Output 3 Unit of A
Quantity of Labour
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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

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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
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Many Firms Producing

Firm IIs Labour
Firm 1s Land
Firm IIs Land
Firm 1s Labour
65
Many Firms Producing

Firm IIs Labour
Firm 1s Land
Firm IIs Land
Firm 1s Labour
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Many Firms Producing Efficient Production

Firm IIs Labour
Firm 1s Land
Firm IIs Land
Firm 1s Labour
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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

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Many Firms Producing Efficient Production

Firm IIs Labour
Firm 1s Land
Firm IIs Land
Firm 1s Labour
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Production Possibility Frontier

Firm IIs Labour
Firm 1s Land
Firm IIs Land
Firm 1s Labour
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Production Possibilities What is Feasible

Firm 2s Output
Firm 1s Output
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Production Possibilities What is Feasible

Firm 2s Output
Slope of this line represents how economy is able
to move from production of 2 into 1 Marginal
Rate of Transformation
Firm 1s Output
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At Last Production Efficiency with Many Goods
and One Consumer

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

Firm 2s Output
Firm 1s Output
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Maximizing Utility given Production

Quantity of B
Higher Utility
Quantity of A
How the consumer values goods
75
Slope of Indifference Slope of Production
Possibilities Ratio of Prices

Quantity of B
Higher Utility
Quantity of A
How the consumer values goods
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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

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Efficiency with Many Goods and Production

IIs Quantity of A
1
Quantity of B
5
1
IIs Quantity of B
5
Quantity of A
78
Many Firms Producing What is produced is
determined by input prices

Firm IIs Labour
1
Firm 1s Land
5
1
Firm IIs Land
5
Firm 1s Labour
79
Their Preferences

IIs Quantity of A
1
Quantity of B
5
1
IIs Quantity of B
5
Quantity of A
80
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