# The Basic Market Equation Price Theory. What do markets do? Do markets tell us the value of things? What is value? Why are diamonds worth more than water?

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The Basic Market Equation Price Theory

What do markets do? Do markets tell us the value of things? What is value? Why are diamonds worth more than water? Use value Exchange value Do markets tell us how scarce things are? Why did oil prices remain flat for 100 years? Why did we harvest North Atlantic Cod almost to extinction with only small price increases?

What do markets do? Markets equilibrate supply and demand Does this mean everyone can satisfy their demand for anything? Rationing function of price Allocative function of price

Equation Components Marginal utility MU xn, MU yn, MU xm, MU ym Whats the marginal utility of a cure for African sleeping sickness to someone dying of African sleeping sickness? Whats the marginal utility of Vaniqa to someone with excessive facial hair? Commodities are the outputs of production. Commodity prices (P x =cost of life saving medicines, P y = cost of cosmetics) Factors are the inputs to production. Factor prices = P a, P b, P c P a the wage of a scientist needed to develop the commodity P b the cost of laboratory equipment to produce the commodity P c the cost of raw materials (e.g. eflornithine) Marginal Physical Product (MPP ax, MPP ay, MPP bx, MPP by, ) Assumes other factors are held constant The laws of physics: can you produce more pizza just by hiring more cooks?

Perfect Market All firms and consumers are price takers All firms and consumers are price takers How do prices change? How do prices change? Plans are adjusted to prices Plans are adjusted to prices

Basic Concepts Law of diminishing marginal utility Law of diminishing marginal utility Assume the opposite, increasing marginal utility Assume the opposite, increasing marginal utility Law of diminishing marginal physical product Law of diminishing marginal physical product Assume the opposite, increasing marginal physical product. Assume the opposite, increasing marginal physical product. What about economies of scale? What about economies of scale?

Basic Concepts Equimarginal principle of maximization Equimarginal principle of maximization Consumer's equimarginal principle of utility maximization Consumer's equimarginal principle of utility maximization MU/P = MU/P MU xn /P x = MU yn /P y Rearrange to get MU /MU = P /P Rearrange to get MU xn /MU yn = P x /P y

Basic Concepts Equimarginal principle of maximization Equimarginal principle of maximization Producer's equimarginal principle of profit maximization Producer's equimarginal principle of profit maximization MPP/P=MPP/P MPP ax /P a =MPP bx /P b How does this relate to the price of X and Y? How does this relate to the price of X and Y? P=P(MPP) = P(MPP) or P=P/MPP= P=P/MPP P a =P x (MPP ax ) = P y (MPP ay ) or P x =P a /MPP ax = P y =P a /MPP ay Rearrange to get MPP/MPP=P/P Rearrange to get MPP ay /MPP ax =P x /P y Which industries get the resources? Which industries get the resources? Which industry can afford to pay the most for scientists, laboratories and raw materials, life saving medicines for the poor or cosmetics for the rich? Which industry can afford to pay the most for scientists, laboratories and raw materials, life saving medicines for the poor or cosmetics for the rich? Allocative function of price Allocative function of price

The Basic Market Equation (cont.) MUxn/MUyn = Px/Py = MPPay/MPPax

Whats so special about the Basic Market Equation? MUxn/MUyn = rate at which consumers are willing to substitute X for Y (psychological rate of substitution) Px/PY = rate at which consumers are able to substitute X for Y (Market rate of substitution) MPPay/MPPax = rate at which producers are able to produce transform one good into another (technical rate of transformation) by reallocating factors of production

Whats so special about the Basic Market Equation? Equation holds for all consumers m, n, o Equation holds for all consumers m, n, o All products x, y, z All products x, y, z All factors of production a, b, c All factors of production a, b, c Decentralized information Decentralized information

Whats so special about the Basic Market Equation? Markets balance what is possible with what is desirable Markets balance what is possible with what is desirable Resources flow to those who value them most Resources flow to those who value them most Leads to optimal allocation of resources Leads to optimal allocation of resources Consumers maximize utility Consumers maximize utility Producers maximize profits Producers maximize profits

Reality Check So does society produce the right balance of life saving diseases and cosmetics? So does society produce the right balance of life saving diseases and cosmetics? Who values eflornithine most, dying Africans or hairy women? Who values eflornithine most, dying Africans or hairy women? Rationing function of price Rationing function of price Pareto optimality: Everyone is as well off as can be without making someone else worse off. Pareto optimality: Everyone is as well off as can be without making someone else worse off. How do we choose between Pareto Optimal outcomes? How do we choose between Pareto Optimal outcomes? Many other reality checks to come! Many other reality checks to come!

Other assumptions not mentioned? Do things that are not bought and sold compete for resources with things that are? Do things that are not bought and sold compete for resources with things that are? Can everyone participate in the market? Can everyone participate in the market?

Monopoly Monopolists are price makers Monopolists are price makers Marginal revenue for monopolist is less than price Marginal revenue for monopolist is less than price Monopolists maximize profits by producing less than is socially optimal. Monopolists maximize profits by producing less than is socially optimal. Are monopolies relevant to the eflornithine example? Are monopolies relevant to the eflornithine example?

Non-Price Adjustments How can we alter the desirability conditions (MU ratios?) How can we alter the desirability conditions (MU ratios?) How can we alter the possibility conditions (MPP ratios) How can we alter the possibility conditions (MPP ratios) What would happen if we redistributed wealth? What would happen if we redistributed wealth?

Demand Curve MUxn/Px=MUyn/Py MUxn/Px=MUyn/Py Let y = money, and let Py = 1. Let y = money, and let Py = 1. Then MUxn/Px=MUmn, and Then MUxn/Px=MUmn, and Px = MUxn/MUmn. Px = MUxn/MUmn. We keep trading money for good X until we maximize utility. We keep trading money for good X until we maximize utility.

Demand curve (cont.) Px = MUxn/MUmn Px = MUxn/MUmn How do we adjust if Px drops? How do we adjust if Px drops? What part of this demand curve corresponds to Africans demand for eflornithine?

Supply curve Px=MCx Px=MCx This is the condition for being on the supply curve This is the condition for being on the supply curve Remember that we are assuming increasing marginal costs. Remember that we are assuming increasing marginal costs. Px=MCx=Pa/MPPax=Pb/MPPbx=... Px=MCx=Pa/MPPax=Pb/MPPbx=... Remember units. Px=\$/X, Pa/MPPax=\$/X Remember units. Px=\$/X, Pa/MPPax=\$/X Look at Px=Pa/MPPax. Say Px increases. Pa stays the same, so MPPax must decrease. More a must be used, so Q increases. Look at Px=Pa/MPPax. Say Px increases. Pa stays the same, so MPPax must decrease. More a must be used, so Q increases.

Demand and Supply (cont.) Supply curve Supply curve

Demand and Supply (cont.) Supply and demand together Supply and demand together MUxn/MUmn=Px=Pa/MPPax MUyn/MUmn=Py=Pa/MPPyx

To think about Can we make more pizza by simply using more ovens or more cooks? Can we make more pizza by simply using more ovens or more cooks? Markets make decisions based on the principle of one dollar, one vote. Is this appropriate for all resources? Markets make decisions based on the principle of one dollar, one vote. Is this appropriate for all resources? Do you think markets allocate scientists towards their best possible use? Do you think markets allocate scientists towards their best possible use? What about information? What about information? Many ecological economists are trying to price non-market goods and services (e.g. ecosystem services). If we could do this, would it lead to their optimal allocation? Many ecological economists are trying to price non-market goods and services (e.g. ecosystem services). If we could do this, would it lead to their optimal allocation?

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