The Big Idea ► How do the decentralized decisions of thousands of firms and households communicated through markets result in optimal allocations? ► Markets appear to have spontaneous order (the invisible hand) (the invisible hand) ► In what sense is market ► allocation efficient? ► Are outcomes fair or sustainable?
5 Concepts & 3 Principles ► Marginal Utility ► Market Price of a Good ► Market Price of Factor ► Marginal Physical Product ► Competitive Market ► Law of Diminishing Marginal Utility ► Law of Diminishing Marginal Physical Product ► Equimarginal Principle of Maximization
Marginal Utility = MUxn ► The marginal utility of good ‘x’ to consumer ‘n’. The extra or additional satisfactaion one gets from consuming one more unit of the good, other things being held equal (ceteris paribus & partial derivatives).
Market Price of Good ‘x’ = Px ► Goods are typically denoted by ‘x’ and ‘y’ ► E.g. Gallon of gas, slice of pizza, lift ticket, etc.
Market Price of Factor ‘a’ = Px ► To produce a slice of pizza there are factor prices of Capital ( kitchen & Stove ); Labor ( chef & dishwasher ); Labor ( chef & dishwasher ); and ingredients ( sauce, and ingredients ( sauce, dough, cheese, etc.). dough, cheese, etc.). ► What is the market price of Labor? of Labor? ► How much does minimum wage really raise the ‘floor’ wage really raise the ‘floor’ of the labor factor price? of the labor factor price?
Marginal Physical Product of Factor ‘a’ = MPPa ► The extra output produced as a result of using one more unit of factor ‘a’ as input ( ceteris paribus ) ► How many more pizzas are made pizzas are made per night by the per night by the addition of one addition of one more oven or one more oven or one more chef? more chef?
Competitive Market ► A market in which there are many buyers and sellers of identical product. ► ‘Many’ means “enough that no single buyer or seller is sufficiently large to affect the market price” – e.g. no firm is ‘too big to fail’ ► ‘Many’ means “enough that no single buyer or seller is sufficiently large to affect the market price” – e.g. no firm is ‘too big to fail’ ► Every ‘player’ is a “Price Taker” rather than a “Price Maker”. ► Question: What goods and services do you think are provided in truly competitive markets? Cell phone service, coffee, gasoline?
The Law of Diminishing Marginal Utility ► As one consumes successive units of a good, the additional satisfaction decreases, that is, total satisfaction increases but at a decreasing rate. ► The marginal utility of one’s first slice of of one’s first slice of pizza on an empty pizza on an empty stomach is great. stomach is great. The marginal utility of The marginal utility of the 5 th slice is much less. the 5 th slice is much less. Proof by Proof by contrapositive contrapositive
The Law of Diminishing Marginal Physical Product ( aka The Law of Diminishing Returns ) ► Law of diminishing returns – as more and more of a variable factor is added to a fixed factor, output will rise initially but will eventually fall. Output (total product) initially rises at an increasing rate, but marginal output then starts to diminish. This means that total output still increases, but at a decreasing rate (the slope of the curve tails off). There may eventually be a point may eventually be a point where returns become negative and output falls.
Economies of Scale ► The law of diminishing marginal product should not be confused with economies or diseconomies of scale. An economy of scale occurs when a 1% increase in all the factors of production together leads to more than a 1% increase in output. This does not contradict the law of diminishing marginal physical product. In reality, physical product. In reality, economies of scale are economies of scale are likely to occur over a limited likely to occur over a limited range of production, usually range of production, usually followed by diseconomies followed by diseconomies of scale. ( Carpenters and House Building example ) of scale. ( Carpenters and House Building example )
The Equimarginal Principle of Maximization (aka the ‘When to Stop’ rule) ► This is true for firms and households – we stop changing our allocations when marginal costs = marginal benefits marginal costs = marginal benefits ► Q: When does a consumer stop reallocatng her income among different goods? ► A: When she has found an allocation that maximizes her total satisfaction or total ‘utility’. ► Examples: Shoes vs. Pizza, guns vs. butter, Wall Street vs. Main Street Wall Street vs. Main Street
The Equimarginal Principle of Maximization (aka the ‘When to Stop’ rule) ► True for Consumers (households) ► True for Producers (firms) ► Pizza Parlor Example: Hire another cook or buy a bigger oven? Hire another cook or buy a bigger oven? Cook costs $1600/mnth Oven $1600/mnth Cook costs $1600/mnth Oven $1600/mnth Additional Cook – 20 more pizzas per day Additional Cook – 20 more pizzas per day Additonal Oven – 18 more pizzas per day Additonal Oven – 18 more pizzas per day 20 Pizzas/day boosts revenue by $1700 / month 20 Pizzas/day boosts revenue by $1700 / month
Failed Assumptions of equimarginal principle of maximization ► Homo Economicus ► Local vs. Global Optima in reallocation decisions ► ‘Lumpiness’ of units ► Ceteris Paribus
Marginal Physical Product for Labor ► Pizzeria and Shoe Store Story ► 1) The town is small – only labor available must be taken from pizzeria and attracted by higher wages. ► Diminished MPPshoes and increased MPPpizza results in labor transfer ► Step ‘2’ continues until equilibrium which is when: MPPshoes = MPPpizzas ► Comment: There is a ‘fairy tale’ element to ‘1’
The Basic Market Equation ► (x & y) are goods; ‘a’ is a factor of production (e.g. labor, capital, resources) ► Px is Price of one unit of good ‘x’ ► ‘n’ is a given individual consumer
How do we know the equation holds for ‘Ends’ or CONSUMPTION More Pizza or more Beer? More Studying time or More Playing Time?
How do we know the equation holds for ‘Means’ or PRODUCTION
What does the Market Equation mean?
The Parametric or ‘Fulcrum Function’ of relative prices The central role of Px/Py is worth emphasizing. It brings about an equality of the marginal utility ratios with the marginal productivity ratios. Things equal to the same thing are equal To each other – Prices serve as a kind of sliding fulcrum on a seesaw that balances the Weight of relative possibility with the weight of relative desirability, of means with ends.
Types of Substitution ► Psychological rate of substitution The rate at which consumers are willing to substitute one good for another. ► Market rate of substitution The rate at which consumers are able to substitute one good for another ► Technical rate of substitution or transformation The rate at which producers are able to produce one good rather than another by reallocation of factors of production.
Key Ideas ► The basic market equation defines an optimal allocation of resources, one in which no one would want to reallocate any factor to any alternative use because doing so would only decrease that person’s total satisfaction. No firm would want to reallocate any factor to any other use because doing so would lower profit. ► Prices in competitive markets lead to an efficient allocation of resources in the sense that no one can be made better off in his own judgment by reallocating resources to produce a different mix of goods.
Pareto Optimum ► A Pareto Optimum occurs when no other allocation could make at least one person better off without making anyone else worse off. This is also known as a Pareto Efficient Allocation. ► Pareto Optimality accepts a given distribution of wealth and income and does not care about the ‘scale’ of the economy.
NCE recognized Market Failure: Monopoly ► The fulcrum function of relative prices depends relative prices depends on pure competition. on pure competition. Firms produce up to where Firms produce up to where MC = MR MC = MR ► In a competitive market marginal revenue is equal to price and price is given. Producers are price takers. Monopolists can control supply and be price makers. ► Consequently Monopolists will underproduce and over charge to maximize profits. to maximize profits.
Assumptions and Limitations ► 1) Ignore distribution of wealth and income ► 2) All goods are market goods (rival & excludable) (rival & excludable) ► 3) Factors of production are substitutes for each another ► 4) External costs and Benefits are negligible ► 5) All players have perfect information ► 6) Markets are competitive
Non-Price Adjustments ► There are myriad pareto optima for every distribution of income; every set of wants and preferences; and every set of technologies, and all the combos thereof. Advertising and Social Movements are a non-price adjustment that can change relative desirability. Technological change can be a non-price adjustment that changes ratios of MPPax/MPPay Price adj - Psychological adj – Techno adj are all possible.
Advertising and creation of demand ► If wants are created and preferences altered through advertising, and if advertising is a cost of production of the product, then production begins to look like a treadmill. If we produce the need along with the product to satisfy it, then we are not really making any forward motion toward the satisfaction of pre-existing needs. The producer replaces the consumer as sovereign. Then, the moral earnestness of production, as well as the concept of Pareto Optimal allocation of resources in the service of such production, suffers a loss.
Quote for Discussion ► “ There is more to welfare than efficient allocation – for example, there are distribution and scale.” and scale.” ► Do you agree or disagree? ► “Welfare ” – what a word…. …promote the general welfare (U.S. constitution) “Welfare queens” and entitlement programs Welfare as “Utility Maximization”
Supply and Demand (intro) ► 1) The Demand Curve 2) The Supply Curve ► “Watch ► Your ► ‘P’s ► And ► ‘Q’s”
The Demand Curve Question: What does it mean to be on one’s demand curve? Question: What is the Marginal Utility of Money?
Demand Curve for Water
The Supply Curve
Summary ► The Basic Market Equation defines and brings about a pareto optimal allocation of resources and establishes te decreasing demand curve and incrreasiing supply curve which produces market clearance at P*,Q*. This is true for any pair of goods (x,y), and pair of factors (a,b), and any consumer (n1, n2, n3, …). This is a simplified picture of overall market equilibrium.
Big Ideas to remember… ► Basic Market Equation Competitive Market ► Pareto Optimal allocation Monopoly & Misallocation ► Sliding Fulcrum Function of Relative Prices ► Law of diminishing marginal physical product ► Marginal Costs = Marginal Revenue “when to stop” ► Non-Price AdjustmentsEquimarginal Principle ► Supply and DemandPrinciple of Substitution