The Basic Market The Basic Market EquationEquation

Price TheoryPrice Theory

Cold Call QuestionsCold Call Questions What is the law of diminishing marginal utility: What is the law of diminishing marginal utility:

what happens if you assume the opposite?what happens if you assume the opposite? What is the law of diminishing marginal What is the law of diminishing marginal

product: what happens if you assume the product: what happens if you assume the opposite?opposite?

What is the link between SS #s and auctions?What is the link between SS #s and auctions? What is Pareto optimal allocationWhat is Pareto optimal allocation Why do monopolies misallocate resources?Why do monopolies misallocate resources? Can demand curves slope up?Can demand curves slope up? Can supply curves slope down?Can supply curves slope down? What are Non-price adjustments for demand? What are Non-price adjustments for demand?

For supply?For supply?

AnnouncementsAnnouncements

Spoon-feedingSpoon-feeding ReflectionsReflections Project due datesProject due dates Next classNext class

Shift from Whole to PartShift from Whole to Part

Whole is driven by photosynthesis Whole is driven by photosynthesis and thermodynamicsand thermodynamics

Part is driven by prices and GDPPart is driven by prices and GDP

What do markets do?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

Why is food worth more to a rich overnourished person than to a poor, undernourished one.

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?What do markets do? Markets equilibrate supply and demand

Does this mean everyone can satisfy their demand for anything?

Does mean people are guaranteed access to basic human needs?

Economists focus entirely on preferences, making no distinction for needs

Rationing function of price Allocative function of price

Equation Components Equation Components Marginal utility MUxn, MUyn, MUxm, MUym

What’s the marginal utility of a cure for African sleeping sickness to someone dying of African sleeping sickness?

What’s the marginal utility of Vaniqa to someone with excessive facial hair?

Commodities are the outputs of production. Commodity prices (Px =cost of life saving medicines, Py = cost of cosmetics)

Equation Components Equation Components Factors are the inputs to production.

Factor prices = Pa , Pb, Pc

Pa the wage of a scientist needed to develop the commodity

Pb the cost of laboratory equipment to produce the commodity

Pc the cost of raw materials (e.g. eflornithine) Marginal Physical Product (MPPax, MPPay,

MPPbx, MPPby, ) Assumes other factors are held constant The laws of physics: can you produce more

pizza just by hiring more cooks?

Perfect MarketPerfect Market

All firms and consumers are price All firms and consumers are price takerstakers How do prices change?How do prices change?

Plans are adjusted to pricesPlans are adjusted to prices

Basic ConceptsBasic Concepts Law of diminishing marginal utilityLaw of diminishing marginal utility

Assume the opposite, increasing Assume the opposite, increasing marginal utilitymarginal utility

Law of diminishing marginal Law of diminishing marginal physical productphysical product Assume the opposite, increasing Assume the opposite, increasing

marginal physical product.marginal physical product. What about economies of scale?What about economies of scale?

Basic ConceptsBasic Concepts Equimarginal principle of Equimarginal principle of

maximizationmaximization Consumer's equimarginal principle of Consumer's equimarginal principle of

utility maximizationutility maximization MUMUxn/P/Px = MU = MUyn/P/Py

Rearrange to get MURearrange to get MUxn /MU /MUyn = P = Px /P /Py

Basic ConceptsBasic Concepts Equimarginal principle of maximizationEquimarginal principle of maximization

Producer's equimarginal principle of profit Producer's equimarginal principle of profit maximizationmaximization MPPMPPax/P/Pa=MPP=MPPbx/P/Pb

What theoretically happens when we raise Pa to What theoretically happens when we raise Pa to $9.00/hr?$9.00/hr?

How does this relate to the price of X and Y?How does this relate to the price of X and Y? PPa=P=Px(MPP(MPPax) = P) = Py(MPP(MPPay) or P) or Px=P=Pa/MPP/MPPax= =

PPy=P=Pa/MPP/MPPay

Rearrange to get MPPRearrange to get MPPay/MPP/MPPax=P=Px/P/Py

Which industries get the resources?Which industries get the resources? Which industry can afford to pay the most for Which industry can afford to pay the most for

scientists, laboratories and raw materials, life scientists, laboratories and raw materials, life saving medicines for the poor or cosmetics for saving medicines for the poor or cosmetics for the rich?the rich?

Allocative function of priceAllocative function of price

The Basic Market Equation The Basic Market Equation (cont.)(cont.)

MUxn/MUyn = Px/Py = MPPay/MPPax

WhatWhat’’s so special about the s so special about the Basic Market Equation?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 or marginal rate of technical substitution) by reallocating factors of production

WhatWhat’’s so special about the s so special about the Basic Market Equation?Basic Market Equation?

Equation holds for all Equation holds for all consumers m, n, oconsumers m, n, o

All products x, y, zAll products x, y, z All factors of production a, b, All factors of production a, b,

cc Decentralized informationDecentralized information

WhatWhat’’s so special about the s so special about the Basic Market Equation?Basic Market Equation?

Markets balance what is possible Markets balance what is possible with what is desirablewith what is desirable

Resources flow to those who value Resources flow to those who value them mostthem most

Leads to Leads to ‘‘optimaloptimal’’ allocation of allocation of resourcesresources Consumers maximize utilityConsumers maximize utility

Producers maximize profitsProducers maximize profits

Reality CheckReality Check So does society produce the right balance So does society produce the right balance

of life saving diseases and cosmetics?of life saving diseases and cosmetics? Who values eflornithine most, dying Africans or Who values eflornithine most, dying Africans or

hairy women?hairy women? Rationing function of priceRationing function of price

Pareto optimality: Everyone is as well off Pareto optimality: Everyone is as well off as can be without making someone else as can be without making someone else worse off.worse off. How do we choose between Pareto Optimal How do we choose between Pareto Optimal

outcomes?outcomes? Many other reality checks to come!Many other reality checks to come!

Other assumptions not mentioned?Other assumptions not mentioned?

Do things that are not bought and Do things that are not bought and sold compete for resources with sold compete for resources with things that are?things that are? E.g. ecosystem structure and ecosystem E.g. ecosystem structure and ecosystem

servicesservices Can everyone participate in the Can everyone participate in the

market?market?

MonopolyMonopoly

Headlines: Mega-Mergers See Headlines: Mega-Mergers See Comeback as Uncertainty of Crisis Comeback as Uncertainty of Crisis FadesFades

Monopolists are price makersMonopolists are price makers Marginal revenue for monopolist is less Marginal revenue for monopolist is less

than pricethan price Monopolists maximize profits by Monopolists maximize profits by

producing less than is socially producing less than is socially ‘‘optimaloptimal’’. . Are monopolies relevant to the Are monopolies relevant to the

eflornithine example?eflornithine example?

Non-Price AdjustmentsNon-Price Adjustments

How can we alter the desirability How can we alter the desirability conditions (MU ratios?)conditions (MU ratios?)

How can we alter the possibility How can we alter the possibility conditions (MPP ratios)conditions (MPP ratios)

What would happen if we What would happen if we redistributed wealth?redistributed wealth?

Demand CurveDemand Curve

MUxn/Px=MUyn/PyMUxn/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 We keep trading money for good X until we maximize utility.until we maximize utility.

Demand curve (cont.)Demand curve (cont.)

Px = MUxn/MUmnPx = 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?

Reality CheckReality Check

Does Px really equal Muxn?Does Px really equal Muxn? Social security numbers and auctionsSocial security numbers and auctions

Supply curveSupply curve

Px=MCxPx=MCx This is the condition for being on the supply This is the condition for being on the supply

curvecurve Remember that we are assuming increasing Remember that we are assuming increasing

marginal costs.marginal costs. Px=MCx=Pa/MPPax=Pb/MPPbx=...Px=MCx=Pa/MPPax=Pb/MPPbx=...

Remember units. Px=$/X, Pa/MPPax=$/XRemember units. Px=$/X, Pa/MPPax=$/X Look at Px=Pa/MPPax. Say Px increases. Pa Look at Px=Pa/MPPax. Say Px increases. Pa

stays the same, so MPPax must decrease. stays the same, so MPPax must decrease. More More aa must be used, so Q increases. must be used, so Q increases.

Demand and Supply (cont.)Demand and Supply (cont.)

Supply curveSupply curve

Demand and Supply (cont.)Demand and Supply (cont.) Supply and demand togetherSupply and demand together

MUxn/MUmn=Px=Pa/MPPaxMUyn/MUmn=Py=Pa/MPPyx

To think aboutTo think about Can we make more pizza by simply using Can we make more pizza by simply using

more ovens or more cooks?more ovens or more cooks? Markets make decisions based on the Markets make decisions based on the

principle of one dollar, one vote. Is this principle of one dollar, one vote. Is this appropriate for all resources?appropriate for all resources?

Do you think markets allocate scientists Do you think markets allocate scientists towards their best possible use?towards their best possible use?

What about information?What about information? Many ecological economists are trying to Many ecological economists are trying to

price non-market goods and services (e.g. price non-market goods and services (e.g. ecosystem services). If we could do this, ecosystem services). If we could do this, would it lead to their optimal allocation?would it lead to their optimal allocation?