1. Efficiency, Coordination and Economic Organization Flashcards
ECONOMIC ORGANIZATIONS (Milgrom and Roberts 1992)
Economic organizations are created-entities within and through which people interact to reach their goals.
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The economic organizations are entities created by individuals and evaluated on the base of their capacity to reach goals.
Economic organisations and goals, preferences, scarcity
The economic organizations are entities created by individuals and evaluated on the base of their capacity to reach goals.
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These goals are not only economic: they could be related to the capacity of satisfying the economic needs of participants such as the consumption of goods.
- The individuals have to know their PREFERENCES, which means needs and priorities. We can describe their satisfaction through a UTILITY FUNCTION and the goal is to maximize it.
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We live in a context of SCARCITY OF RESOURCES: if we choose to consume more than one good, we will have to reduce the consumption of another good. Moreover, the satisfaction of the utility function of an individual is at the expense of others.
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Concept of Scarcity:
Within individual scarcity: give up one for another
___ scarcity: The level of my utility satisfaction comes at expensive of other
Typology of economic organisations (like a matrioshka)
The highest-level organization: the “Economy”
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lower-level economic organizations: “Markets” (and the way transactions are governed, managed and carried out);
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Independent legal entities: Economic organizations that are formed and interact with individuals in markets: “Firms” and other formal entities (e.g. labor unions, government/regulatory agencies, associations, etc.).
They are independent legal entities: they can enter binding contracts and providing enforcement of those contracts in their own name.
The place where individuals and firms interact are:
PRODUCT MARKET: households express a demand for goods and producers supply these goods.
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Samuelson and Nordhaus, 2001. Fig: Inputs, Production, Outputs, and Consumption Form the Circular Flow of Economic Life
Inputs, Production, Outputs, and Consumption Form the Circular Flow of Economic Life
Market strongly interrelated..circular flow.
Every decision taken in one market, has an effect on other markets.
Consumer consumes more one 1 good, increase demand, I have to reduce demand of other market.
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consume all good, have to increase my labour hours to increase salary, affects demand and also less spare time to spend money of other activities.
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firm increase production plans, affects labour inputs, additional money in market, they will use in other markets.
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How do we choose best allocation of resources and goods as a society?
possible outcomes are infinite. tough question. Never been completely solved in economic analysis but we can try addressing the question. to deliver some guidance on what can be preferred to something else. We can do it through PARETO EFFICIENCY CRITERIUM. PAreto: famous Italian economist.
Pareto efficiency
Pareto efficiency, or Pareto optimality, is an economic state where resources cannot be reallocated to make one individual better off without making at least one individual worse off.
An allocation of resources A is inefficient if there is some other available allocation B that everyone concerned likes at least as A and that one person strictly prefers.
In such a case A is Pareto dominated by B (B is Pareto superior to A) and it is clearly wasteful from a society point of view.
It needs to beA is at least pareto efficient as B.
Otherwise A is said to be Pareto efficient (or Pareto optimal).
A pareto inferior than B: (eg, 4 people)
level of utility is unchanged for 3 across A & B, but for 4th, B is more level of utility than A.
Pareto efficient: can’t tell which one is better because equally maintaining. utility level.
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1. ETHICS NOT CONTEMPLATED: Notice that to give all resources to a single insatiable and completely selfish individual would be efficient (ethics is not contemplated). what if 1% get all the value in A and in B, everyone gets value?
It would seem Pareto efficient but it’s not ethical.
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2. Given a set of resources, there are many efficient allocations. Therefore, Pareto efficiency has a NORMATIVE POWER: it has the positive power to predict the outcomes of allocations but with negative implications from an ethical point of view.
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(Moreover, there are typically many efficient allocations for a given collection of resources. Thus, the efficiency criterion may be weak on ethical grounds and as a predictor of outcomes.)
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But its predictive power is not totally absent: THE EFFICIENCY PRINCIPLE.
Extra:
This is a way to EVALUATE DIFFERENT CHOICES leading to different allocation of resources and products.
The Pareto efficient depends on the GROUP OF PEOPLE and SET OF AVAILABLE RESOURCES considered.
If there are more people and resources, the Pareto efficient changes.
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Giving all resources to a single insatiable and completely selfish individual would be Pareto efficient, even if there were no ETHICAL CONSIDERATIONS.
The efficiency principle
If people are able to bargain together effectively
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and can effectively implement and enforce their decisions,
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then the outcomes of economic activity will tend to be pareto efficient (at least for the parties to the bargain).
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Indeed, since efficient choices and allocations are less vulnerable, we should expect inefficient arrangements to be replaced over time, while efficient ones survive.
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Extra: The efficiency principle states that an action achieves the most benefit when marginal benefits from its allocation of resources equal marginal social costs. The goal is to produce desired products at the lowest possible cost, eliminating deadweight loss or misused resources.
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Firm A gaining a lot as a monopoly; customers B are not gaining. Benefit for consumer is low because they have to pay more.
Possiblity to reduce profit of firm to increase benefit of consumer. No situation is pareto- dominant but it’s unfair for firm to have so much power.
There is no migration from A to B because firm will never agree to that. We need the intervention of government policies/ regulatory policies.
The Edgeworth Box and the gains from Trade. Economist from 80s (Talks about externalities)
Two consumers, A and B.
Their endowments of goods 1 and 2 are
ω^A= (ω1^A , ω2^A) and ω^B= (ω1^B, ω2^B)
For eg: ω^A= (6,4) and ω^B=(2,2).
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total quantities available are:
ω1^A + ω1^B = 6 + 2 = 8 units of good 1
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ω2^A + ω2^B = 4 + 2 = 6 units of good 2
ω (omega) is endowment allocation
Starting an Edgeworth Box, The endowment Allocation
The dimensions of the box are thequantities available of the goods.
The BOX includes all feasible allocations of the goods between the 2 consumers.
Of course including the before-trade allocation or endowment allocation.
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Dimensions:
X axis:
Width= ω1^A + ω1^B = 6 + 2 = 8 units of good 1
Y axis:
Height= ω2^A + ω2^B = 4 + 2 = 6 units of good 2
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Map: The endowment Allocation
Map ω^A= (6,4) and ω^B=(2,2)
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Other feasible allocations
Formulas
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Consumer A will happy with the move because it will increase consumption of both but consumer B may not like it.
Is there any allocation that will make both happy considering the initial allocation before trade?
Can we incentivise consumers to move to the new place (black dot)?
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Which allocations will be blocked by one or both consumers?
Which allocations make both consumers better off?
- at the intersection of the indifference curves
3 fundamental assumptions of well-behaved preferences: Preference curves, indifference curves
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Add preferences to box: preference curves
Well-behaved preferences: rely on 3 funda assumptions:
1. Monotonic preference/ non-satiety assumption: more we consume, better we are. Never reaching satiety point. Higher utility.
The indifference curves have a negative slope because if I want to maintain the same level of utility increasing the consumption of one good, I have to reduce the consumption of the other. The 2 indifference curves of a consumer never cross each other.
Notes: we can observe the indifference curves of the perfect substitutes and complementary goods. In the case of perfect substitutes, the extreme quantities of the goods (on the axes) give the same level of utility to the consumer. In the case of complementary goods, if the consumer buys one of the two goods, he must buy the other (for example shoes).
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2. Convex preferences: Consumers want balance mix consumption of both. Indifference curve with utility level that is higher.
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3. Transferability preference: If consumer is indifferent between bundle X and Y, indifferent between X and z. Indifference curve don’t cross one with the other.
They have to stay on the same indifference curve.
Pareto Optimality and contract curve
At the intersection of the indifference curves, best place to help consumers move.
This is where trade happens, in the space of the indifference curves.
Pareto Optimality
At the intersection of indifference curves. anywhere else, you will increase utility of someone and decrease someone else’s.
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Contract curve
There are many points in the box where the curve of one consumer is tangent to the curve of the other: all these points form the contract curve. If there is an initial allocation of resources, there is limited set of allocations reachable in the contract curve. Mixing the contract curve and the indifference curve within the box, we can find the Pareto efficient allocations not blocked by a consumer. These Pareto optimal allocations, called the Core, are welfare improving for both consumers relatively to their own endowments.
- Fundamental theories of Welfare Economics
- From any possible endowment allo, by allowing ppl to trade u will reach a point in the contract curve, a pareto optimality. Trading possibilities are maximum. If you make market competitive, you are sure to reach a pareto efficient solution.
CE to PE - If you want a specific P-effic in contract curve, you have to find right endowment allocation. Make people trade when you find the right endowment allocation.
PE to CE
Trade is important to increase welfare (example)
Trade is important to increase welfare
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Consumer A and B are two families.
2 goods 1 and 2 are wealth and babies/ children.
Endowment allocation
omega A rich but no babies
Omega B poor but babies
In principle, it can work in the contract curves, this market should never happen. We need to preserve morals and ethics. Politics
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A caveat and an excursus lecture slide
Example provided in this book: Michael J Sandel: What Money can’t buy.
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Rational trades should achieve a core allocation. The ultimate trade should be into the core. Therefore, trades can increase the welfare of a community. Moreover, they allow specialization with positive impacts on productivity and production. Through specialization and coordination,
