EC201 Micro LT Flashcards
The Market System
• Decentralisation- people are being instructed or explicitly coordinated
• Greed - they do not care about people that they are producing for/trading with
• What we mean by this is a way of producing goods allocating resources to people using price signals
• We refer to a “system” because we are looking at the whole economy and how it works rather than any specific sector or market
• There are many grand debates about the merits of markets and what they achieve:
forces us to think about what we value in human welfare
efficiency, equality, freedom etc.
• We want our models to give some insight into these issues
What is a good?
- Goods may not just be things that we conventional recognise as goods: mobile phone services, food, paper, pens etc.
- A good can be different according to where and when it is consumed so they are distinct goods and prices could vary if supply and demand for the good need to be equalised on different dates
- There are complete markets when all possible variants of goods can be traded
Market Goods
- The focus is on those things that are traded at defined prices
- Statistical agencies collect price data in markets and data on what people buy and produce
- These are used to get measures of aggregate activity in the market economy (important for guiding policy)
- The non-market sector is also important: home production, government production, some parts of the non-profit sector
- Demand for each good has standard properties: goods can be complements and substitutes, but each individual only supplies labour in the area in which they have a talent
General Equilibrium
- Prices are set so as to “clear” all markets simultaneously
- Consumers are able to get what they want given these prices
- Given the distribution of talents, the market delivers enough goods to provide for what consumers want
- We will denote equilibrium prices as p* = (p1,… pN)
- The best way to think about this is in terms of “excess demand”, where excess demand = demand - supply
- When markets clear, all excess demand are zero
Intuitions about Excess Demand Functions
- More people who are able to produce a particular good
- Then excess demand will fall for any given price
- We would then expect the market clearing price to fall
- But it will also affect markets for complements and substitutes for that good
If a good becomes more popular
- Then excess demand for that good increases
- We would expect the market clearing price to rise
- Will affect other markets which are complements or substitutes
Price normalisation
- A general equilibrium can be expressed entirely in terms of numeraire good since only relative prices matter
- But the choice of numeraire is arbitrary: we can set pk = 1 for any k
Walras Law
- If all but one market is in equilibrium, then so is the last one
- To see this, set p1 = 1 and note that demand for X1 + sum of demand for all other X1s = Demand for Z1 + sum of demand for all other Z1s
Consistency
- Main breakthroughs came in the second half of the 20th century
- Often called an Arrow-Debreu economy
- Key innovation was to apply “fixed point” reasoning to the market economy
Excess Demand in a Single Market
- High enough price discourages demand and encourage supply
- Low enough price encourages demand and discourages supply
- No jumps in supply and demand
- Importance of convexity assumptions to make supply and demand continuous
- Averaging over people also helps too
Extension to Multiple Markets
- Cannot be drawn by the basic idea is the same as a single market except that all prices are moving to achieve equilibrium across all markets
- However, continuity and what happens in a market as prices become high and low still play a key role
- A set of prices that set all excess demand functions equal to zero simultaneously is known as a “fixed point”
- A market system in this very stylised world is set of market-clearing prices
The Role of Government
- The general equilibrium model is generally though of as a “pure market system”
- But this is misleading
- Two key things that government might do: enforce property rights, i.e. ensure that people own what they produce, enforce trades at agreed prices
- In practice, there is no guarantee that this happens: many countries have poorly developed court systems and corrupt governments who do these jobs poorly, widely studied in political economy, creates an impediment to having an effective market economy
The Distribution of Property Rights in a Market Economy
- Behind a market economy is a distribution of property rights
- No slavery assumption: people own their own labour power
- But this does not mean that they own the output that they produce
- We will consider a distribution of property rights to output which could be different to who produces what
- Changes in the distribution of property rights to output corresponds it what economists call lump-sum redistribution
- Taking output from one person and giving to another
- Reallocation of property rights
Edgeworth Box
- Two individuals A and B
- Two goods: books (good 1) and food (good 2)
- Individual A can produce food and individual B writes books
- But the distribution of property rights determines who owns the books and food
- Suppose there is a fixed labour supply (zero disutility of labour)
- If both like books and food then it would make sense for them to trade
- There is a market for books and market for food
- Let p1(p2) be the price of books (food)
- Income depends on poverty rights which are equal to 1
EB, Two parts:
- Goods availability for each individual
- Reflecting the amount of food and books that each individual owns
- Distribution of income
- At an equilibrium point prices allocate consumption so that each consumer gets what they want given equilibrium prices
- We will now build up a picture of general equilibrium (supply = demand)
General Equilibrium point:
- General equilibrium is the point where both consumers get what they want given the prices
- Demand comes from tangency between indifference curve and budget line
- Both simultaneously achieving tangency where supply = demand
Wages and Prices in General Equilibrium
- Reflect supply and demand in different markets
- All else equal:
- Benefit as consumers when fewer people demand the things that they like
- Benefit as producers if?
- Wages and prices distribute who gets what
- Property rights decide who owns what
The Utility Possibility Frontier (UPF)
- Now ask what level of utility does each consumer obtain in a general equilibrium
- This is a crucial idea when it comes to thinking about efficiency and equity
- We allow for the possibility of redistribution between the two individuals
- Imagine a redistribution of property rights to output
- Relative prices will change to reflect the scarcity of the goods to achieve a general equilibrium outcome
- And each will be associated with a particular level of utility for each individual
- Endowment: who starts in an advantageous position, what are the wages and prices?
- Increase utility of A, decrease utility of B
- All different levels of A and B depend on resource endowment
- A point on the frontier corresponds to a general equilibrium point
Lump-sum redistribution
- What happens if there is a change of property rights so that some of the food produced by A is transferred to B before trade begins
- After the transfer of food, we assume that they trade in markets to achieve a general equilibrium
- Prices may now have to change to clear markets depending on the preferences of the two individuals
- Individual B who now has a greater purchasing power may like one good more than the other
- This results in a new point on the UPF
- So the UPF maps out what happens in a market system with different levels of purchasing power
- Important and useful when we think about redistribution
- Inequality cause by starting point
- Market only exacerbates inequalities
Welfare Economics
- Branch of economics that engages with normative analysis and moral philosophy
- This underpins how we think about the role of government
- A cornerstone of the approach is a framework for thinking about inequality
- We will try to think systematically about welfare judgements based on the distribution of income
The First Fundamental Welfare Theorem
- Consider an equilibrium price vector p* (p1,…,pN)
- Key concept: Pareto efficient
- An allocation of goods and services (x,L) is Pareto efficient if we cannot make someone better off without making someone else worse off
- The first fundamental theorem of welfare economics says: every general competitive equilibrium is Pareto efficient (supply = demand)
- But, nobody is directly coordinating economic activity and people are acting independently and selfishly
- The invisible hand: a term used by Adam Smith to describe the unintended social benefits of an individual’s self-interested actions
- Why is it true?
- We know that everyone is maximising given the prices that they face
- Then if there is bundle of consumption and labour supply that a consumer prefers, it must be unaffordable
- Equally if there is a consumption bundle with U(x,L) > U(f,g) then is must be infeasible
- Market is Pareto efficient by construction, in market, everyone is maximising if someone could be doing better they would be
- Not every point in an Edgeworth box is Pareto efficient: just need to reallocate
- Trade until everyone is better off
Contract Curve
- The contract curve is the set of points representing final allocations of two goods between two people that could occur as a result of mutually beneficial trading between those people given their initial allocations of the goods
- Directions of Pareto change
- Any point on contract curve is Pareto efficient where trade has been exhausted
- Every transaction creates a Pareto improvement, assumes you are a ‘positively’ free consumer
- At the market clearing price, everyone gets what they want at the equilibrium point
- But, a society can be Pareto optimal and still perfectly disgusting
- Edgeworth box can’t say whether Ua or Ub is better or worse off, we would have to assume utilities matter comparatively??
What determines the distribution of income in general equilibrium?
1) Distribution of property rights
2) Distribution of talent
3) Distribution of effort
4) Market prices
• With equal ownership, property rights is the same for everyone and every good, there will be equality of incomes
• If individuals own what they produce, then an individual skilled in the production of k gets income independent of property rights
• Therefore inequality must depend on
Level of skill - a
Scarcity - X
Extent of effort - g
Distribution of utility
- Individuals may have different tastes for income and goods
- Some people may dislike work/value consumption more
- This will be important when we think about a just distribution of income looks like