Chapter 8Chapter 8

The Basic Market EquationThe Basic Market Equation

Geog 3890: ecological Geog 3890: ecological economicseconomics

The Big IdeaThe Big Idea►How do the decentralized decisions of How do the decentralized decisions of

thousands of firms and households thousands of firms and households communicated through markets result in communicated through markets result in optimal allocations?optimal allocations?

►Markets appear to have spontaneous order Markets appear to have spontaneous order

(the invisible hand)(the invisible hand)

► In what sense is market In what sense is market ► allocation efficient?allocation efficient?

► Are outcomes fair or sustainable?Are outcomes fair or sustainable?

5 Concepts & 3 Principles5 Concepts & 3 Principles►Marginal UtilityMarginal Utility►Market Price of a GoodMarket Price of a Good►Market Price of FactorMarket Price of Factor►Marginal Physical ProductMarginal Physical Product►Competitive MarketCompetitive Market

►Law of Diminishing Marginal UtilityLaw of Diminishing Marginal Utility►Law of Diminishing Marginal Physical Law of Diminishing Marginal Physical

ProductProduct►Equimarginal Principle of MaximizationEquimarginal Principle of Maximization

Marginal Utility = MUxnMarginal Utility = MUxn►The marginal utility of good ‘x’ to The marginal utility of good ‘x’ to

consumer ‘n’. The extra or additional consumer ‘n’. The extra or additional satisfactaion one gets from consuming satisfactaion one gets from consuming one more unit of the good, other one more unit of the good, other things being held equal (things being held equal (ceteris ceteris paribus & partial derivativesparibus & partial derivatives).).

Market Price of Good ‘x’ = PxMarket Price of Good ‘x’ = Px

►Goods are typically denoted by ‘x’ and Goods are typically denoted by ‘x’ and ‘y’‘y’

►E.g. Gallon of gas, slice of pizza, lift E.g. Gallon of gas, slice of pizza, lift ticket, etc.ticket, etc.

Market Price of Factor ‘a’ = Market Price of Factor ‘a’ = PxPx

►To produce a slice of pizza there To produce a slice of pizza there are factor prices of Capitalare factor prices of Capital ( (kitchen & kitchen & StoveStove); );

Labor Labor ((chef & dishwasherchef & dishwasher);); and ingredientsand ingredients ( (sauce, sauce,

dough, cheese, etcdough, cheese, etc.)..).

► What is the market price What is the market price of Labor?of Labor?

► How much does minimum 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 Marginal Physical Product of Factor ‘a’ = MPPaof Factor ‘a’ = MPPa

►The extra output produced as a The extra output produced as a result of using one more unit of result of using one more unit of factor ‘a’ as input (factor ‘a’ as input (ceteris paribus ceteris paribus ))

►How many moreHow many more pizzas are madepizzas are made per night by theper night by the addition of one addition of one more oven or onemore oven or one more chef?more chef?

Competitive MarketCompetitive Market►A market in which there are many buyers A market in which there are many buyers

and sellers of identical product. and sellers of identical product. ► ‘‘Many’ means “Many’ means “enough that no single buyer enough that no single buyer

or seller is sufficiently large to affect the or seller is sufficiently large to affect the market pricemarket price” – e.g. no firm is ‘too big to ” – e.g. no firm is ‘too big to fail’ fail’

►Every ‘player’ is a “Price Taker” rather than Every ‘player’ is a “Price Taker” rather than a “Price Maker”. a “Price Maker”.

►Question: What goods and services do you Question: What goods and services do you think are provided in truly competitive think are provided in truly competitive markets? Cell phone service, coffee, markets? Cell phone service, coffee, gasoline?gasoline?

The Law of The Law of Diminishing Marginal UtilityDiminishing Marginal Utility

►As one consumes successive units of a As one consumes successive units of a good, the additional satisfaction good, the additional satisfaction decreases, that is, total satisfaction decreases, that is, total satisfaction increases but at a decreasing rate. increases but at a decreasing rate.

► The marginal utilityThe marginal utility of one’s first slice ofof one’s first slice of pizza on an emptypizza on an empty stomach is great.stomach is great. The marginal utility ofThe marginal utility of the 5the 5thth slice is much less. slice is much less.

Proof by Proof by contrapositivecontrapositive

The Law of The Law of Diminishing Marginal Physical Diminishing Marginal Physical

ProductProduct((aka The Law of Diminishing Returnsaka The Law of Diminishing Returns))

► Law of diminishing returns – as more and more Law of diminishing returns – as more and more of a variable factor is added to a fixed factor, of a variable factor is added to a fixed factor, output will rise initially but will eventually fall. output will rise initially but will eventually fall.

Output (total product) Output (total product) initially rises at an initially rises at an increasing rate , but increasing rate , but marginal output then marginal output then starts to diminish. This starts to diminish. This means that total output means that total output still increases, but at a still increases, but at a decreasing rate (the slope decreasing rate (the slope of the curve tails off). Thereof the curve tails off). There may eventually be a point may eventually be a point where returns become where returns become negative and output falls.negative and output falls.

Economies of ScaleEconomies of Scale► The law of diminishing marginal product should The law of diminishing marginal product should

not be confused with economies or diseconomies not be confused with economies or diseconomies of scale. An economy of scale occurs when a 1% of scale. An economy of scale occurs when a 1% increase in all the factors of production together increase in all the factors of production together leads to more than a 1% increase in output. This leads to more than a 1% increase in output. This does not contradict the law of diminishing does not contradict the law of diminishing marginal 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. (of scale. (Carpenters and House Building exampleCarpenters and House Building example))

The Equimarginal Principle of The Equimarginal Principle of

MaximizationMaximization (aka the ‘When to Stop’ rule)(aka the ‘When to Stop’ rule)

►This is true for firms and households – we This is true for firms and households – we stop changing our allocations when stop changing our allocations when

marginal costs = marginal benefitsmarginal costs = marginal benefits►Q: When does a Q: When does a consumerconsumer stop reallocatng stop reallocatng

her income among different goods? her income among different goods? ►A: When she has found an allocation that A: When she has found an allocation that

maximizes her total satisfaction or total maximizes her total satisfaction or total ‘utility’.‘utility’.

►Examples: Shoes vs. Pizza, guns vs. butter, Examples: Shoes vs. Pizza, guns vs. butter, Wall Street vs. Main StreetWall Street vs. Main Street

The Equimarginal Principle of The Equimarginal Principle of

MaximizationMaximization (aka the ‘When to Stop’ rule)(aka the ‘When to Stop’ rule)

► True for Consumers (households)True for Consumers (households)► True for Producers (firms)True for Producers (firms)

► Pizza Parlor Example: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/mnthCook costs $1600/mnth Oven $1600/mnth

Additional Cook – 20 more pizzas per dayAdditional Cook – 20 more pizzas per day

Additonal Oven – 18 more pizzas per dayAdditonal Oven – 18 more pizzas per day

20 Pizzas/day boosts revenue by $1700 / 20 Pizzas/day boosts revenue by $1700 / monthmonth

Failed Assumptions of Failed Assumptions of equimarginal principle of equimarginal principle of

maximizationmaximization►Homo EconomicusHomo Economicus►Local vs. Global Optima in reallocation Local vs. Global Optima in reallocation

decisionsdecisions► ‘‘Lumpiness’ of unitsLumpiness’ of units►Ceteris ParibusCeteris Paribus

Marginal Physical Product for Marginal Physical Product for LaborLabor

►Pizzeria and Shoe Store StoryPizzeria and Shoe Store Story►1) The town is small – only labor 1) The town is small – only labor

available must be taken from pizzeria available must be taken from pizzeria and attracted by higher wages.and attracted by higher wages.

►Diminished MPPshoes and increased Diminished MPPshoes and increased MPPpizza results in labor transferMPPpizza results in labor transfer

►Step ‘2’ continues until equilibrium which Step ‘2’ continues until equilibrium which is when: is when: MPPshoes = MPPpizzasMPPshoes = MPPpizzas

►Comment: There is a ‘fairy tale’ element Comment: There is a ‘fairy tale’ element to ‘1’to ‘1’

The Basic Market EquationThe Basic Market Equation

►(x & y) are goods; ‘a’ is a factor of (x & y) are goods; ‘a’ is a factor of production (e.g. labor, capital, resources)production (e.g. labor, capital, resources)

►Px is Price of one unit of good ‘x’Px is Price of one unit of good ‘x’► ‘‘n’ is a given individual consumern’ is a given individual consumer

How do we know the equation How do we know the equation holds for ‘Ends’ or holds for ‘Ends’ or

CONSUMPTIONCONSUMPTION

More Pizza or more Beer?

More Studying time or More Playing Time?

How do we know the equation How do we know the equation holds for ‘Means’ or holds for ‘Means’ or

PRODUCTIONPRODUCTION

What does the Market Equation mean?What does the Market Equation mean?

The Parametric or ‘Fulcrum Function’ of relative The Parametric or ‘Fulcrum Function’ of relative pricesprices

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 SubstitutionTypes of Substitution►Psychological rate of substitutionPsychological rate of substitution

The rate at which consumers are willing to The rate at which consumers are willing to substitute one good for another.substitute one good for another.

►Market rate of substitutionMarket rate of substitution The rate at which consumers are The rate at which consumers are ableable to to

substitute one good for anothersubstitute one good for another

►Technical rate of substitution or Technical rate of substitution or transformationtransformation The rate at which producers are able to The rate at which producers are able to

produce one good rather than another by produce one good rather than another by reallocation of factors of production.reallocation of factors of production.

Key IdeasKey Ideas►The basic market equation defines an The basic market equation defines an

optimal allocation of resources, one in optimal allocation of resources, one in which no one would want to reallocate any which no one would want to reallocate any factor to any alternative use because doing factor to any alternative use because doing so would only decrease that person’s total so would only decrease that person’s total satisfaction. No firm would want to satisfaction. No firm would want to reallocate any factor to any other use reallocate any factor to any other use because doing so would lower profit.because doing so would lower profit.

►Prices in competitive markets lead to an Prices in competitive markets lead to an efficient allocation of resources in the efficient allocation of resources in the sense that no one can be made better off sense that no one can be made better off in his own judgment by reallocating in his own judgment by reallocating resources to produce a different mix of resources to produce a different mix of goods.goods.

Pareto OptimumPareto Optimum

►A A Pareto OptimumPareto Optimum occurs when no occurs when no other allocation could make at least other allocation could make at least one person better off without making one person better off without making anyone else worse off. This is also anyone else worse off. This is also known as a known as a Pareto Efficient AllocationPareto Efficient Allocation..

►Pareto OptimalityPareto Optimality accepts a given accepts a given distribution of wealth and income and distribution of wealth and income and does not care about the ‘scale’ of the does not care about the ‘scale’ of the economy.economy.

NCE recognized Market Failure: NCE recognized Market Failure: MonopolyMonopoly

► The fulcrum function of 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 = MRMC = MR

► In a competitive market marginal revenue is equal to In a competitive market marginal revenue is equal to price and price is given. Producers are price takers. price and price is given. Producers are price takers. Monopolists can control supply and be price makers. Monopolists can control supply and be price makers.

► Consequently Monopolists will Consequently Monopolists will underproduceunderproduce and and over over charge charge

to maximize profits.to maximize profits.

Assumptions and LimitationsAssumptions and Limitations

►1) Ignore distribution of wealth and income1) Ignore distribution of wealth and income►2) All goods are market goods 2) All goods are market goods

(rival & (rival & excludable)excludable)►3) Factors of production are substitutes for 3) Factors of production are substitutes for

each anothereach another►4) External costs and Benefits are negligible4) External costs and Benefits are negligible►5) All players have perfect information5) All players have perfect information►6) Markets are competitive6) Markets are competitive

Non-Price AdjustmentsNon-Price Adjustments►There are myriad pareto optima for every There are myriad pareto optima for every

distribution of income; every set of wants distribution of income; every set of wants and preferences; and every set of and preferences; and every set of technologies, and all the combos thereof.technologies, and all the combos thereof. Advertising and Social Movements are a non-Advertising and Social Movements are a non-

price adjustment that can change relative price adjustment that can change relative desirability.desirability.

Technological change can be a non-price Technological change can be a non-price adjustment that changes ratios of adjustment that changes ratios of MPPax/MPPayMPPax/MPPay

Price adj - Psychological adj – Techno adj Price adj - Psychological adj – Techno adj are all possible. are all possible.

Advertising and creation of Advertising and creation of demanddemand

► If wants are created and If wants are created and preferences altered through preferences altered through advertising, and if advertising advertising, and if advertising is a cost of production of the is a cost of production of the product, then production product, then production begins to look like a treadmill. begins to look like a treadmill. If we produce the need along If we produce the need along with the product to satisfy it, with the product to satisfy it, then we are not really making then we are not really making any forward motion toward the any forward motion toward the satisfaction of pre-existing satisfaction of pre-existing needs. The producer replaces needs. The producer replaces the consumer as sovereign. the consumer as sovereign. Then, the moral earnestness of Then, the moral earnestness of production, as well as the production, as well as the concept of Pareto Optimal concept of Pareto Optimal allocation of resources in the allocation of resources in the service of such production, service of such production, suffers a loss. suffers a loss.

Quote for DiscussionQuote for Discussion►““There is more to welfare than efficient There is more to welfare than efficient

allocation – for example, there are distribution allocation – for example, there are distribution and scaleand scale.”.”

► Do you agree or disagree? Do you agree or disagree?

► ““Welfare Welfare ” – what a word….” – what a word….

……promote the general welfare (U.S. constitution)promote the general welfare (U.S. constitution) ““Welfare queens” and entitlement programsWelfare queens” and entitlement programs Welfare as “Utility Maximization”Welfare as “Utility Maximization”

Supply and Demand (intro)Supply and Demand (intro)► 1) The Demand Curve 2) The Supply 1) The Demand Curve 2) The Supply

CurveCurve

► ““Watch Watch ► Your Your ► ‘ ‘P’s P’s ► AndAnd► ‘ ‘Q’s”Q’s”

The Demand CurveThe Demand Curve

Question: What does it mean to be on one’s Question: What does it mean to be on one’s demand curve?demand curve?

Question: What is the Marginal Utility of Money?Question: What is the Marginal Utility of Money?

Demand Curve for WaterDemand Curve for Water

The Supply CurveThe Supply Curve

Market ClearanceMarket Clearance

SummarySummary

►The Basic Market Equation defines and The Basic Market Equation defines and brings about a pareto optimal allocation of brings about a pareto optimal allocation of resources and establishes te decreasing resources and establishes te decreasing demand curve and incrreasiing supply demand curve and incrreasiing supply curve which produces market clearance at curve which produces market clearance at P*,Q*. This is true for any pair of goods P*,Q*. This is true for any pair of goods (x,y), and pair of factors (a,b), and any (x,y), and pair of factors (a,b), and any consumer (n1, n2, n3, …). This is a consumer (n1, n2, n3, …). This is a simplified picture of overall market simplified picture of overall market equilibrium.equilibrium.

Big Ideas to remember…Big Ideas to remember…► Basic Market Equation Basic Market Equation Competitive MarketCompetitive Market► Pareto Optimal allocation Pareto Optimal allocation Monopoly & Monopoly &

MisallocationMisallocation► Sliding Fulcrum Function of Relative PricesSliding Fulcrum Function of Relative Prices► Law of diminishing marginal physical productLaw of diminishing marginal physical product►Marginal Costs = Marginal Revenue “when to Marginal Costs = Marginal Revenue “when to

stop”stop”►Non-Price AdjustmentsNon-Price Adjustments Equimarginal PrincipleEquimarginal Principle► Supply and DemandSupply and Demand Principle of Principle of

SubstitutionSubstitution

Minnesota Welfare MoniesMinnesota Welfare Monies