The Basic Market Equation Price Theory. What do markets do? Do markets tell us the value of things? What is value? Why are diamonds worth more than water?

The Basic Market The Basic Market EquationEquation

Price TheoryPrice Theory

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

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?

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)

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 marginal Assume the opposite, increasing marginal utilityutility

Law of diminishing marginal physical Law of diminishing marginal physical productproduct Assume the opposite, increasing marginal Assume the opposite, increasing marginal

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

Basic ConceptsBasic Concepts Equimarginal principle of maximizationEquimarginal principle of maximization

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

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 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

What’s so special about the What’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) by reallocating factors of production

What’s so special about the What’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

What’s so special about the What’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 ‘optimal’ allocation of Leads to ‘optimal’ 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?

Can everyone participate in the Can everyone participate in the market?market?

MonopolyMonopoly

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

less than priceless than price Monopolists maximize profits by Monopolists maximize profits by

producing less than is socially producing less than is socially ‘optimal’. ‘optimal’.

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 We keep trading money for good X until we maximize utility.X 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?

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?