The Basic Market
Equation
Price Theory
Cold Call Questions
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What is the law of diminishing marginal utility:
what happens if you assume the opposite?
What is the law of diminishing marginal product:
what happens if you assume the opposite?
What is the link between SS #s and auctions?
What is Pareto optimal allocation
Why do monopolies misallocate resources?
Can demand curves slope up?
Can supply curves slope down?
What are Non-price adjustments for demand? For
supply?
Announcements
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Spoon-feeding
Reflections
Project due dates
Next class
Shift from Whole to Part
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Whole is driven by photosynthesis and
thermodynamics
Part is driven by prices and GDP
What do markets do?
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Do markets tell us the value of things?
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What is value?
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Why are diamonds worth more than water?
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Use value
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Exchange value
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Why is food worth more to a rich overnourished
person than to a poor, undernourished one.
Do markets tell us how scarce things are?
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Why did oil prices remain flat for 100 years?
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Why did we harvest North Atlantic Cod almost to
extinction with only small price increases?
What do markets do?
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Markets equilibrate supply and demand
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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
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Marginal utility MUxn, MUyn, MUxm, MUym
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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
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Factors are the inputs to production. Factor
prices = Pa , Pb, Pc
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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, )
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Assumes other factors are held constant
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The laws of physics: can you produce more pizza
just by hiring more cooks?
Perfect Market
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All firms and consumers are price takers
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How do prices change?
Plans are adjusted to prices
Basic Concepts
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Law of diminishing marginal utility
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Assume the opposite, increasing marginal
utility
Law of diminishing marginal physical
product
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Assume the opposite, increasing marginal
physical product.
What about economies of scale?
Basic Concepts
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Equimarginal principle of maximization
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Consumer's equimarginal principle of utility
maximization
MUxn/Px = MUyn/Py
 Rearrange to get MUxn /MUyn = Px /Py
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Basic Concepts
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Equimarginal principle of maximization
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Producer's equimarginal principle of profit
maximization
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MPPax/Pa=MPPbx/Pb
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How does this relate to the price of X and Y?
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What theoretically happens when we raise Pa to $9.00/hr?
Pa=Px(MPPax) = Py(MPPay) or Px=Pa/MPPax= Py=Pa/MPPay
Rearrange to get MPPay/MPPax=Px/Py
Which industries get the resources?
Which industry can afford to pay the most for
scientists, laboratories and raw materials, life saving
medicines for the poor or cosmetics for the rich?
 Allocative function of price
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The Basic Market Equation
(cont.)
MUxn/MUyn = Px/Py = MPPay/MPPax
What’s so special about the
Basic Market Equation?
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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
What’s so special about the
Basic Market Equation?
 Equation
m, n, o
holds for all consumers
 All
products x, y, z
 All
factors of production a, b, c
 Decentralized
information
What’s so special about the
Basic Market Equation?
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Markets balance what is possible with
what is desirable
Resources flow to those who value them
most
Leads to ‘optimal’ allocation of resources
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Consumers maximize utility
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Producers maximize profits
Reality Check
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So does society produce the right balance of life
saving diseases and cosmetics?
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Who values eflornithine most, dying Africans or hairy
women?
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Rationing function of price
Pareto optimality: Everyone is as well off as can
be without making someone else worse off.
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How do we choose between Pareto Optimal
outcomes?
Many other reality checks to come!
Other assumptions not mentioned?
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Do things that are not bought and sold
compete for resources with things that
are?
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E.g. ecosystem structure and ecosystem
services
Can everyone participate in the market?
Monopoly
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Headlines: Mega-Mergers See Comeback
as Uncertainty of Crisis Fades
Monopolists are price makers
Marginal revenue for monopolist is less
than price
Monopolists maximize profits by producing
less than is socially ‘optimal’.
Are monopolies relevant to the eflornithine
example?
Non-Price Adjustments
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How can we alter the desirability
conditions (MU ratios?)
How can we alter the possibility conditions
(MPP ratios)
What would happen if we redistributed
wealth?
Demand Curve
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MUxn/Px=MUyn/Py
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Let y = money, and let Py = 1.
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Then MUxn/Px=MUmn, and
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Px = MUxn/MUmn.
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We keep trading money for good X until we
maximize utility.
Demand curve (cont.)
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Px = MUxn/MUmn
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How do we adjust if Px drops?
What part of this
demand curve
corresponds to
Africans’ demand for
eflornithine?
Reality Check
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Does Px really equal Muxn?
Social security numbers and auctions
Supply curve
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Px=MCx
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This is the condition for being on the supply curve
Remember that we are assuming increasing
marginal costs.
Px=MCx=Pa/MPPax=Pb/MPPbx=...
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Remember units. Px=$/X, Pa/MPPax=$/X
Look at Px=Pa/MPPax. Say Px increases. Pa stays
the same, so MPPax must decrease. More a must
be used, so Q increases.
Demand and Supply (cont.)
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Supply curve
Demand and Supply (cont.)
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Supply and demand together
MUxn/MUmn=Px=Pa/MPPax
MUyn/MUmn=Py=Pa/MPPyx
To think about
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Can we make more pizza by simply using more
ovens or more cooks?
Markets make decisions based on the principle
of one dollar, one vote. Is this appropriate for all
resources?
Do you think markets allocate scientists towards
their best possible use?
What about information?
Many ecological economists are trying to price
non-market goods and services (e.g. ecosystem
services). If we could do this, would it lead to
their optimal allocation?