Hoorcollege 1
What is a good market outcome
A good market outcome maximises ≈ utility of a group of individuals / society
This may be achieved by way of the market, voluntary exchange build upon property rights
→ leaving people alone to make deals and to do what is to their own taste
But sometimes the market does not maximise welfare namely when markets lead to
inefficient or unfair outcomes
What is an efficient market outcome?
‘Efficiency’ has a very particular meaning with economics
A market outcome is efficient if:
- All opportunities for trading are exploited (and changes in the allocation of
resources/mix of products
- Goods end up in the hands of those who value them the most
- It is not possible to make one individual better of without making any other individual
worse off
Illustrate in a stylized way: using a 2 persons-2 goods economy
Illustrate the 1st welfare theorem: free/voluntary exchange among people makes everybody
best off, leads to an “efficient outcome” that cannot be improved upon
Theorem: local propositions in which the conclusions follows from the assumptions
We will do so by using Edgeworth Economy
Imagine
- A world with only water and bread
- Fixed amount of each good, shared between Adam, Eve
- They need both of them (imperfect substitutes)
- There will be some trading between Adam and Eve
,Recall: indifference curves
● Indifference curve: to get one more bread, how much water do i want to give up to
remain equally happy
● In case of imperfect substitutes: when you have very little bread, to give up some
more bread the other person has to pay many litres of water
● I.e. price of water and bread depends on where you are on indifference curve
● Trading → prices of water and bread change
A trade constitutes a pareto improvement if at least one
individual is made better off without any other individual
being made worse off
,Pareto efficiency in consumption
With imperfect substitutes, the trading stops when the
slopes of the indifference curves of adam and eve are
tangent
MRSadam = MRSeve i.e. how much you are willing to
give up bread in turn of water by trading
You trade up to the point where your valuation of bread
(in terms of water) is exactly equal to the other person’s
valuation of bread → exchange efficiency
Adding production decisions
● so far: fixed production of water and bread
● Now: producers can vary how much water and bread to produce
● MRTbw = marginal rate of transformation of bread for
water
● MRTbw = MCb / MCw
MRTbw = MRSbwadam = MRSevebw
MCb/MCw = MRSbw
Product mix efficiency
, When is a market efficient?
No unexploited opportunities; opportunities to make things better for all parties involved
When is a market efficient?
Three dimensions of efficiency:
● Exchange efficiency: all trades that lead to higher utility of the parties involved are
exploited
● Production efficiency: all changes in allocation of production factors that lead to a
higher level of production are exploited
● Product mix efficiency: all changes in the mix of products that are produced that lead
to higher utility are exploited
Note:
In the colloquial sense, ‘efficiency’ mainly refers to production efficiency (getting the
maximum output per unit of input)
Question: can an ‘efficient production process’ in the colloquial sense be inefficient in the
sense that we use the term here?
Could it be that we have a production process that is efficient in the colloquial sense but not
in terms of welfare? (agricultural)
Market-based shoe production
● Leave it up to entrepreneurs to enter/leave business; if they see a profit opportunity,
they will jump on it
● Continuous drive to exploit opportunities for trading and for reallocation of resources
● More profit can be made by replacing
○ Expensive labour for cheap labour, and
○ By replacing labour by machines = reallocation of resources
Disposable shoes:
- Less sustainable
- Cheaper
- Worn for a shorter period of time
Cheap shoes cannot be resoled, because sole is cemented rather than stitched to rest of
shoe
Waste incinerator: generates air pollution, which makes us sick and leads to premature
death
Is the rise of the ‘disposable shoe’ - and greater production and incineration of waste - an
inefficiency?
I.e. Are all opportunities for trading/changes in production exploited?
Or can you think of opportunities for trading/changes in production (towards more durable
shoes) that makes everybody better off?
Some people may be willing to pay for less air pollution, i.e. pay you for buying more durable
shoes
What is a good market outcome
A good market outcome maximises ≈ utility of a group of individuals / society
This may be achieved by way of the market, voluntary exchange build upon property rights
→ leaving people alone to make deals and to do what is to their own taste
But sometimes the market does not maximise welfare namely when markets lead to
inefficient or unfair outcomes
What is an efficient market outcome?
‘Efficiency’ has a very particular meaning with economics
A market outcome is efficient if:
- All opportunities for trading are exploited (and changes in the allocation of
resources/mix of products
- Goods end up in the hands of those who value them the most
- It is not possible to make one individual better of without making any other individual
worse off
Illustrate in a stylized way: using a 2 persons-2 goods economy
Illustrate the 1st welfare theorem: free/voluntary exchange among people makes everybody
best off, leads to an “efficient outcome” that cannot be improved upon
Theorem: local propositions in which the conclusions follows from the assumptions
We will do so by using Edgeworth Economy
Imagine
- A world with only water and bread
- Fixed amount of each good, shared between Adam, Eve
- They need both of them (imperfect substitutes)
- There will be some trading between Adam and Eve
,Recall: indifference curves
● Indifference curve: to get one more bread, how much water do i want to give up to
remain equally happy
● In case of imperfect substitutes: when you have very little bread, to give up some
more bread the other person has to pay many litres of water
● I.e. price of water and bread depends on where you are on indifference curve
● Trading → prices of water and bread change
A trade constitutes a pareto improvement if at least one
individual is made better off without any other individual
being made worse off
,Pareto efficiency in consumption
With imperfect substitutes, the trading stops when the
slopes of the indifference curves of adam and eve are
tangent
MRSadam = MRSeve i.e. how much you are willing to
give up bread in turn of water by trading
You trade up to the point where your valuation of bread
(in terms of water) is exactly equal to the other person’s
valuation of bread → exchange efficiency
Adding production decisions
● so far: fixed production of water and bread
● Now: producers can vary how much water and bread to produce
● MRTbw = marginal rate of transformation of bread for
water
● MRTbw = MCb / MCw
MRTbw = MRSbwadam = MRSevebw
MCb/MCw = MRSbw
Product mix efficiency
, When is a market efficient?
No unexploited opportunities; opportunities to make things better for all parties involved
When is a market efficient?
Three dimensions of efficiency:
● Exchange efficiency: all trades that lead to higher utility of the parties involved are
exploited
● Production efficiency: all changes in allocation of production factors that lead to a
higher level of production are exploited
● Product mix efficiency: all changes in the mix of products that are produced that lead
to higher utility are exploited
Note:
In the colloquial sense, ‘efficiency’ mainly refers to production efficiency (getting the
maximum output per unit of input)
Question: can an ‘efficient production process’ in the colloquial sense be inefficient in the
sense that we use the term here?
Could it be that we have a production process that is efficient in the colloquial sense but not
in terms of welfare? (agricultural)
Market-based shoe production
● Leave it up to entrepreneurs to enter/leave business; if they see a profit opportunity,
they will jump on it
● Continuous drive to exploit opportunities for trading and for reallocation of resources
● More profit can be made by replacing
○ Expensive labour for cheap labour, and
○ By replacing labour by machines = reallocation of resources
Disposable shoes:
- Less sustainable
- Cheaper
- Worn for a shorter period of time
Cheap shoes cannot be resoled, because sole is cemented rather than stitched to rest of
shoe
Waste incinerator: generates air pollution, which makes us sick and leads to premature
death
Is the rise of the ‘disposable shoe’ - and greater production and incineration of waste - an
inefficiency?
I.e. Are all opportunities for trading/changes in production exploited?
Or can you think of opportunities for trading/changes in production (towards more durable
shoes) that makes everybody better off?
Some people may be willing to pay for less air pollution, i.e. pay you for buying more durable
shoes
