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R. Larry Reynolds 

 Markets as Allocative Process

· Markets are a social process that allocates

scarce resources and goods among
alternative uses.
· A market exchange is a transfer of
property rights based on “quid pro quo”
[“I will give you this for that!”]
· Market exchange
· barter
· monetized
Fall ‘ 97 Principles of Microeconomics Slide -- 2
 Barter

· Barter is an market exchange that is a

trade of one good for another
· Barter can be costly
· double coincidence of wants
· transaction costs of information and
trade
· Exchange ratio is the relative amounts of
one good given in exchange for another

Fall ‘ 97 Principles of Microeconomics Slide -- 3

 Monetized Economy
· Because the transaction costs of barter can be
significant, societies often adopt the use of a
numeraire good, “money,” to reduce those costs.
· Money as a medium of exchange makes exchange
easier
· commodity money
· fiat money
· Exchange ratios expressed in monetary terms

Fall ‘ 97 Principles of Microeconomics Slide -- 4

Consider a closed economy with 50 people, each given one case
of cola and one case of beer. This distribution does not
guarantee that the welfare or utility of the group is maximized.
some people like cola but not beer, others like beer but not cola,
others might like neither or both.

How could these 50 individuals increase their utility?

Voluntary exchange!
Individuals who do not like beer could trade for cola, those who
like cola could trade for beer. What they lack is information
about the terms of trade and who will trade with them.

To acquire this information they offer to trade a few bottles

of what the don’t like for bottles of what they do like.

Fall ‘ 97 Principles of Microeconomics Slide -- 5

Through trading and observing others who trade, an
“exchange ratio” tends to emerge. On average two colas [2C]
seems to trade for one beer [1B]. 2C = 1B.

This exchange ratio reflects the initial distribution of cola

and beer, the preferences of the individuals and the abilities
to acquire information. A different distribution or a group
of individuals with different preferences would result in a
different exchange ratio. Notice that this example does not
explain the process of how to decide “HOW MUCH OF EACH
SHOULD BE PRODUCED.”

Rather than look for individuals who are willing to trade and
then haggling, a numeraire good [money] may be used. The
numeraire good is universally acceptable so individuals will
accept it in payment even though it is not the good they want.

Fall ‘ 97 Principles of Microeconomics Slide -- 6

.
 The exchange ratio that emerges from the trading determines
a set of relative prices.
Using the example 2C = 1B, a price of $1 for colas [Pc = 1]
implies a price of $2 for beer [Pb= 2] or,
[Pb= 1] would imply [Pc = .50] or,
[Pc = 2] implies [Pb = 4],
These relative prices represent the preferences of the
individuals, the initial distribution and abilities to acquire
information or bargain [haggle].

It is the relative prices of beer and cola that reflect

relevant information! Market exchange is a process
that provides information [relative prices] and
incentives that coordinates the choices of individuals.

.Fall ‘ 97 Principles of Microeconomics Slide -- 7

 These relative prices, when established through voluntary
exchange reflect the relative value of each good to the group.
Relative prices can be altered by changes in:
a. the preferences of individuals in the group,
b. the distribution of the initial endowment {relative
incomes of the group},
c. the relative amounts of the goods,
d. the information and bargaining abilities of the
individuals,
e. or, . . .

Each individual engaging in a voluntary exchange is

“better off” or “no worse off;” a move toward a
Pareto Efficient solution.
Utilitarianism is the Philosophy that rationalizes
free market economies!
.
Fall ‘ 97
.
Principles of Microeconomics Slide -- 8
 Utilitarianism
· Utilitarianism is the underlying philosophy of the market
system
· Jeremy Bentham [1748-1832]
· Philosophy of market system is based on each individual
attempting to optimize [maximize] their individual
welfare or utility
· Maximize the welfare or utility of the members of
society
· utility of individuals is “additive,” [if each person
maximizes their welfare it maximizes the welfare of
society]

Fall ‘ 97 Principles of Microeconomics Slide -- 9

 Jeremy Bentham [1748-1832]
Jeremy Bentham was trained in the
law but became interested in social
philosophy. His major contribution to
economics is the philosophy of
Utilitarianism. It became the basic
principle underlying the philosophy of
Western, industrial market economies.
In one of his major books, An
Introduction to the Principles of
Morals and Legislation [1789] he
attempts to show how the welfare of
society can be increased.

Fall ‘ 97 Principles of Microeconomics Slide -- 10

 Coordination of Individual
Actions
· Individuals, organizations and society may
have competing interests
· Markets are one way in which the
competing interests and subsequent actions
can be coordinated
· Market philosophy is based on individuals
having information and acting on that
information in “rational” ways

Fall ‘ 97 Principles of Microeconomics Slide -- 11

 Adam Smith
[1723 - 1790]

· Popularized the idea that markets could be a

dominant allocative mechanism in society
· “But man has almost constant occasion for the help of his brethren,
an it is vain for him to expect it from their benevolence only. He
will be more likely to prevail if he can interest their self-love in his
favor, and shew them that it is for their own advantage to do for
him what he requires of them. Whoever offers to another a
bargain of any kind proposes to do this. Give me that which I want
, and you shall have this which you want, is the meaning of every
such offer; . . . It is not from the benevolence of the butcher, the
brewer, or the baker, that we expect our dinner, but from their
regard to their self interest.” Wealth of Nations, 1776

Fall ‘ 97 Principles of Microeconomics Slide -- 12

 Need For Justice
· In the book The Theory of Moral
Sentiments, Smith argues:
· “Justice, on the contrary, is the main pillar
that upholds the whole edifice. If it is
removed, the great, the immense fabric of
human society, that fabric which, to raise and
support, seems, in this world, if I may say so,
to have been the peculiar and darling care of
nature, must in a moment crumble into atoms.”
The Theory of Moral Sentiments 1759

Fall ‘ 97 Principles of Microeconomics Slide -- 13

 Markets, Justice and
Jurisprudence
· Adam Smith’s system included three segments;
· A Theory of Moral Sentiments [1759]
· Argued that Justice was crucial for a society
· An Inquiry into the Nature and Causes of the Wealth of
Nations [1776]
· argued the importance of markets and self interest
· A third book, on jurisprudence [Lectures on
Jurisprudence], was burned about the time of his death
and showed the importance of law

Fall ‘ 97 Principles of Microeconomics Slide -- 14

Totals, Averages, Marginals and Optimization

· total, average and marginal values are used to describe

relationships in benefit, utility, revenue, product, cost,...
· There is a mathematical relationship between totals,
averages and marginals
· These relationships can be used to evaluate alternative
choices with respect to different alternatives
· These relationships will be demonstrated using revenue. The
principles are the same with benefits or utility.

Fall ‘ 97 Principles of Microeconomics Slide -- 15

 Totals
· Total Revenue is defined as Price times Quantity TR = PQ.
For 2 goods, X and Y, TR = PxQx +Py Qy. This can be
expanded to include as many goods as required. Note that
this is also the total expenditure.
· Total cost is defined as the total expenditure to produce a
given output. TC = PL L + PK K+. . . + PR R, where L = Labour,
· K = kapital, R = land [as many inputs as you want can be
included. Sometimes inputs are classified as “variable or
fixed.” The cost of the variable inputs is VC, the cost of the
fixed inputs is FC. In this case; TC = VC + FC

Fall ‘ 97 Principles of Microeconomics Slide -- 16

A relationship between the price of a good [P] and the quantity
purchased [Q] is estimated through observation and statistical
analysis.
Q = 10 - .5P This can also be expressed: P = 20 - 2Q
Since we usually identify the horizontal axis as Q [quantity],
the equation for the graph that we typically construct is;
P = 20 - 2Q
Total Revenue can be calculated:TR PQ,
\ TR = (20-2Q)Q, or TR = 20Q- 2Q2
AR = TR/Q, \ AR = 20 - 2Q [\ AR = P]

P MR =
DTR  TR
20 DQ or, MR 
TR
Q
\ MR = 20 - 4 Q
Demand, AR, TR and MR can also be
MR 10 Q shown using a table. . . . .

Fall ‘ 97 Principles of Microeconomics Slide -- 17

 Demand, TR, AR and MR Given: P=20-2Q

Price Quantity TR AR MR TR is calculated

$20 0 $0 TR = PQ
$18
DQ = 1
$18
DTR = 18 18 18 Average Revenue,
1 $18
[AR] is calculated,
$16 2 $32 $16 14
TR
$14 AR =
3 $42 $14 10 Q
$12 4 $48 AR and Price are the
$12 6 same thing! The AR
$10 5 $50 $10 and demand functions
2
are the same thing!
$8 6 $48 $8 -2
Marginal Revenue is defined as the change in TR caused by a change
in quantity, DTR The MR associated with the 1st unit of
MR =
DQ output is 18.This is actually between 0 & 1.

Fall ‘ 97 Principles of Microeconomics Slide -- 18

 The demand equation that is consistent with
Demand the table being used as an example can be
calculated.
Q P=AR
Based on the table from the previous slide
1 $18 The slope of the demand function is,

2 $16 DQ = -.5
DP Since the slope is -.5, for each
$14 $1 change in price, Q will
3
decrease by .5. At P= $0, the
4 $12 quantity would be 10. From $6
to $0, Q increases by .5
5 $10 for each $1, so when P = 0 then
Q = 10
6 $8
Q = 10
a --.5
m P or, P = 20 - 2Q
7 $6 Is the Demand function being used as an example.

Fall ‘ 97 Principles of Microeconomics Slide -- 19

 Demand, TR, AR and MR MR is the change
in TR [DTR]“caused”
Price Quantity TR AR MR by a change in Q [DQ].
In principles of econ
$20 0 $0 we will let DQ = 1. MR
$18 1 $18 $18 18 is then the change
in TR that results
$16 2 $32 $16 14 from a 1 unit change
in Q.
$14 3 $42 $14 10
$12 4 $48 $12 6 When the table has
$10 $50 DQ in one unit
5 $10 2 increments, TR can be
$8 6 $48 $8 -2 calculated by s
subtraction.
as Q increases from 0 to 1, TR increases by 18 [18-0]
as Q increases from 1 to 2, TR increases by 14 [32-18]

Fall ‘ 97 Principles of Microeconomics Slide -- 20

 .
P,$ Graph Demand / AR
MR = DTR
Demand Remember when MR is
DQ Graph MR 18
calculated by subtraction,

.
Q MR
P=AR 16 the value associated with a
level of output is actually
1 $18
$18 14 between that quantity

.
and the next lower
12 quantity.
2 $16
$14
10

.
3 $14
$10 8
4 $12
$6 6

5
6
$10
$2
$8
$-2
4
2 .
1 2 3 4 5 6 7 8
7 $6
$-6 Q/ut
MR

Fall ‘ 97 Principles of Microeconomics Slide -- 21

P, $ Given the MR, as output increases DTR
from 0 to 1, TR increases by 18 MR =
18 DQ
The red area represents the DTR from
16 each additional unit of Q, this is MR. Q MR
14 As the change in quantity becomes 1 $18
DTR from firs unit

smaller, the red columns “fill’

DTR from second unit

12 in the area under the MR function. 2 $14

10
8 The area under the MR is 3 $10
DTR from 3 unit

the sum of the DTR added

6 TR= 50 by each additional unit, \ 4 $6
DTR of 4rth

P = $10, Q = 5 TR = the sum of DTR’s

4 5
TR = PQ = 50 $2
2 When MR = 0 TR is a MAX
18 + 14 + 10 + 6+2
5th 6 $-2
The 6th
1 2 3 4 5 6 7 8 unit reduces
If Q is 4, TR is 2 less Q/ut TR by 2 7 $-4
MR
Fall ‘ 97 Principles of Microeconomics Slide -- 22
..
P, $ As price increases.
TR decreases. TR can also be related to AR or the demand
18 function.
16 ep|> 1; elastic At a price of $16, Q is 2: TR = PQ = 32
14 Remember that the ep = -1 at

.
TR=PQ
the point where TR is a Maximum.
12
ep = -1
10 at P = $12 As price decreases, TR decreases.
TR
Q = $10x5=$50
= 4;
16x2=
8 The maximum |ep| < 1; inelastic
TR = $48
32=TR
6 TR
AtisP at theQ=6
= $8,
“midpoint”
TR = $48 of
4 a linear demand.
At a price of $4, Q is 8:
2
TR = PQ = 32

1 2 3 4 5 6 7 8
Q/ut
Fall ‘ 97 Principles of Microeconomics Slide -- 23
P, $
AR and MR are related;
18 The MR function is 2x as steep as AR or,
16 its slope it twice the slope of AR. It will be
half as far away from the Y-axis at every
14 price [it bisects the space between the axis and
demand function.]
12
10 The maximum TR occurred where; MR= 0
3 3
8 TR = PQ The area under the MR is TR, by
6 TR = $10x5 =50 taking a piece of this area, it can
be shown that it is the equivalent of
4 the maximum TR as described by
PQ = TR [using AR function].
2
MR=0 [both are right angles,
1 2 3 4 5 6 7 8 sides are equal,
Q/ut angles are equal]
MR
Fall ‘ 97 angle, side,Principles
angle of = angle, side, angle
Microeconomics Slide -- 24
.
 50 = TR

TR is related to both
AR and MR.
Where MR = O, TR is a maximum.
For out example, this occurs
at Q = 5, P=$10.
TR is a maximum where,
ep = -1
P, $
Soooo, if there are no
max
costs, you would want to
produce 5 units which you
TR ep = -1
$10
could sell at $10 for a total TR = PQ AR TR
of $50. Sum
TRof
= 50
DTR’s
5 Q/ut
Fall ‘ 97 Principles of Microeconomics
MR Slide -- 25
Consider the choices of picking blackberries. Instead of TR
you want to maximize Total utility [TU] or Total Benefit [TB]
As more and more blackberries are picked, the marginal benefit
[MB] of each additional unit of blackberries decreases.
A rational person would pick the easiest blackberries first,
therefore as they pick additional units of fruit the marginal
cost rises.

Marginal Decision Rule:

When the objective is to maximize net benefits from an action,

MB > MC Do it! [or MR > MC]

Net benefits are maximized where MB = MC
MB < MC Don’t do it! [or MR < MC]

Fall ‘ 97 Principles of Microeconomics Slide -- 26

Picking Blackberries [BB] MC,d
MB A MC
As more BB are picked, the
MC =MB To maximize the
effort required to pick an
additional unit rises. Hence, net benefits, pick
the MC has a positive slope. BB until MC = MB
C
As the amount of BB available f MB
for consumption in a period
0
of time increases, each 1 BB/ut
additional unit adds a smaller amount of utility; the MB function declines.
The marginal decision rule indicates you should pick the first unit of BB
The MB of the first unit exceeds the MC of the first unit, MB > MC
The benefit associated with the first unit of BB is the blue area 01Ad.
This is the MB associated with the first unit of BB.
The cost associated with the first unit of BB is the yellow area 01Cf.
This is the MC associated with the first unit of BB
The net benefits that result from the first unit of BB is the red area fCAd.

Fall ‘ 97 Principles of Microeconomics Slide -- 27

.
 If one unit less is
picked, [X-1], the MC=MB
net benefit declines. t e w To maximize the
net benefits, pick
BB until MC = MB
Net benefits are reduced r s
by area ret.

0 [X-1] X [X+1]
If one more unit is picked [X+1], BB/ut
net benefits are reduced by area esw

Net benefits are maximized where MC = MB,

profits will be maximized where MR = MC.

.
Fall ‘ 97 Principles of Microeconomics Slide -- 28
TB the slope of TC
TC TR = slope Total benefits [TB] tend to
TB1 of TC TB increase at a decreasing rate,
and may decline.
MAX
Total costs [TC] tend to
TC1 increase at an increasing rate.
NET BENEFITS TB-TC are maximized
where the vertical distance
Q/ut between TB and TC is greatest.
X
or, max net benefits is where MB = MC
MB
MC MC MB [the slope of TB] decreases,
and MB becomes negative.
max MC [the slope of TC] increases.
net
The slope of TR = MR,
benefits
the slope of TC = MC.
MB
Q/ut
X
Fall ‘ 97 Principles of Microeconomics Slide -- 29
.
 Highest Valued Use
· An important function of markets is to
insure that resources are used in their
highest valued use.
· markets can be viewed as an “information
system” that uses relative prices as a
signaling mechanism
· individuals react to relative prices in an
attempt to optimize the achievement of
their objectives
Fall ‘ 97 Principles of Microeconomics Slide -- 30
MB
MC Net benefits are maximized where MB = MC.
MC
As long as the MB > MC, produce the
Max additional unit.
P net
benefits If MC > MB, reduce production a unit.
At X units of output: the last unit
MB produced has a MB = MC.

At a market price of P, buyers will

X
X Q/ut continue to purchase the good so long
as they receive a MB > P.
Buyers who expect to receive a MB less than the price P would
not purchase the good. In this way the market allocates the
good to those who place the greatest “value” on the good.
Sellers who can produce the good for a MC less than a price of P will be
willing to offer the good for sale.

Fall ‘ 97 Principles of Microeconomics Slide -- 31

Buyers and sellers making independent choices will behave in such a way that
resources and goods are allocated to the “highest valued” use.
Buyers will buy so long as their MB > P, Sellers will produce and offer for
sale so long as the MC is less than P.

The value of the last unit produced and sold [bought] will be equal to the
price, P.
Where MB = P = MC, the results are MB
“optimal,” i.e. those who can produce MC MC
the good at a MC less than [or equal] P,
will have an incentive to supply the
good. P
Buyers who have a MB > P will
be able to purchase the units they want.
MB

X
.Fall ‘ 97
. Principles of Microeconomics Slide -- 32
 A
MB Using MB and MC, the distribution of
MC MC benefits between buyers and sellers
can be demonstrated.
Consumer
E
surplus At a market price of P, buyers can buy
P the X units they want. All the units up
producer
surplus to X units of the good have a MB in
excessive the price. P. This area is
MB
called “consumer surplus” [or consumer’s
R
surplus] and is shown in the area PEA.
X
The sellers can produce the first X units at a MC less than the
price, P. Since they can sell at the price P, the earn a surplus on
those units; “producer surplus” is shown as area REP.

. Fall ‘ 97 Principles of Microeconomics Slide -- 33

 MB = P = MC
Under ideal circumstances the market will produce the
ideal result: The market price [P] will represent the value
of the last unit that any buyer is willing to purchase. This
same price [P] also represents the cost of producing that
last unit!

The “ideal” is the benchmark that we use to gauge the

performance of the processes that actually occur.

When MB  P  MC, there is a problem. It is the job of the

economic analysis to determine why the market forces have
not established a price that reflects the conditions of buyers
and sellers.

. Fall ‘ 97 Principles of Microeconomics Slide -- 34

 Price Distortions
· “Noncompetitive markets” i.e buyers or sellers
have the power to influence the market price
· monopoly, monopsony, oligopoly, oligopsony,
imperfect competitive markets,. . . {structure}
· collusion, price discrimination,. . . {process or
behavior}
· Property rights problems
· externalities
· collective or public goods
· common property resources
Fall ‘ 97 Principles of Microeconomics Slide -- 35
 Noncompetitive Markets
· Monopoly -- a single seller of a good with no close
substitutes.
· Monopsony -- a single buyer of a good.
· oligopoly -- a “few” sellers who recognize their
interdependence.
· oligopsony -- a “few” buyers who recognize their
interdependence.
· imperfect competition, monopolistic competition
· pure competition -- the “ideal” market structure
that results in P = MR = MC = AR = ATC
Fall ‘ 97 Principles of Microeconomics Slide -- 36
 Competition
· Pure competition as the ideal -- a structural
concept of competition.
· large number of buyers and sellers no one of
which can influence the market
· homogeneous product
· relatively free entry and exit
· Competition as rivalry -- a process concept of
competition.

Fall ‘ 97 Principles of Microeconomics Slide -- 37

 Property Rights
· For markets to produce optimal results,
nonattenuated property rights are required
· exclusive
· transferable
· enforceable
· “weakened” or “attenuated” property rights
result in”
· externalities
· collective or public goods
· common property resources

Fall ‘ 97 Principles of Microeconomics Slide -- 38

Externalities --
A market transaction imposes a cost [negative externality] or confers a
benefit [positive externality] on another person(s) who is (are) not involved
with the market transaction.

When all costs and benefits are recognized by

MC + external
the parties in the transaction, MB = P = MC.
costs
A negative externality imposes MB
a cost on a person(s) who is not MC MC
included as a party to the exchange. P’
these costs must be added to the MC
that was recognized as part of the P
exchange.
P is the market price but, the
higher price, P’, correctly reflects MB
MB & MC.

X X0
The parties to the exchange will agree to X amount as optimal,
if the externality had been included, only X0 would be optimal.

Fall ‘ 97 Principles of Microeconomics Slide -- 39

Externalities --
A positive externality confers a benefit on a person(s) who is not
included as a party to the exchange. These benefits must be
added to the MB that was recognized as part of the exchange.
If the external benefits are included,
the optimal output is X1, and the MB
price that represents the benefits MC MC
and costs to society is P1.
P1 MB +
P is the market price but, the P external
higher price, P1, correctly benefits
reflects MB & MC.
MB

The parties to the exchange will

agree to X amount as optimal, if X X1
the positive externality had been included, X1 would be optimal.

Fall ‘ 97 Principles of Microeconomics Slide -- 40

Public or Collective Goods
When it is impossible to exclude individuals from using a good
and their use of that good imposes no opportunity cost, or
MC on society, that good is called a collective or public good.

National defense is the most often used example of a collective

good. After a given level of national defense is provided, a new
member of society cannot be excluded from that protection and
the additional person protected does not increase the MC of
national defense.

Since the individual cannot be excluded, the have no incentive to pay for the
good even though they benefit from it; they become “free riders.” To pay
for the collective good government may tax the individuals and provide the
good. In which case individuals may become “forced riders.” A quasi-public
good is like a road or park, we could exclude an individual from using the
good, but it may not be desirable to do so. Because of the problems
associated with collective goods and quasi-public goods, markets do not
result in optimal allocations.

Fall ‘ 97 Principles of Microeconomics Slide -- 41

Common Property Resources

These are resources that are held “in common,” or are “fugitive”
resources; whoever captures the resources acquires the right to
use it.

Unlike collective or public goods, common property resources are

subject to a marginal cost for their use. If I get it, you don’t.

In the case of exhaustable or depletable resources, individuals

tend to capture as much as they can as quickly as they can.
Resources such as buffalo. whales, carrier pigeons, oceans,
air, [biosphere], common lands, etc. tend to be “overused” and
may be driven to extinction or depletion.

..
Fall ‘ 97 Principles of Microeconomics Slide -- 42
 Summary
· Markets are a social institution that will
coordinate individuals’ behavior
· Problems develop when
· lack of competition
· property rights are not;
· exclusive
· enforceable
· transferable

Fall ‘ 97 Principles of Microeconomics Slide -- 43