• This course is about economic modeling and formal theory

• Applications in electives (this semester):

  • Industrial Organization
  • Labor Economics
  • Public Economics

• Models help us understand reality, but they are not reality!

  • Don't mistake the map for the territory itself

"All models are wrong. Some are useful" - George Box

• Our models so far have given us interesting results,

  • Markets reach equilibrium
  • Economic profits are zero in the long run in competitive markets

• Both are fictional

• But the models still show us useful insights about how a market economy works

• Some readings in today's readings page to help you understand

• Law of One Price: all units of the same good will tend to have the same market price (the market-clearing price, p∗)

• Consider if there are multiple different prices for same good:

• Arbitrage opportunities: optimizing individuals recognize profit opportunity:

  • Buy at low price, resell at high price!
  • There are possible gains from trade or gains from innovation to be had

• Entrepreneurship: recognizing profit opportunities and entering a market as a seller to try to capture gains from trade/innovation

• Nobody knows "the right price" for things

• Each Buyer and Seller only knows their own reservation prices

• Buyers and sellers adjust their bids/asks

• Markets do not start competitive, but monopolistic!

• New entrepreneurs enter to try to capture gains from trade/innovation

• As these gains are exhausted, prices converge to equilibrium

• Errors and imperfect information ⟹ multiple prices

  • ⟹ arbitrage opportunities ⟹ entrepreneurship
  • ⟹ correcting mistakes ⟹ people update their behavior & expectations

• Markets are discovery processes that discover the right prices, the optimal uses of resources, and cheapest production methods, none of which can be known in advance!

• Consider the economy as a cat-and-mouse game between two sets of variables:

  • "Underlying variables": preferences, technology, and resource availability
  • "Induced variables": market prices, least-cost technologies

• Induced variables always chasing underlying variables

  • Underlying variables always changing
  • Any time underlying and induced variables are different, profit opportunities

• IF underlying variables froze, market would rest at equilibrium

• Why do we trade?

• Resources are in the wrong place!

• People have better uses of resources than they are currently being used!

• Why are resources in the wrong place?

• We have the same stuff but different preferences

• Why are resources in the wrong place?

• We have the same stuff and/but different preferences

• But Transaction costs!
  • Search costs: cost of finding trading partners
  • Bargaining costs: cost of reaching an agreement
  • Enforcement costs: trust between parties, cost of upholding agreement, dealing with unforeseen contingencies, punishing defection, using police and courts

• With high transaction costs, resources cannot be traded

• Resources cannot be switched to higher-valued uses

• If others value goods higher than their current owners, resources are inefficiently allocated!

• Markets are institutions that facilitate voluntary impersonal exchange and reduce transaction costs

• There's a lot of institutions in the "bundle" we call "markets":

  • Prices, profits and losses, property rights, rule of law, contract enforcement, dispute resolution, protection, trust

• All of these things are assumed when we draw nice supply & demand graphs on the blackboard

  • Much of this course: how do various political institutions enable these market institutions?

• Problem 1: Resources have multiple uses and are rivalrous

• Problem 2: Different people have different subjective valuations for uses of resources

• It is inefficient (immoral?) to use a resource in a way that prevents someone else who values it more from using it!

• Problem 1: Resources have multiple uses that are rivalrous

• Problem 2: Different people have different subjective valuations for uses of resources

• It is inefficient (immoral?) to use a resource in a way that prevents someone else who values it more from using it!

• Solution: Prices in a functioning market accurately measure opportunity cost of using resources in a particular way

  • The price of a resource is the amount someone else is willing to pay to acquire it from its current use/owner

• Voluntary exchange is a Pareto improvement: change in allocation that makes at least one person better off and making nobody worse off

• An allocation of resources is Pareto efficient when there are no possible Pareto improvements

• Allocative efficiency: resources are allocated to highest-valued uses

  • Goods produced up to the point where MB=MC (p=MC)

• Pareto efficient: no possible Pareto improvements exist

• All potential gains from trade are fully exhausted

• Economic surplus = Consumer surplus + Producer surplus

• Maximized in competitive equilibrium

• Resources flow away from those who value them the lowest to those that value them the highest

• The social value of resources is maximized by allocating them to their highest valued uses!

• Markets are social processes that generate information via prices

• Efficiency of prices: use distributed knowledge and incentivize local actors to exploit opportunities, which reduce error and bring about greater social coordination

• Prices are never "given", prices emerge dynamically from negotiation and market decisions of entrepreneurs and consumers

• Competition: is a discovery process which discovers what consumer preferences are and what technologies are lowest cost, and how to allocate resources accordingly

• A relatively high price

• Information conveyed: good is relatively scarce

• Incentivizes:

  • Buyers: conserve use of this good, seek substitites
  • Sellers: produce more of this good
  • Entrepreneurs: find substitutes and innovations to satisfy this unmet need

• A relatively low price

• Information conveyed: good is relatively abundant

• Incentivizes:

  • Buyers: substitute away from expensive goods towards this good
  • Sellers: Produce less of this good, talents better served elsewhere
  • Entrepreneurs: talents better served elsewhere: find more severe unmet needs

• Economic theory: in a perfectly competitive market, in the long run, profit falls to zero

• Real world: there are often economic profits

• Our blackboard models assume perfect information

• In reality we have to deal with uncertainty

• People don't know what the right price is - mispricing and multiple prices → arbitrage/profit opportunities

  • Some people recognize opportunities ($20 bills) that others do not see

• In a world of no uncertainty, there would be no profit

• In markets, production must face the profit test:

  • Is consumer's willingness to pay > opportunity cost of inputs?

• Profits are an indication that value is being created for society

• Losses are an indication that value is being destroyed for society

• Survival for sellers in markets requires firms continually create value and earn profits or die

• People often confuse the economic problem with a technological problem

• Technological problem: how to allocate scarce resources to accomplish a particular goal

  • e.g. buy the right combination of goods to maximize utility
  • e.g. buy the right combination of inputs and produce output to maximize profits
  • given stable prices, preferences, and technologies, a computer can solve this problem

• Economic calculation problem: how to determine which of the infinite technologically-feasible options are economically viable?

• How to best make use of dispersed knowledge to coordinate conflicting plans of individuals for their own ends?

• ONLY through prices, profits, and losses

• In perfect competition (model):

  • price-taking firms set price equal to marginal cost
  • long run economic profits are zero
  • allocative efficiency: consumer and producer surplus maximized

• This is a tendency only because of free entry and exit

• In perfect competition (model):

  • price-taking firms set price equal to marginal cost
  • long run economic profits are zero
  • allocative efficiency: consumer and producer surplus maximized

• This is a tendency only because of free entry and exit

• Don't judge real world markets by their similarity to perfect competition, judge them on their level of competition (ease of entry)!