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Unformatted text preview: 1 Government in a market economy 1.1 Introduction This course is about government in a market economy. So we have two big protagonists, gov- ernment and private markets, and some general themes about how they relate to each other. 1.2 Efficiency of competitive markets Most economists (not all) think the market economy works pretty well in allocating. What should government do? Act when market failures are identified. We will formalize these ideas. Basic idea is Smiths: competition leads everybody, acting to maximize their own self-interest, to create outcomes in the public interest this is the invisible hand . This is a contentious idea even today. Makes sense in a limited context. Intuition: consumers maximize own well-being and firms maximize profit. Hence: 1. If some commodity is not being produced and consumers willing to pay its cost, profit- maximizing firms will provide it. 2. If firms are not producing efficiently (at minimum cost) then competition will drive them out. The key is that government intervention is not required to obtain these outcomes. Notice this was a controversial view in Smiths day, and even is today. We formalize the idea and then focus on cases in which it is not valid . (If Smith were right, this would be a very short course.) An exchange economy. We will prove a formal, modern statement of Smiths idea, known as the First Theorem of Welfare Economics. (We do so for an exchange economy: one in which supplies of goods are fixed, not produced by firms, but they may be traded among agents in competitive markets.) There are n consumers with utility functions u i ( x i ) , i = 1, . . . , n , where x i = ( x i 1 , . . . , x ik ) is a vector describing i s consumption of each of k commodities. Consumer i s endowment (supply) of all commodities is a vector w i . An allocation is x = ( x 1 , . . . , x n ) : a complete description of what is consumed by everybody. We say an allocation x = ( x 1 , . . . , x n ) is feasible if i x i = i w i : that is, demand equals sup- ply for all commodities. Recall we can illustrate allocations in this economy (for n = 2 ) in an Edgeworth box . A competitive equilibrium is then defined as an allocation ( x * 1 , . . . , x * n ) and a vector of prices p such that: 1. supply equals demand: i x * i = i x * i , and 2. consumers maximize utility: for any other vector x i , if u i ( x i ) > u i ( x * i ) then j p j x ij > j p j w ij (if the consumer prefers a different bundle, then it must be unaffordable at the equilibrium prices)....
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This note was uploaded on 12/20/2009 for the course ECO ECO336 taught by Professor Smart during the Spring '09 term at University of Toronto- Toronto.
- Spring '09