Imperfect Markets and WelfareECO 36229/8/13Dr. WatsonAUN

People are Rational Making “right” choices: Maximize utility People think at the margin – marginal cost Preference

Have GOALS. Make choices in order to fulfill those goals

Preferences complete Preferences transitive

Bananas>apples>papaya>banana

What are your goals? Graduate Get a job

Work for customs Governor of CBN

Graduate school – higher degrees N N N N N N N 4.0 this semester Go out there somewhere. Do research Write a fantasy book; religion book See my children married and happy Stay awake during this class

Self-Interested Trying to please yourself Trying to make yourself better off Doing this to make you happy Needs come before everyone else

NOT SELF-CENTERED I am happy when my kids are happy In ECO 301, we ignore other people Others can be in my utility function

Why do markets work? If I make my customers happy, I become rich Social awareness provides intrinsic value

As customer, I trade money for something I need more.

Producer does not value the stuff as much as the consumer. Producer wants to buy something else and needs money to do it.

Coffee bean video: http://www.youtube.com/watch?v=yOY91E7htXU

What are the conditions? Craftsmanship and quality Demand – need

People who CAN and WILL spend money Market PLACE Sufficient supply

Inputs, factors of production Trust - http://

www.youtube.com/watch?v=79ZosnxGKgk Why thieves hate free markets

Transparency Thick markets – lots ofbuyers/sellers

Princess Academy by Shannon Hale

The market works. Hunh? Everybody is “happy” Goods have to move freely

A: Efficient allocation of resources 1. Resources used to their full productive capacity

Prices tell us 2. Resources used to make people as happy as

possible PARETO EFFICIENCY

Pareto Improvements

Pareto Pareto improvement: I can make at least one

person better off without making anyone else worse off.

DOES NOT NOT NOT mean: If you cannot make anyone better off without

making someone else worse off, DON’T do it In that case, Pareto says: “????”

First Welfare Theorem Given some assumptions ANY competitive equilibrium is Pareto efficient

Perfect Information Complete markets Price-taking behavior Marginal social benefits/costs = private

Second Welfare Theorem Given some more assumptions You can reach ANY Pareto outcome using a

competitive equilibrium through lump sum transfers PLUS No increasing returns to scale

What the government needs Perfect knowledge of tastes and production Perfect benevolence All power of enforcement

Homework Watch the following video on why

markets do not work in Africa http://

www.youtube.com/watch?v=WFsMJi9tRok

For each case study in the video, identify which of the assumptions of the 1st and 2nd Welfare Theorems are failing and why.