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Group 4- The Honey Badgers
MARKETS
Markets allocate goods to consumers based on their desirability while telling producers
how to allocate their resources based on possible profits. Markets match what is
desirable with what is possible, the ultimate means with the ultimate ends.
Objective 1: Understanding The Basic Market Equation
The basic market equation is an economic equation used to define the optimal allocation of resources for a particular set of conditions. The equation is composed of three factors: Marginal Utility, Price, and the MarginalPhysicalProduct. It can be written as; MUxn/MUyn = Px/Py = MPPay/MPPax, given person n, factor of production a, good x and good y.
MUxn = MPPay
MUyn MPPax
Marginal Utility (MU): is the amount of satisfaction a consumer gets from purchasing one more unit of a particular good. See the Law of Diminishing Marginal Utility,
explained below.
Price (P): is at the center of the basic market equation; it balances what products
consumers are willing to spend their money on and what products producers are willing to make with their factors of production. Price is how supply meets demand. Microeconomics is frequently called price theory in order to accentuate the important role of prices.
Marginal Physical Product (MPP): is the output produced from adding one more variable factor of production. As explained below, the increase in output per unit of a variable factor added decreases with each addition.
The equation consists of three ratios, and states that the ratio of a person’s marginal utilities of good x and good y is equal to the ratio of x and y prices, which in turn is equal to the ratio of marginal physical products of x and y given factor or production a. The equation does not mean that each person consumes the same amount of each good, nor does it mean that each company uses the same amount of each production factor equally, because the equation is made up of ratios. The central piece of the equation, price, plays a critical role of fulcrum in the balancing act of the market equation. Because of the price ratio, the basic market equation is able to define an optimal allocation of resources. Optimal allocation means that no one would want to reallocate any factor to alternative use because doing so would decrease that person’s total satisfaction, and no firm would want to reallocate any factor to any other use because doing so would diminish profits. Optimal allocation is also sometimes referred to as a Pareto optimum, or Pareto efficient allocation.
Activity 1: The Basic Market Equation
Read this page on Encyclopedia of Earth to further your understanding of markets.
Talk to a friend or family member about what you have read and learned; see what you can teach them and what they can teach you.
Objective 2: Understanding Market Laws
Before going further, it is important that we examine the three basic market laws upon which market economics is based.
A.Law of Diminishing Marginal Utility:a consumer derives less satisfaction for each additional unit consumed of a given good. Marginal utility is defined as the additional pleasure or satisfaction to be gained from consuming one more unit of a good or service (Daly and Farley, 2004). This law can be used to explain why consumers spend their income on a variety of goods, rather than simply on one product.
x
B.Law of Diminishing Marginal Physical Product (or, Law of Diminishing Marginal Returns):as a producer adds successive units of a variable factor to a production process, other factors remaining constant, then the extra output per unit of the variable factor diminishes with each addition (Daly and Farley, 2004). This law can be used to explain why producers do not simply put all their resources into increasing one factor of production and instead divide them among their different production inputs in order to remain as efficient as possible.
C.Equimarginal Principle of Maximization (or, the “when to stop” rule):this principle is one principle that comes in two flavors, one for the consumer side (desirability) of the equation, and one for the producer side (possibility).
-Consumer Satisfaction:consumers are always seeking to maximize their utility.
-Producer Profits:producers are always trying to maximize their profits.
The equimarginal principle of maximization will be satisfied when these two desires are balanced through the manipulation of prices. This is a central role of prices.
Activity 2: Understanding Market Laws
A classic example of the law of diminishing marginal utility is the hungry customer at the local pizzeria. The hungry patron receives great satisfaction from the first slice, slightly less from the second, and consistently less for each additional successive piece consumed at that time. Eventually, an extra slice will make the customer feel ill (which is in a sense negative utility).
Think of another example of this law, and examples of the law of diminishing marginal physical product and the equimargnial principle of maximization to enhance your understanding of the material. How many can you come up with? Are their any products that deviate from these laws, if so how?
Objective 3: Overview of Market Assumptions
Markets are imperfect and rely on a series of assumptions that may or may not be true in this non-perfect world. In later modules you will learn more about the different ways in which the market can fail, but for now we will simply explore these different assumptions upon which market theory is based.
A.Competitive Market: In a competitive market, all firms are price-takers not price-
makers.This means that no buyer or seller is sufficiently large enough to control or affect market price (Daly and Farley, 2004). Think of competitive markets as having multiple sellers and buyers; a competitive market is the opposite of a monopoly or monospony. Thus, supply and demand for a good are the sole price-makers of that good.
B.Perfect Information: It is assumed in a competitive market everyone has perfect
information about a good and has not been misled by advertising; that both buyers and sellers can acquire information about a product at a small cost, and that everyone has equal and reliable information.
C.Rational Actor Model (aka homo economicus): In this model, everyone works for their own self interest. Each individual will choose to do the activity that will minimize work and pain while maximizing rewards and pleasure.
D.Homogonous Product: In a perfect market setting, all suppliers produce the same quality good at the same price to all consumers.
E.Rival and Excludable: Market theory assumes that all goodsare rival and excludable and can therefore be easily priced and sold. In reality, there are many goods which are non-rival and/or non-excludable, making pricing more complex and fluid, or impossible. Just to review, rival goods are those whose consumption by one person reduces the amount available for everyone else, and excludable goods are those which an owner can exclude others from using.
Activity 3: Overview of Market Assumptions
Explain why a market might not function correctly if the assumptions did not hold true for A through E. Can you think of any examples in your life that these assumptions may not be true? Add your thoughts to this wiki.
Objective 4: Substitutable vs. Complementary Goods
The basic market equation rests on the assumption of homogenous goods, and are therefore substitutable. But not all products can be substituted for each other, some products are of a higher quality, others can be made more cheaply, still others are made sustainably. Though not exactly equivalent, some products are still substitutable, for example ham and sausage, or hash browns and home fries.
Complementary goods are not necessarily alike, but compliment each other, meaning they go well hand-in-hand. In cases like this, the price of one is highly correlated to the price of the other. Peanut butter and jelly or eggs and sausage are two examples of complementary goods.
The price of complementary goods may be affected from outside factors other than supply and demand.
In the economic production function, labor, capital and resources are the main factors to be considered. Over time, people have come to think of capital as a substitute for both labor and resources. Ecological economics is more careful to separate these, and acknowledge that resources especially are not necessarily equivalent to any dollar amount.
Activity 4: Substitutable vs. Complementary Goods
Consider alternative energy: is this a compliment or a substitute to current conventional forms of energy? Both? Neither?
Review these links to help answer the questions:
-National Renewable Energy Laboratory:
-Alternative. Renewable. Energy: [Blog]
-Energy Refuge [Blog] :
Submit as Proof of Learning
Matching:
Match each of the following terms with the definition that best describes it.
A. complementary goods I.satisfaction
B. substitutable goodsII.goods in which anincrease in price for one will
lead to a decrease in demand for another.
C. allocateIII.distribute for a specified purpose
D. ration IV.an assumption that is logically impossible
E. utility V. a market law
F. perfect information VI. goods for which a decrease in price for one will lead to a decrease in demand for another
G. rational actor VII.distribute a specific amount
H. laborVIII.use of a good depletes it
I. diminishing marginal utilityIX.two people cannot use at the same time
J. profitX. a factor of production
K. rival XI. an assumption not supported by biology
L. excludable XII. revenue minus costs
Discussion questions/short answer:
Think of a time when you have acted in a way that was not in your own self interest. Describe below.
Is there a product that you would or would not have bought if you had better information than you did? Explain.
For those with a math background: work out with real numbers a basic market equation
The market does a fairly good job of allocating certain goods and services. Name a few:
The market does a terrible job allocating other goods and services. Name a few:
What are the characteristics of those goods and services (i.e. rival, excludable, biotic, abiotic, subject to contestability, renewable, nonrenewable) from the last two questions, and what generalizations can you draw from this?
See if you can come up with some other ways in which goods/services could be better allocated to the people who need them most, and not necessarily and always to the people who can pay the most: