

Exhibition: The perfect market
economy 1 Introduction The perfect market economy model from introductory
microeconomics is presented in a concise and graphical way (This exhibition was made by inspiration
from Nicholson, W. [1979], Markusen, J. H. [1988], and Bohm, P. [1987]). The
exhibition proceeds as follows. First the pure consumption economy is
illustrated. Then the pure production economy is explained, and finally it presents
the combined production and consumption economy. 2 The Consumption Model Model
assumptions The assumptions underlying the perfect market economy
model are often not made explicit. The following presents a list of the
general assumptions. Additional assumptions follow. 1.
Utility
maximization (opportunism). 2.
Perfect
rationality (Strongform rationality). 3.
Firms
maximize profit (Strongform efficiency). 4.
Preferences
are transitive and stable. 5.
Perfect
competition (Price taking agents). 6.
Perfect
information. 7.
Certainty. 8.
No
externalities (e.g. no pollution, no network externalities, no lookins). 9.
No asset
specificity i.e. no quasi rents. 10.
No public
goods. 11.
Separability
of production. 12.
No
economics of scale and scope. 13.
No
connectedness of exchange. 14.
No
distortions (e.g. taxes). 15.
Homogeneous
goods. 16.
No direct
transaction cost. 17.
All
property is privately held. 18.
Human
capital can be sold (Slavery is legal). 19.
All
assets are priced and traded in markets. 20.
All
utility can be measured in pecuniary terms. 21.
No
measurement problems. 22.
No crime
or war and litigation is does not cost anything. 23.
Time is
static. 24.
All
exchange is voluntary. 



Additional
assumptions 1.
The
economy is a pure exchange economy (no production, all resources is initially
given) with two consumers Sam and Jim (easily generalized to a multiple of
consumers). 2.
Two
commodities is exchanged; X, Y (easily generalized to a multiple of
commodities). 3.
Sam and
Jim has utility functions; U_{S}=U_{S}(X,Y) and U_{J}=U_{J}(X,Y), where U’_{S} >0, U’_{J} >0 and U’’_{S }< 0, U’’_{J }< 0 for both commodities. That is, both
commodities are perceived as goods because the first derivatives are
positive, but the utility function exhibit diminishing marginal utility
because the second derivatives are negative. It can be proved that this will
yield a smooth and concave preference curve, which is necessary for existence
of a unique equilibrium. 4.
Each
person knows how to rank alternative commodity combinations available to him. 5.
All
indifference curves are convex to the origin, that is, U(.) is convex. 6.
Utility
is measured ordinal not cardinal. 7.
The
economy has no institutions (monetary system, legal system, government etc.).
Or the institutions exist but are irrelevant because they work perfect at no
cost. 8.
There are
no changes in society that may affect preferences. 3 The Production Model Figure 2 presents the box diagram and it is conceptually
identical to the above Edgeworth Box. However, the interpretation and some of
the assumptions are slightly changed. 



Additional
assumptions 1.
The
economy is a pure production economy (no consumption, all factors of
production is initially given) with two producers Sam and Jim (easily
generalized to a multiple of producers). 2.
Two
commodities is exchanged; X, Y (easily generalized to a multiple of
commodities). 3.
Sam and
Jim has production functions; X=F_{S}(X,Y) and Y=F_{J}(X,Y), where F’_{S} >0, F’_{J} >0, and F’’_{S }< 0, F’’_{J }< 0
in both arguments. That is, factors are always productive but at a decreasing
rate or both producers are subject to decreasing return to scale. It can be
proved, that this will yield a smooth concave production possibility curve,
which is necessary for existence of a unique equilibrium. 4.
Producers
know their F and will therefore always produce in an efficient way. 5.
All
isoquant curves are convex to the origin, that is, F(.) is convex. 6.
Production
[X,Y] is measured cardinally. 7.
The
economy has no institutions (monetary system, legal system, governments
etc.). Or the institutions exist but are irrelevant because they functions
perfect at no cost. 8.
There are
no changes in society that may affect preferences. 4 Efficiency in Production and Exchange Figure 3 below is the final
graph illustrating the general equilibrium economy including production and
consumption. No further assumptions are needed if the figure is interpreted
as a Robinson Crusoe economy. This economy only has one agent; Robinson who
produces his own consumption. All the above mentioned assumptions remain
unchanged. The more general interpretation is one with multiple commodities,
consumers, and producers. In this case all the above assumptions are needed.
Again they must be corrected for the fact that that there are more than two
commodities, producers and consumers. In figure 3, X and Y may be considered
as bundles of commodities and services. Unfortunately, we need a few more
assumptions in order to aggregate the utility functions into community indifference
curves. Additional assumptions 1) The utility functions are homogeneous. That is
U_{i }= U_{i}(X,Y) is homogeneous of degree k if t^{k}*U_{i }= U_{i}(t*X,t*Y) for all t > 0. This must hold for all
consumers i Î (1,...,N). 2) The utility functions are identical or the
distribution of income is fixed. The perfect
market economy model 



5 Concluding Remarks The perfect market economy model introduces the concepts
of utility maximization, general equilibrium, substitution at the margin and
the concept of social and private efficiency. The model is both socially and
privately efficient because
all imperfections are assumed away. The model demonstrates that what is good
for consumers and producers are also good for society. 

 Copyright 19972019, H. Mathiesen. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Legal notice. 