Page info: *Author: Mathiesen, H. *Document version: 2.2. *Copyright 1997-2014, ViamInvest. Legal notice. 

 

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 (Strong-form rationality).

3.        Firms maximize profit (Strong-form 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 look-ins).

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; US=US(X,Y) and UJ=UJ(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=FS(X,Y) and Y=FJ(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 Ui = Ui(X,Y) is homogeneous of degree k if tk*Ui = Ui(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 1997-2014, ViamInvest. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Legal notice.