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Lecture 1 (Topic 2) : Markets and Efficiency

The document summarizes key concepts from two lectures on markets and consumption/investment decisions. It discusses how perfectly competitive markets achieve efficient outcomes by maximizing consumer and producer surplus. It also explains how consumption is modeled using utility functions and indifference curves, and how investment decisions are modeled using production possibility curves. Capital markets allow separation of production and consumption decisions by enabling borrowing and lending at the same interest rate.

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Jason
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50 views2 pages

Lecture 1 (Topic 2) : Markets and Efficiency

The document summarizes key concepts from two lectures on markets and consumption/investment decisions. It discusses how perfectly competitive markets achieve efficient outcomes by maximizing consumer and producer surplus. It also explains how consumption is modeled using utility functions and indifference curves, and how investment decisions are modeled using production possibility curves. Capital markets allow separation of production and consumption decisions by enabling borrowing and lending at the same interest rate.

Uploaded by

Jason
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Lecture 1 (Topic 2): Markets and Efficiency

- An equilibrium in a perfectly competitive market will achieve an efficient outcome:


 Maximises consumer and producer surplus

- Efficiency requires the use of resources to produce an extra unit of a good if


consumer’s WTP ≥ cost of production

- Government intervention in markets can prevent efficient resource allocation


 Creates a deadweight loss
 Changes the consumer and producer surplus from its equilibrium
values

Lecture 2 (Topic 3): Consumption and Investment Decisions under


Certainty
- Preferences are always decided by a utility function in economic models:
 Determine how consumption is valued today and tomorrow
 Utility is maximised by rational consumers

- Total utility of consumption is positively sloped but it has diminishing marginal


utility:
 Extra unit of consumption today = Less extra utility

- Indifference curves represent the consumer’s time preference of consumption:


 Slope of the indifference curve is the marginal rate of substitution
(MRS)
 Diminishing MRS between consumption today and tomorrow can be
observed
 Look at the tangent line of the slope to see diminishing MRS

- Production possibilities curve:


 Assume all physical projects are different
 Invest in best projects first
 Assume all investments are perfectly divisible
- A higher investment lowers the marginal investment’s rate of return
- Slope of the production possibility curve is the marginal rate of transformation
(MRT):
 Transformation: Giving up consumption today for consumption
tomorrow “transforming consumption today into consumption
tomorrow”
 If investment is not possible then the slope of the production
possibility curve would be straight

No Capital Markets
- No capital markets = Consumers consume the amount they produce
 Optimal amount to invest is when the indifference curve is tangent to
the production possibility curve
 MRT = MRS at this point between consumption today and tomorrow
 Individuals with different preferences will choose different consumption
decisions even given the same production possibility curve

With Capital Markets


- Frictionless Markets: Assets are divisible and there are no taxes, transaction costs
or regulations in place
 More assumptions on slide 19 and 20

- Capital Market Line (CML):


 Individuals can achieve any point on the CML by borrowing and lending
accordingly

- Best point to maximise utility is still when the indifference curve is tangent to the
CML

- Fisher Separation Theorem (FST):


 Decisions to invest in physical projects is independent to individual
preferences

- Choose optimal production and then optimal consumption


- Separation of production and consumption is the FST

- A world with capital markets is better than a world without capital markets
 Capital markets allow individuals to borrow or lend at the same interest
rate r to achieve the desired point on the CML

- Indifference curves represent the utility function of a consumer


- Always rank preferences from best to worst:
 Best: Highest return
 Worst: Lowest return

Cr
- CML Equation: C 0+ =W 0
1+r
 Lending: Go left “up the hill” along the CML
 Borrowing: Go right “down the hill” along the CML

- Fischer Separation Theorem: Production and consumption decisions are


independent to each other
 When the borrowing rate > lending rate the FST does not hold due to
transaction costs

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