Chapter 16

General Equilibrium

Cut Down Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Main Topics

The nature of general equilibriumPositive analysis of general equilibrium

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The Nature of General Equilibrium Already studied competitive equilibrium in a single

isolated market: partial equilibrium analysis Useful when supply and demand for a good are largely

independent of activities in other markets However, markets are often interdependent (e.g., if

complements or substitutes) General equilibrium analysis is the study of

competitive equilibrium in many markets at the same time Allows us to understand the consequences of

interdependence among markets Factors that affect supply and demand in one market can have

ripple effects in other markets Accounts for feedback between markets Markets can be linked because the price or production of one

good affects the demand or cost of another….think substitutes or complements.

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Figure 16.1: General Equilibrium

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Above is the general equilibrium in the markets for Pie and Ice cream. Both equilibriums take the other product (and product price) into account in identifying its own product clearing price and quantity.

Positive Analysis ofGeneral Equilibrium

General equilibrium analysis can provide more accurate answers than partial equilibrium analysis does to positive questions

Examine the effects of a sales tax on ice cream Assume pie and ice cream are complements Assume no supply linkages

General equilibrium effects of the tax include: Demand curve for pie shifts downward, so price of pie falls This produces a feedback effect on the ice cream market Effects of the tax ripple back and forth between the markets

Need a new tool to determine the prices that will prevail in both markets in a general equilibrium

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Market-Clearing CurvesFirst step in identifying a general equilibrium is

to find the market-clearing curve for each goodShows the combinations of prices for that good and

related goods that bring supply and demand for the good into balance

Prices of the goods are on the axesFor two goods that are complements, the

market-clearing curves will be downward slopingExample: an increase in the price of pie reduces the

demand for ice cream, which lowers the partial equilibrium price of ice cream

For substitutes, the curves will be upward sloping

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Figure 16.2: A Market-Clearing Curve

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Slide A shows the ice cream curve with 3 different demand curves that correspond to different prices for pie. Slide B is the general equil. market-clearing curve for both products.

Figure 16.2: A Market-Clearing Curve

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Slide A shows the pie curve with 3 different demand curves that correspond to different prices for ice cream. Slide B is the general equil. market-clearing curve for both products.

General Equilibrium inTwo Markets

If a price combination lies on both market-clearing curves, then both markets are in equilibriumThis is a general equilibrium

Find a general equilibrium by plotting both market-clearing curves on the same graph

Horizontal axis shows the price of one good; vertical axis shows the price of the other good

Intersection of the two market-clearing curves reveals the general equilibrium pricesThe two goods markets clear at these prices

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Figure 16.4: General Equilibrium Price Combination

General equilibrium prices are $12 per pie and $6 per gallon of ice cream

Pie and ice cream markets both clear at these prices

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Effects of a Sales Tax:Partial Equilibrium

Continue the ice cream exampleExamine effects of $3 per gallon sales tax on ice

creamBegin from initial equilibrium price of $6 per gallon,

25 million gallonsTax shifts supply curve upward by $3New partial equilibrium is at intersection of the

new supply curve and initial demand curvePrice of pie held constant at $12 per pie

(Consumer) Price of ice cream rises by $1.67 per gallon, less than the amount of the tax

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Effect of a Sales Tax:Gen. Equilibrium

Need new market-clearing curve for ice cream, to find general equilibrium effects of tax

Tax shifts market-clearing curve for ice cream upwardNew curve lies exactly $1.67 above the old oneMagnitude of the shift equals partial equilibrium

effect of the taxLook for intersection of new market-clearing

curve for ice cream and old market-clearing curve for pieShows new general equilibriumPie price is $11 per pie, ice cream price is $8 per

gallonThese prices clear both markets

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Effect of a Sales Tax:Gen. Equilibrium

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Sales Tax Effect : General Equilibrium

As a result of the tax, demand curves for both goods shift

Sales tax on ice cream reduces the price of a pie by $1Because pie and ice cream are complements

Partial equilibrium analysis understates the effect of the tax on the price of ice creamBased on partial anal., ice cream prices rise only by

$1.67, but based on general equil, prices rise by $2.Lower pie price leads to greater demand for ice

creamReinforces pressure for ice cream price to riseGeneral equilibrium analysis accounts for this

feedback; partial equilibrium analysis does not

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Figure 16.6: Effects of a Tax, part 2

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