general equilibrium analysis
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General Equilibrium Analysis. Partial equilibrium analysis assumes that activity in one market is independent of other markets. General equilibrium analysis determines the prices and quantity in all markets simultaneously and takes the feedback effect into account. - PowerPoint PPT PresentationTRANSCRIPT
Chapter 16 Slide 1
General Equilibrium Analysis
Partial equilibrium analysis assumes that activity in one market is independent of other markets.
General equilibrium analysis determines the prices and quantity in all markets simultaneously and takes the feedback effect into account.
A feedback effect is a price or quantity adjustment in one market caused by price and quantity adjustments in related markets.
DVDM
Two Interdependent Markets (Movie Tickets and Videocassette Rentals) Moving to General Equilibrium
Price
Numberof Videos
Price
Number ofMovie Tickets
SMSV
$6.00
QMQV
$3.00
$6.35
Q’M
S*M
Assume the governmentimposes a $1 tax on
each movie ticket.
Q’V
D’V
$3.50
General Equilibrium Analysis:Increase in movie ticket pricesincreases demand for videos.
DVDM
Two Interdependent Markets (Movie Tickets and Videocassette Rentals) Moving to General Equilibrium
Price
Numberof Videos
Price
Number ofMovie Tickets
SMSV
$6.00
QMQV
$3.00
The Feedback effects continue.
$3.58
Q*V
D*V
$6.35
Q’M
D*M
$6.82
Q*M
S*M
Q’V
D’V
$3.50
D’M
Q”M
$6.75
The increase in the priceof videos increases the
demand for movies.
Chapter 16 Slide 4
Efficiency in Exchange
Exchange increases efficiency until no one can be made better off without making someone else worse off (Pareto efficiency).
The Advantages of TradeTrade between two parties is mutually
beneficial.
Chapter 16 Slide 5
Efficiency in Exchange
AssumptionsTwo consumers (countries)Two goodsBoth people know each others
preferencesExchanging goods involves zero
transaction costsJames & Karen have a total of 10 units of
food and 6 units of clothing.
Chapter 16 Slide 6
The Advantage of Trade
James 7F, 1C -1F, +1C 6F, 2C
Karen 3F, 5C +1F, -1C 4F, 4C
Individual Initial Allocation Trade Final Allocation
Karen’s MRS of food for clothing is 3.James’s MRS of food for clothing is 1/2.
Karen and James are willing to trade: Karentrades 1C for 1F. When the MRS is not equal,there is gain from trade. The economically
efficient allocation occurs when the MRS is equal.
Exchange in an Edgeworth Box
10F 0K
0J
6C
10F
6C
James’sClothing
Karen’sClothing
Karen’s Food
James’s Food
2C
1C 5C
4C
4F 3F
7F6F
+1C
-1F
The allocation after trade is B: James
has 6F and 2C & Karen has 4F and 4C.
A
B
The initial allocation before trade is A: James has 7F and 1C & Karen
has 3F and 5C.
Chapter 16 Slide 8
A
A: UJ1 = UK
1,but the MRSis not equal.
All combinationsin the shaded
area arepreferred to A.
Gains fromtrade
Karen’sClothing
Karen’s Food
UK1UK
2UK3
James’sClothing
James’s Food
UJ1
UJ2
UJ3
B
C
D
Efficiency in Exchange
10F 0K
0J
6C
10F
6C
Is B efficient?Hint: is theMRS equal
at B?
Is C efficient?and D?
Chapter 16 Slide 9
Efficiency in Exchange
A
Karen’sClothing
Karen’s Food
UK1UK
2UK3
James’sClothing
James’s Food
UJ1
UJ2
UJ3
B
C
D
10F 0K
0J
6C
10F6C
Any move outside the shaded area will make one person worse off (closer to their origin).
B is a mutually beneficial trade -higher indifference curve for each person.
Trade may be beneficial but not efficient.
MRS is equal when indifference curves are tangent and the allocation is efficient.
The Contract Curve: to find all possible efficient allocations of food and clothing between Karen and James, we look for all points of tangency between each of their indifference curves.
Chapter 16 Slide 10
The Contract Curve
0J
James’sClothing
Karen’sClothing
0KKaren’s Food
James’s Food
E
F
G
ContractCurve
E, F, & G arePareto efficient . If a change improvesefficiency, everyonebenefits.
Chapter 16 Slide 11
Efficiency in Exchange
Application: The policy implication of Pareto efficiency when removing import quotas:
1) Remove quotas Consumers gain Some workers lose
2) Subsidies to the workers that cost less than the gain to consumers
Chapter 16 Slide 12
Efficiency in Exchange
Equilibrium in a Competitive MarketCompetitive markets have many actual or
potential buyers and sellers, so if people do not like the terms of an exchange, they can look for another seller who offers better terms.
There are many Jameses and Karens.
They are price takers
Price of food and clothing = 1 (relative prices will determine trade)
UK1UK
2
P
Price Line
P’
PP’ is the price lineand shows possible
combinations; slope is -1
UJ1
UJ2
Competitive Equilibrium
10F 0K
0J
6C
10F
6C
James’sClothing
Karen’sClothing
Karen’s Food
James’s Food
C
A
Begin at A:Each James buys 2C and sells 2FEach James would move fromUj1 to Uj2, which is preferred (A to C).
Begin at A:Each Karen buys 2F and sells 2C. Each Karen would move fromUK1 to UK2, which is preferred (A to C).
At the prices chosen: Qdclothing (James) = Qsclothing (Karen) – competitive equilibrium.
At the prices chosen: Qd food (K) = Qs food (J) – competitive equilibrium.
Chapter 16 Slide 14
Competitive Equilibrium
10F 0K
0J
6C
10F
6C
James’sClothing
Karen’sClothing
Karen’s Food
James’s Food
P
Price Line
UJ1
UK1
A
P’
UJ2
UK2
C
Point C shows that theallocation in a competitiveequilibrium is economicallyefficient. If the ICs were nottangent, trade would occur. The competitive equilibriumIs achieved w/o intervention.
The MRSCF is equal to the ratio of the prices, or MRSJ
FC = PC/PF = MRSK
FC.
Chapter 16 Slide 15
Equity and Efficiency
In a competitive market, all mutually beneficial trades take place and the resulting equilibrium allocation of resources will be economically efficient (the first theorem of welfare economics)
Is an efficient allocation also an equitable allocation?Economists and others disagree about how to
define and quantify equity.
Chapter 16 Slide 16
H
*Movement from one combination to another (E to F) reduces one person’s utility.*All points on the frontier are efficient.
Utility Possibilities Frontier
James’s Utility
OJ
OK
E
F
G
Karen’sUtility
L
*Any point inside the frontier (H) is inefficient.*Combinations beyond the frontier (L) are not obtainable.
Lets compare H to E&F. E&F are efficient: E&F make one person
better off without making the other worse off.
The Utility Possibilities Frontier indicates the level of satisfaction that each of two people achieve when they have traded to an efficient outcome on the contract curve.
Chapter 16 Slide 17
Equity and Efficiency
Is H equitable?
Assume the only choices are H & G
Is G more equitable? It depends on one’s perspective.
At G James’ total utility > Karen’s total utility
H may be more equitable because the distribution is more equal, therefore, an inefficient allocation may be more equitable.
James’s Utility
Karen’sUtility
OJ
OK
E
F
HG
Chapter 16 Slide 18
Equity and Efficiency
Equity & Perfect Comp.: A competitive equilibrium leads to a Pareto efficient outcome that may or may not be equitable.
Points on the frontier are Pareto efficient.
OJ & OK are perfect unequal distributions and Pareto efficient.
To achieve equity (more equal distribution) must the allocation be efficient?
James’s Utility
Karen’sUtility
OJ
OK
Chapter 16 Slide 19
Efficiency in Production
AssumeFixed total supplies of two inputs; labor
and capital
Produce two products; food and clothing
Many people own and sell inputs for income
Income is distributed between food and clothing
Chapter 16 Slide 20
Efficiency in Production
Production in the Edgeworth BoxEach axis measures the quantity of an
inputHorizontal: Labor, 50 hoursVertical: Capital, 30 hours
Origins measure outputOF = FoodOC = Clothing
60F
50F
40L 30L
Labor in clothing production
Efficiency in Production
50L 0C
0F
30K
Capitalin clothingproduction
20L 10L
20K
10K
10L 20L 30L 40L 50L
Capitalin food
production
10K
20K
30K
30C
25C
10C
80F
Labor in Food Production
B
C
D
A
Each point measures inputs to the production A: 35L and 5K--FoodB: 15L and 25K--ClothingEach isoquant shows inputcombinations for a given outputFood: 50, 60, & 80Clothing: 10, 25, & 30
EfficiencyA is inefficientShaded area is preferred to AB and C are efficientThe production contract curve shows all combinations that are efficient
Chapter 16 Slide 22
Efficiency in Production
Competitive Market Observations The wage rate (w) and the price of capital (r) will be
the same for all industries. Minimize production cost
MPL/MPK = w/r w/r = MRTSLK
MRTS = slope of the isoquant
Competitive equilibrium is on the production contract curve.
Competitive equilibrium is efficient.
Chapter 16 Slide 23
Efficiency in Production: Production Possibilities Frontier (derived from the contract curve)
Food(Units)
Clothing(units)
OF & OC are extremes.
Why is the productionpossibilities frontier
downward sloping? Why is it concave?
B, C, & D areother possiblecombinations.
AA is inefficient. ABC
triangle is also inefficientdue to labor market
distortions.
60
100
OF
OC
B
C
D
Chapter 16 Slide 24
IndifferenceCurve
Output Efficiency
Food(Units)
Clothing(units)
60
100
ProductionPossibilitiesFrontier
MRS = MRT
C
How do you find theMRS = MRT combination
with many consumerswho have different
indifference curves?
Goods must be produced at minimum cost and in combinations that match people’s WTP. The efficient output and Pareto efficient allocation occurs where MRS = MRT
Chapter 16 Slide 25
Efficiency in Production
Efficiency in Output MarketsConsumer’s Budget Allocation
Profit Maximizing Firm
CF PP MRS
CCFF MCP and MCP
MRSMC
MC MRT
C
F C
F
P
P
Chapter 16 Slide 26
Conditions Required for Economic EfficiencyEfficiency in Exchange (for a
competitive market)
KFCCF
JFC MRSPPMRS /
Overview: The Efficiency of Competitive Markets
Chapter 16 Slide 27
Conditions Required for Economic EfficiencyEfficiency in the Use of Inputs in
Production (for a competitive market)
CLKMRTS/MRTS rwF
LK
Overview: The Efficiency of Competitive Markets
Chapter 16 Slide 28
Conditions Required for Economic EfficiencyEfficiency in the Output Market (in a
competitive market)
CFCF
CFF
PP
PP
/MC/MC MRT
MC ,MC
FC
C
Overview: The Efficiency of Competitive Markets
Chapter 16 Slide 29
Conditions Required for Economic EfficiencyHowever, consumers maximize their
satisfaction in competitive markets only if
FCFC
FCCF PP
MRT MRS Therefore,
consumers) all(for MRS /
Overview: The Efficiency of Competitive Markets