general equilibrium economics

7/27/2019 General Equilibrium Economics

1/65

Chapter 16

GeneralEquilibrium and

EconomicEfficiency


2/65

Chapter 16 Slide 2

Topics to be Discussed

General Equilibrium Analysis

Efficiency in Exchange

Efficiency in Production


3/65

Chapter 16 Slide 3


Partial equilibrium analysis presumes

that activity in one market is

independent of other markets.


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Chapter 16 Slide 4


General equilibrium analysis

determines the prices and quantity in

all markets simultaneously and takesthe feedback effectinto account.


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Chapter 16 Slide 5


A feedback effect is a price or

quantity adjustment in one market

caused by price and quantityadjustments in related markets.


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Chapter 16 Slide 6


Two Interdependent Markets--Moving

to General Equilibrium

ScenarioThe competitive markets of:

DVDs

Movie theater tickets


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DVDM

Two Interdependent Markets:Movie Tickets and DVDs

Price

Numberof Videos

Price

Number ofMovie Tickets

SMSV

$6.00

QM QV

$3.00

$6.35

QM

S*M

Assume the government

imposes a $1 tax oneach movie ticket.

QV

DV

$3.50

General Equilibrium Analysis:Increase in movie ticket pricesincreases demand for videos.


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DVDM


Price

Numberof Videos

Price

Number ofMovie Tickets

SMSV

$6.00

QM QV

$3.00

The Feedbackeffects continue.

$3.58

Q*V

D*V

$6.35

QM

D*M

$6.82

Q*M

S*M

QV

DV

$3.50

DM

QM

$6.75

The increase in the price

of videos increases thedemand for movies.


9/65Chapter 16 Slide 9

Observation

Without considering the feedback effect

with general equilibrium, the impact ofthe tax would have been

underestimated

This is an important consideration for

policy makers.




Questions

What would be the feedback effect of a

tax increase on one of twocomplementary goods?

What are the policy implications of using

a partial equilibrium analysis compared

to a general equilibrium in this scenario?

Two Interdependent Markets:Movie Tickets and Videocassette Rentals




Exchange increases efficiency until

no one can be made better off

without making someone else worse

off (Pareto efficiency).

The Advantages of Trade

Trade between two parties is mutuallybeneficial.


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Chapter 16 Slide 12


Assumptions

Two consumers

Two goods Both people know each others

preferences

Exchanging goods involves zerotransaction costs

James & Karen have a total of 10 unitsof food and 6 units of clothing.


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Chapter 16 Slide 13


The Edgeworth Box Diagram

Which trades can occur and which

allocation will be efficient can beillustrated using a diagram called an

Edgeworth Box.


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Exchange in an Edgeworth Box

10F 0K

0J

6C

10F

6C

JamessClothing

KarensClothing

Karens Food

Jamess Food

2C

1C 5C

4C

4F 3F

7F6F

+1C

-1F

The allocationafter trade is B: James

has 6F and 2C & Karenhas 4F and 4C.

A

B

The initial allocationbefore trade is A : Jameshas 7F and 1C & Karen

has 3F and 5C.


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Chapter 16 Slide 15


Efficient Allocations

If Jamess and Karens MRS are the

same at B the allocation is efficient.This depends on the shape of their

indifference curves.


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Chapter 16 Slide 16

A

A : UJ1 = UK

1,but the MRSis not equal.

All combinationsin the shaded

area arepreferred to A.

Gains fromtrade

KarensClothing

Karens Food

UK1UK

2UK3

JamessClothing

Jamess Food

UJ1

UJ2

UJ3

B

C

D


10F 0K

0J

6C

10F

6C


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Chapter 16 Slide 17

A

KarensClothing

Karens Food

UK1UK

2UK3

JamessClothing

Jamess Food

UJ1

UJ2

UJ3

B

C

D


10F 0K

0J

6C

10F

6C

Is Befficient?Hint: is the

MRS equalat B?

Is Cefficient?

and D?


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Chapter 16 Slide 18


A

KarensClothing

Karens Food

UK1

UK2

UK3

JamessClothing

Jamess Food

UJ1

UJ2

UJ3

B

C

D

10F 0K

0J

6C

10F

6C

Efficient Allocations

Any move outside theshaded area will makeone person worse off(closer to their origin).

B is a mutually beneficialtrade--higher indifferencecurve for each person.

Trade may be beneficialbut not efficient.

MRS is equal whenindifference curves aretangent and the allocationis efficient.


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Chapter 16 Slide 19


The Contract Curve

To find all possible efficient allocations

of food and clothingbetween Karen andJames, we would look for all points of

tangency between each of their

indifference curves.


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Chapter 16 Slide 20

The Contract Curve

0J

JamessClothing

KarensClothing

0KKarens Food

Jamess Food

E

F

G

ContractCurve

E, F, & GarePareto efficient . Ifa change improvesefficiency, everyonebenefits.


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Chapter 16 Slide 21


Observations

1) All points of tangency between the

indifference curves are efficient.2) The contract curve shows all

allocations that are Pareto efficient.

Pareto efficientallocation occurs when

trade will make someone worse off.


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Chapter 16 Slide 22


Consumer Equilibrium in aCompetitive Market

Competitive markets have many actualor potential buyers and sellers, so ifpeople do not like the terms of anexchange, they can look for anotherseller who offers better terms.


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Chapter 16 Slide 23


Consumer Equilibrium in aCompetitive Market

There are many Jameses and Karens.

They are price takers

Price of food and clothing = 1 (relativeprices will determine trade)


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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

JamessClothing

KarensClothing

Karens Food

Jamess Food

C

A

Begin at A:Each James buys2C and sells 2FEach James wouldmove fromUj1 to Uj2, which

is preferred (A to C).

Begin at A:Each Karen buys 2F andsells 2C. Each Karen

would move fromUK1 to UK2, whichis preferred (A to C).


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UK1UK

2

P

Price Line

P

UJ1

UJ2


10F 0K

0J

6C

10F

6C

JamessClothing

KarensClothing

Karens Food

Jamess Food

At the prices chosen:Quantity fooddemanded (Karen)equals quantityfood supplied

(James)--competitiveequilibrium.

At the prices chosen:Quantity clothing demanded(James) equals quantity

clothing supplied (Karen)--competitive equilibrium.

C

A


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Chapter 16 Slide 26


Scenario

PFand PC= 3

Jamess MRS of clothing for food is 1/2.

Karens MRS of clothing for food is 3.

James will not trade.

Karen will want to trade.

The market is in disequilibrium. Surplus of clothing

Shortage of food


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Chapter 16 Slide 27


Questions

How would the market reachequilibrium?

How does the outcome from theexchange with many people differ fromthe exchange between two people?


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Chapter 16 Slide 28


The Economic Efficiency ofCompetitive Markets

It can be seen at point C(as shown onthe next slide) that the allocation in acompetitive equilibrium is economicallyefficient.


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Chapter 16 Slide 29


10F0K

0J

6C

10F

6C

JamessClothing

KarensClothing

Karens Food

Jamess Food

P

Price Line

UJ1

UK1

A

P

UJ2

UK2

C


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Chapter 16 Slide 30


Observations concerning C:

1) Since the two indifference curves

are tangent, the competitiveequilibrium allocation is efficient.

2) The MRSCF is equal to the ratio of

the prices, or MRSJFC = PC/PF=MRSKFC.


31/65

Chapter 16 Slide 31



3) If the indifference curves were not

tangent, trade would occur.4) The competitive equilibrium is

achieved without intervention.


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Chapter 16 Slide 32



5) In a competitive marketplace, all

mutually beneficial trades will becompleted and the resulting

equilibrium allocation of resources

will be economically efficient (thefirst theorem of welfare economics)


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Chapter 16 Slide 33

Equity and Efficiency

Equity and Perfect Competition

A competitive equilibrium leads to a

Pareto efficient outcome that may or

may not be equitable.


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Chapter 16 Slide 34

Equity and Efficiency

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?Jamess Utility

KarensUtility

OJ

OK


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Chapter 16 Slide 35


Assume

Fixed 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


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Chapter 16 Slide 36


Observations

Linkage between supply and demand

(income and expenditures)

Changes in the price of one input

triggers changes in income and demand

which establishes a feedback effect.

Use general equilibrium analysis with

feedback effects


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Chapter 16 Slide 37


Production in the Edgeworth Box

The Edgeworth box can be used to

measure inputs to the production

process.


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Chapter 16 Slide 38


Production in the Edgeworth Box

Each axis measures the quantity of aninput

Horizontal: Labor, 50 hours

Vertical: Capital, 30 hours

Origins measure output

OF= Food

OC= Clothing


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60F

50F

40L 30L

Labor in clothing production


50L 0C

0F30K

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--Clothing

Each isoquant shows input

combinations for a given output

Food: 50, 60, & 80

Clothing: 10, 25, & 30

Efficiency

A is inefficient

Shaded area is preferred to AB and Care efficient

The product ion contract curveshows

all combinations that are efficient


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Chapter 16 Slide 40


Producer Equilibrium in a

Competitive Input Market

Competitive markets create a point ofefficient production.


41/65

Chapter 16 Slide 41


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 productioncontract curve.

Competitive equilibrium is efficient.


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60F

50F

40L 30L

Labor in clothing production


50L 0C

0F30K

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

Discuss the adjustment process that would

Move the producers from A to B or C.


43/65

Chapter 16 Slide 43


The Production Possibilities Frontier

Shows the various combinations of food

and clothing that can be produced with

fixed inputs of labor and capital.

Derived from the contract curve


44/65

Chapter 16 Slide 44

Production Possibilities Frontier

Food(Units)

Clothing(units)

OF& OCare extremes.

Why is the productionpossibilities frontier

downward sloping?

Why is it concave?

B, C, & Dareother possiblecombinations.

AA is inefficient. ABC

triangle is also inefficient

due to labor marketdistortions.

60

100

OF

OC

B

C

D


45/65

Chapter 16 Slide 45

Production Possibilities Frontier

Food(Units)

Clothing(units)

60

100

OF

OC

A

B

C

D

B

1C

1F

D

2C

1F

MRT = MCF/MCC

The marginal rate of

transformation (MRT)is the slope of the

frontier at each point.


46/65

Chapter 16 Slide 46


Output Efficiency

Goods must be produced at minimum

cost and must be produced in

combinations that match peoples

willingness to pay for them.

Efficient output and Pareto efficient

allocation

Occurs where MRS = MRT


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Chapter 16 Slide 47


Assume

MRT = 1 and MRT = 2

Consumers will give up 2 clothes for 1food

Cost of 1 food is 1 clothing

Too little food is being produced

Increase food production (MRS falls and

MRT increases)


48/65

Chapter 16 Slide 48

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?

ff


49/65

Chapter 16 Slide 49


Efficiency in Output Markets

Consumers Budget Allocation

Profit Maximizing Firm

CF PPMRS

CCFF MCPandMCP

MRSMC

MCMRT

C

F

C

F

P

P


50/65

Chapter 16 Slide 50

U2

),(@MRT/ 1111 FCAPP CF

Competition and Output Efficiency

Food(Units)

Clothing(units)

60

100

AC1

F1

B

C2

F2

Ashortage offood and surplusof clothing causesthe price of foodto increase and

the price ofclothing to decrease.

CC*

F*

Adjustment continues untilPF= PF*and PC= PC*;

MRT = MRS; QD= QSfor

food and clothing.U1

An Overview---The Efficiency


51/65

Chapter 16 Slide 51

An Overview The Efficiencyof Competitive Markets

Conditions Required for Economic

Efficiency

Eff ic iency in Exchange

K

FC

J

FC

MRSMRS



52/65

Chapter 16 Slide 52


Efficiency

Eff ic iency in Exchange (for acompet it ive market)

K

FCCF

J

FCMRSPPMRS

/




53/65

Chapter 16 Slide 53


Efficiency

Eff ic iency in the Use of Inputs inProduct ion

C

LKMRTSMRTS F

LK




54/65

Chapter 16 Slide 54


Efficiency

Eff ic iency in the Use of Inputs inProduct ion (for a compet i tive market)

C

LKMRTS/MRTS rwF

LK




55/65

Chapter 16 Slide 55


Efficiency

Eff ic iency in the Output Market

consumers)all(forFCFC

MRSMRT




56/65

Chapter 16 Slide 56


Efficiency

Eff ic iency in the Output Market (in acompet it ive market)

CFCF

CFF

PP

PP

/MC/MCMRT

MC,MC

FC

C




57/65

Chapter 16 Slide 57


Efficiency

However, consumers maximize theirsat is fact ion in compet it ive markets

only i f

FCFC

FCCFPP

MRTMRSTherefore,

consumers)all(forMRS/


Wh M k t F il


58/65

Chapter 16 Slide 58

Why Markets Fail

Market Power

In a monopoly in a product market, MR

< P

MC = MR

Lower output than a competitive market

Resources allocated to another market

Inefficient allocation

Wh M k t F il


59/65

Chapter 16 Slide 59

Why Markets Fail

Market Power

Monopsony in the labor market

Restricted supply of labor in foodwfwould rise, wLwould fall

Clothing input:

Food input:

rwc

C

LK/MRTS

C

LKcF

F

LKrwrw MRTS//MRTS

Wh M k t F il


60/65

Chapter 16 Slide 60

Why Markets Fail

Incomplete Information

Lack of information creates a barrier to

resource mobility.

Externalities

When consumption or production

creates cost and benefits to third partieswhich changes the cost and benefits of

decisions and create inefficiencies.

S


61/65

Chapter 16 Slide 61

Summary

Partial equilibrium analyses of markets

assume that related markets are

unaffected, while general equilibrium

analyses examine all marketssimultaneously.

An allocation is efficient when no

consumer can be made better off by trade

without making someone else worse off.

Summary


62/65

Chapter 16 Slide 62

Summary

A competitive equilibrium describes a set

of prices and quantities, so that when each

consumer chooses his or her most

preferred allocation, the quantitydemanded is equal to the quantity supplied

in every market.

The utility possibilities frontier measures allefficient allocations in terms of the levels of

utility that each person achieves.

Summary


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Chapter 16 Slide 63

Summary

An allocation of production inputs is

technically efficient if the output of

one good cannot be increased

without increasing the output of some

other good.

Summary


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Chapter 16 Slide 64

Summary

The production possibilities frontiermeasures all efficient allocations in termsof the levels of output that can beproduced with a given combination ofinputs.

Efficiency in the allocation of goods toconsumers is achieved only when the

MRS of one good for another inconsumption is equal to the MRT of onegood for another in production.


65/65

End of Chapter 16

GeneralEquilibrium and

EconomicEfficiency

general equilibrium economics

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