ECONOMICS ANALYSIS

WELFARE – as the state of well being of the persons comprising an economic system.

EQUILIBRIUM – as state of rest, a position from which there is either no Incentive or

no opportunity to move

WELFARE
Most economic analysis is concerned with the welfare aspects of economic activity- how to
achieve or optimum welfare constitutes a major problem. As we noted in previous
chapters, the concept is straightforward where only one person is being considered and is
synonymous with that person’s well being. But when more than one individual is at issue,
an objective definition of a unique optimum welfare position for the group as a whole
becomes impossible, since such a definition would require interpersonal comparisons of
satisfaction. The Pareto optimal situation, in which no one can be made better off
without making someone else worse off, is the best solution that we can attain.
There is no unique Pareto optimal situation for a group.

The welfare of a group is much more difficult to handle, comparisons of this sort raise
serious problems. How can changes in the well being of different persons be compared? In
some specific cases we can make rough subjective judgments. Taking a Rembrandt away
from a connoisseur of art and giving it to a person who does not understand or value art
would surely reduce group welfare. We are left with a group welfare concept known as
Pareto optimal situation exists when no even can increase the well being of someone else
to consider the matter in another way, a situation is not Pareto optimal if one is to make
persons can be made better off without making anyone else worse off. If a situation is not
Pareto optimal, a movement towards it –making at least one person better off without
making anyone else worse off-increases group welfare.

Equilibrium
Concept is important, not because equilibrium position is ever in fact attained but
because these concepts show us the direction in which economic processes move. When
equilibrium positions are unstable, disturbances will cause economic units to move farther
away from rather than toward such positions.

Partial equilibrium
A large part of the analytical structure that we have built up is called partial
equilibrium analysis. It has been concerned with the movements of individual economic
units toward equilibrium positions in response to the given economic conditions confronting
them. Thus, the consumer, with given tastes and preferences, is confronted with a given
income and with given prices of goods and services. Each consumer adjusts his or her

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ECONOMICS ANALYSIS
purchase accordingly to move toward equilibrium. The business firm-faced with given
product demand situations-moves toward an equilibrium adjustment. The resource owner
possesses given quantities of resources to place in employment, for which there is a given
alternative employment possibilities and resource price offers. The equilibrium adjustment
is made on the basis of the given data. Changes in the given data facing economic units
and industries alter the position of equilibrium that each is attempting to reach and
motivate movements toward the new positions.

Partial equilibrium is especially suitable for the analysis of two types of problems
both of which we have met time and again through the book. Problems of the first type are
those arising from economic disturbances that are not of sufficient magnitude to reach far
and beyond the confines of a given industry or sector of the economy. Problems of the
second type are concerned with the first order effects of an economic disturbance of any
kind.

As an illustration of the first kind of the first problem, suppose that the production
workers of a small manufacturer or plastic products go on strike. Suppose further that the
plant is located in a large city and that the workers are fairly well dispersed among the
residential areas there. The effects of the strike will be limited largely to the company and
the employers concerned. Partial equilibrium analysis will provide the relevant answer to
most of the economic problems arising from the strike.

As an example of the second type of problem, supposed that a rearmament program

increases the demand for steel suddenly and substantially. Partial equilibrium analysis will
provide answers to the first order effects on the steel industry- what happens to each
prices, output, demand for resources, resource price and its resource employments levels.

General Equilibrium
General equilibrium for the entire economy only exists if all economic units were to achieve
simultaneous partials or particular equilibrium adjustments.

General equilibrium theory provides the analytical tools for accomplishing two objectives:

From the stand point of pure theory, it provides the Means of viewing the economic
system in each entirety. The means of seeing what holds it together, what makes it
works, and how it operate,
It permits the determination of the second, third and higher order effects of an
economic disturbance.

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Supposed of that higher-order repercussions from the increase in demand for steel
are to be examined. The first order or partial, equilibrium effects are higher prices, greater
out puts with given facilities, larger profit, and higher to the owners of resources used in
making steel. This effect generates additional disturbances. Higher incomes for the
resource owner increase the demand for other product, setting off disturbances and
adjustment in other industry. Demand also increase for steel substitute, generating another
series of disturbances and adjustments.

Since general equilibrium analysis covers the interrelationships among all parts of
the economy, it necessarily becomes exceedingly complex. There are two principal
variants of it. In the first one, following Leon Walras most economists find it convenient to
discuss general equilibrium in mathematical terms. The interdependence of economic units
is shown through a system of simultaneous equation relating the many economic variables
to one another the walrasian version of general equilibrium provides the essential
theoretical apparatus for understanding the interrelationships of the various sector of the
economy.

The second variant of general equilibrium analysis is Wassily W.Leontief’s input-

output approach is an empirical descendants of the abstract Walrasian approach. It divides
the economy into a number of sectors or industries including households and the
government as “industries” of final demand. Each industry is viewed as selling its output to
others; these outputs become inputs for the purchasing industries. Likewise, each industry
is viewed as a purchaser of the outputs of other industries.

The attainment of general equilibrium in an economic system does not imply that
Pareto optimality is also attained. A price system tends to move the economy toward
general equilibrium. However, unless pure competition exist in both product and resource
markets, and unless there are no externalities occurring, Pareto optimally will not follow.

The Theory of General Equilibrium

The French economy Leon Walras (1834-1910) was the first to design a model of
the general equilibrium of a purely competitive economy.

Walra’s general equilibrium model is simple, that is to say, the economic ideas that
are its building blocks are simple, modern versions of them have been presented earlier in
this book. To a mathematician, Walra’s mathematics is not complex. But full and easy und
of the general equilibrium of prices is denied to many students of economics.

The mathematics gives a vision of interdependence of prices that is clear, precise in

detail, complete and self checking in its logical consistency.

Limitations of the Model

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The simple model has other but less serious limitations; the assumption of fixed
production coefficients can be removed and in much more intricate models, replaced with
an assumption of variable coefficients. More complicated models can also be constructed
to contain increasing and decreasing returns to sale, money and securities, and even
certain forms of imperfect competition.

Uses of General Equilibrium Theory

The simple general equilibrium model is a model of a private enterprise system at
rest, all of the consumers and producers having made their best adjustments. In the
domain of the discussion of economic and social philosophies and systems, the general
equilibrium model is the strongest of the serious arguments for private enterprise and
against collectivism but remember, maximum satisfaction means no more than the
maximum attainable under the circumstances, whatever they might be. The economy
might be poor, with meager resources, a primitive market and the eager pursuit of self
interest, the poor economy would still approach the maximum satisfaction of its consumers
that is consistent with its limited resources.

Some admirers of private enterprise might not like the fate of business people in the
model. The entrepreneur’s in Walra’s model are drones. They control no prices, they exert
no power over other person; they fulfil no social responsibilities. They are compelled by the
system of prices to be efficient to produce at the lowest attainable costs. Infact their
singular function is to be innovators and risk takers, entrepreneurs do not exist at all in
Walra’s model. Neither do labor leaders.
General equilibrium theory has furnished the conceptual foundation for input-output
analysis, which was created by Wassily Leontief of Harvard University. Input-output
analysis is the statistical measurement of the input and outputs of all industries taken
together in an interdependent system of commodity flow.

The Conditions of Optimum Welfare

Optimum welfare conditions in an economy are usually grouped into three sets.
1.) Consist of the conditions leading to maximum consumer welfare when supplies
of goods and services are fixed
2.) Consist of the conditions of maximum efficiency in production, assuming that
resource supplies are fixed.
3.) Consumer welfare and maximum productive efficiency are brought together to
determine conditions under which the outputs of different goods and services
are optimal.

WELFARE

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Up until now we have focused on considerations of Pareto efficiency in evaluating
economic allocations. But there are other important considerations. It must be
remembered that Pareto efficiency has nothing to say about the distribution of welfare
across people; giving everything to one person will typically be Pareto efficient. But the rest
of us might not consider this a reasonable allocation. In this chapter we will investigate
some techniques that can be used to formalize ideas related to the distribution of welfare.

Pareto efficiency is in itself a desirable goal- if there is some way to make some
group of people better off without hurting other people, why not do it? But there will usually
be many Pareto efficient allocations; how can society choose among them?

The major focus of this chapter will be the idea of a welfare function, which
provides a way to “add together” different consumers` utilities. More generally, a welfare
function provides a way to rank different distributions of utility among consumers. Before
we investigate the implications of this concept, it is worthwhile considering just how might
go about “adding together” the individual consumers` preferences to construct some kind
of “social preferences.”

EXTERNALITIES:
We can say that an economic situation involves a consumption externality if one
consumer cares directly about another agent`s production or consumption. For example, I
have definite preferences about my neighbor or playing loud music at 3 in the morning, or
the person next to me in a restaurant smoking a cheap cigar, or the amount of pollution
produced by local automobiles. These are all examples of negative consumption
externalities. On the other hand, I may get pleasure from observing my neighbor`s flower
garden-this is an example of a positive consumption externality.

Similarly, a production externality arises when the production possibilities of one

firm are influenced by the choices of another firm or consumer. A classic example is that of
an orchard located next to a bookkeeper, where there are mutual positive production
externalities-each firm`s production positively affects the production possibilities of the
other firm. Similarly, a fishery cares about the amount of pollutants dumped into its fishing
area, since this will negatively influence its catch.

In earlier chapters we saw that the market mechanism was capable of achieving
Pareto efficient allocations when externalities were not present .If externalities are present,
the market will not necessarily result in a Pareto efficient provision of resources. However,
there are other social institutions such as the legal system or government intervention that
can “mimic” the market mechanism to some degree and thereby achieve Pareto efficiency.

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My neighbor may believe that he has the right to play his trumpet at 3 in the morning, and I
may believe that I have the right to silence. A firm may believe that it has the right to dump
pollutants into the atmosphere that I breathe, while I may believe that it doesn’t. Cases
where property rights are poorly defined can lead to an inefficient production of
externalities-which means that there would be ways to make both parties involved better
off by changing the production of externalities. If property rights are well defined, and
mechanisms are in place to allow for negotiation between people, then people can trade
their rights to produce externalities in the same way that they trade rights to produce and
consume ordinary goods.

PREFERENCES
The economic model of consumer behavior is very simple: people choose the best things
they can afford. This chapter will be devoted to clarifying the economic concept of “best
things.” We call the objects of consumer choice consumption bundles .This is a complete
list of the goods and services that are involved in the choice problem that we that we are
investigating. The word “complete” deserves emphasis: when you analyze a consumer`s
choice problem, make sure that you include all of the appropriate goods in the definition of
the consumption bundle.

If we are analyzing consumer choice at the broadest level, we would want not only a
complete list of the goods that a consumer might consume, but also a description of when,
where, and under what circumstances they would become available. After all, people care
about how much food they will have tomorrow as well as how much food they have today.

The Conditions of Optimum Welfare:

Optimum welfare conditions in an economy are usually grouped into three sets. The
first consists of the conditions leading to maximum consumer welfare when supplies of
goods and services are fixed. The second consists of the conditions of maximum efficiency
in production, assuming that resource supplies are fixed. In the third, consumer welfare
and maximum productive efficiency are brought together to determine conditions under
which the outputs of different goods and services are optimal.

Maximum Consumer Welfare: Fixed Supplies:

The conditions of maximum welfare consumer with fixed supplies of goods and
services per time unit are illustrated in the two-good, two-person model of Figure 84. If the
distribution of goods X and Y between the two consumers A and B is initially off the
contract curve at some point such as D, exchanges can be made that will increase the
welfare of either without decreasing that of the other. A movement from distribution D to
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distribution E increases the welfare of both. Once a contract curve distribution is achieved,
any further exchanges can benefit only one consumer at the expense of the other. Any
point on the contract curve represents a Pareto optimal distribution of X and Y between the
two consumers. Each such point is defined by the condition that

MRSxy = MRSxy

This condition can be extend to as many goods and services and as many
consumers as there in the economy.

Figure 84
Optimum Consumer Welfare: Fixed Supplies

Sometimes there are externalities involved in the consumption of a good service. An

externality in consumption occurs if the consumption of a good by someone else affects
the level of satisfaction attained by any given consumer. Suppose for example, that A and
B are neighbors, that A increases her stereo capacity and that B whose musical taste
parallel those of A, can now hear and enjoy the music she plays. B receives an external
benefit from A`s consumption-his set of indifference curves between music and other
goods and services is shifted inward toward the origin of his indifference curve map. On
the other hand, the externality could have operated in the opposite direction: the music
played by A could have annoyed B, interfering with his sleep and shifting his set of
indifference curves between music and other goods and services outward from the origin
of his indifference map.

When an externality in consumption occurs, we can no longer be sure that a point

on the contract curve such as E in Figure 85 is Pareto optimal. Suppose that B`s
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ECONOMICS ANALYSIS
satisfaction is enhanced by A`s increased purchase of music via an expansion of stereo
capacity. An exchange of other goods and services for distribution F would not change A`s
level of satisfaction. Suppose that the external benefits that B receives from A`s increased
consumption of music shifts to B`s indifference curves toward origin Qb so that the
satisfaction level formerly represented by Ub. At point F, B will be at higher level of
satisfaction, represented by U, than before; since A`s satisfaction has not been lessened,
by welfare of the two consumers combined is greater than it was at point E.

Figure 85
Externalities in Consumption

The Conditions of Efficiency: No Externalities

Maximum efficiency in production refers to Pareto optimality in production
processes. Given the supplies of resources available, these must be allocated among the
production of goods and services in such a way that the production of any one good
cannot be increased unless the production of another decreased.

The conditions of efficiency are illustrated in the two-resource, two-product model of

Figure 86. Fixed supplies of resources A and B are used in the production of products X
and Y. Any distribution of resources between the two products that lie on the contract
curve, such as that at E, is more efficient than in any distribution not on that curve, such as
that at N. Given any initial distribution such as N, the output of either product can be
increased with no sacrifice of the other. It is also possible to increase the outputs of both

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ECONOMICS ANALYSIS
products by allocating more A and less B to the output of Y, thus moving from N to E. With
any distribution such as E, neither product`s output can be increased unless some of the
other is sacrificed. Any point on the contract curve represents a maximum efficiency
allocation of resources. The condition that determines any such point is that

MRTSab = MRTSYab

These conditions can be expanded to include as many resources and as many

goods and services as exist in the economy.

The infinite number of efficiently produced combinations of X and Y shown by the

contract curve of Figurer 86 are also shown by the transformation curve of Figure 87. For
every combination of X and Y on the transformation curve, resources are allocated to each
product in the optimal combinations. The transformation curve is often appropriately called
the production possibilities curve. Its slope at any point measures the rate at which one
product must be given up to obtain an additional unit of the labor, that is, the MRT.

Figure 86
Optimum Productive Efficiency
EXTERNALITIES

Can arise between producers, between customers, or between both the producers
and the customers.

Is a consequence of an economic activity that is experienced by unrelated third

parties. Externalities are not reflected in market prices, they can be a source of
economic inefficiency when producing firms do not take into account the harm
associated with negative activities.

Source: investopedia
An externality can be either positive or negative.

Negative Externalities – Occurs when action of one party imposes costs to other party.

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Example:

(1) Pollution emitted by a factory that spoils the surrounding environment

and affects the health of nearby residents is an example of a negative
externality.

(2) When a producing plant of steel dumps their waste in a river basin
which fisher folks is dependent on their daily catch of fish for their daily
living; producing plant has no incentive to account for the external cost
that they imposes on the affected fishermen when making its production
decision.

(3) Suppose, that a two way lane highway are used by the producers of
automobiles, producers of can goods and other manufacturing
industries, and other marketing sources for delivering their goods to
consumers

Positive Externalities – When the action of one party benefits another party.

Example:

A positive externality is the effect of a well-educated labor force on the

productivity of a company.

The effects of Externalities:

If externalities occur in the production of a good and services, the contract curve
may no longer show the conditions of maximum efficiency. Furthermore, there is no market
in which these external costs can be reflected in the price of goods and services.

One of the common examples is the condition of Philippine road network (Major Highways,
secondary road and other form of roads):

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ECONOMICS ANALYSIS
Other Resources
Q
per unit of time a

a
2
Highway Highway
Facilities Facilities
per Unit of per Unit of
Time Time
a
1
E

Qw
Other Resources
per unit of time
Suppose, producers of automobiles, producers of can goods and producers of
processed meat products used the two way lane highway at the same time without
consideration

with other road users; tendencies are, congestion in the highway is inevitable and will
cause transportation delays in the delivery goods and other services.

The marginal rate of technical substitution between highway facilities and other resources
is the same at point “E”. This distribution or allocation of resources is not optimal. If one
firm decreases their usage of highway facilities by using other alternative road, production
productivity of highway facilities and the remaining firms using the same facilities will tend
to increase provided that they maintained their output level.

Efficiency in Exchange:

Allocation of goods in which no one can be made better off unless someone else is
made worse off.*
Source: *Microeconomics by: R. Pindyck & D. Rubinfield

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The optimum distributions of the two commodities between two persons.
“Let us assume that two persons engage in barter transactions in the
absence of money and prices. Is trade or exchange always mutually
advantageous?”

Name of
Allocation (Initial) Exchange Allocation (Final)
Individual
Food Clothing Food Clothing Food Clothing
Kathy 3 5 1 -1 4 4
Jaime 7 1 -1 1 6 2
As a rule, voluntary trade between two people or two countries is mutually beneficial1.

If trade is beneficial, which trades can occur? Which of those trades will allocate goods
efficiently among customers? How much better off will consumers then be?

The EDGEWORTH BOX Diagram

Showing all possible allocations of either two goods between two people or two
inputs between production processes.

Illustration 1

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ECONOMICS ANALYSIS
Kathy's Food
10 F 4 F 3 F OK
6C

Jaime’s Kathy's
Clothin Clothin
g g
B
2
C 4C

+ 1C
1
C 5C
-
1F A
6
C
OJ Jaime’s Food 6 F 7 F 10 F

Note: Each point in the Edgeworth box simultaneously represents Jaime’s and Kathy’s market baskets of food
and clothing. At point A, Jaime has 7 units of food and 1 unit of clothing; and Kathy has 3 units of food and
5 units of clothing.
1

Efficient Allocations:

A trade from point A to point B thus made both (Jaime & Kathy) better off. But is
point B an efficient allocation?

Answer: It is depends on whether Jaime & Kathy’s MRS are at the same at B, which
depends in turn on the shape of their indifference curves. In the illustration below show
several indifference curves for both Jaime & Kathy. Their allocation2 are measured from
the OJ, Jaime’s indifference curves are drawn in the usual way while for Kathy, it was
rotated the indifference curves opposite (180 degrees) of Jaime, so that the origin is at the
upper right hand corner of the box. Kathy’s indifference curves are convex, while Jaime
indifference curves are concave.

Illustration 2

10 F Kathy's Food OC

1 There are several situations in which trade may not be advantageous. First, limited information may lead people to
believe that trade will make them better off when in fact it will not. Second, people may be coerced into making trades,
either by physical threats or by the threat of future economic reprisals. Third, barriers to free trade can sometimes
provide a strategic advantage to a country.

2
Even if a trade from an inefficient allocation makes both people better off, the new allocation is not
necessarily efficient.

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6C

Kathy'
Jaime's s
Clothin Clothi
g ng

6C
OJ Jaime’s Food 10F

Note: The Edgeworth box illustrates the possibilities for both consumers to increase their satisfaction by
trading goods. If “A” the initial allocation of resources, the shaded area describes all mutually
beneficial trades.

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