General Equilibrium

We will talk about Pareto Efficiency

The Free-Market Argument: Competitive
Markets are Efficient
Market Failure: An introduction.

Slide 1

The Free-Market Argument

We will discuss the conditions for Pareto
efficiency.
We will show that competitive markets are
Pareto efficient, given certain assumptions.

Slide 2

Examples of GE models
We will mostly work with simple examples
of general equilibrium models.
You already know the exchange economy in
the Edgeworth box.
We will talk about the so-called Robinson
Crusoe economy: One input, one consumer.
And the 2x2 production model with two
consumers: 2 goods, 2 inputs, 2 consumers
Slide 3

Example of Robinson Crusoe

Economy with linear PPF
Robinson Crusoe can spend the whole day
letting sun shine on his belly (leisure) or he
can gather coconuts. Crusoe can gather 3
coconuts per hour. Crusoes utility function
over coconuts and leisure is given by U(c,l)
=c1/3l2/3.
Suppose Crusoe has 12 hours a day to spend
on leisure and gathering coconuts.
Slide 4

Problem Crusoe must solve:

How to allocate the total amount of time

(resource) between gathering coconuts and
leisure so to maximize his utility?
We can do this in two steps:
1. What are the production efficient allocations of
Crusoes time?
2. Once we have production efficiency, what is the
utility maximizing amount of coconuts and
leisure?
Slide 5

Production Efficiency
Robinson can spend an hour of leisure or he can
spend an hour gathering 3 coconuts.
Since he has 12 hours available per day, he could
spend 12 hours of leisure and zero hours of
gathering coconuts. This is production efficient,
because he spends every hour available to him to
produce the maximum amount of leisure.
Similarly he could spend all his time gathering
coconuts and then ending up with 36 coconuts per
day. Again this would be production efficient.
Slide 6

Production Efficiency Contd

How can Robinson efficiently produce a
combination of leisure and coconuts?
As Crusoe increases the production of coconuts by
1 coconut at a time, he sacrifices 1/3 hr or 20
minutes of leisure for each additional coconut.
Therefore 1 coconut and 12-1/3 hrs of leisure are
another point on the PPF. So are 2 coconuts and
12-2/3hrs of leisure; 3 coconuts and 12- 3/3hrs of
leisure and so on and so forth.
Thus, his production possibility frontier would
look like this:
Slide 7

Crusoes Production Possibility

Frontier
leisure
12
PPF: l = 12 (1/3)*c

Production
Possibility Set

The slope of the

PPF is equal to
the opportunity
cost of coconuts

1/3
36 coconuts
The slope of the PPF is also called the marginal rate of transformation
(MRT leisure for coconut): in order to produce one additional coconut Crusoe
Slide 8
sacrifices 1/3 hr of leisure.

leisure

Crusoes Pareto efficient

allocation
12

Utility for
Robinson
increases

Production
possibility set
in Crusoes
problem plays a
role similar to
the budget set
in the
consumers
problem.

1/3
12

36 coconuts
Slide 9

Pareto Efficiency
1
maxU(c,l) s.t. l = 12 c
3
Intertiorsolution :
(1) MRSleisure for coconut = MRTleisure for coconut
==>

l
1
=
2c 3

1
(2) Need to be on PPF : l = 12 c
3
1

12 c

3 1
=
2c
3
Slide 10

Pareto Efficient Allocation

Slide 11

Robinson Crusoe Economy with

concave PPF
Suppose Crusoe does not care for leisure anymore.
Instead he enjoys fish and coconuts: U(f,c)
=f1/3c2/3. He can gather coconuts according to the
production function c=lc1/2 and he can catch fish
according to f =2 lf1/2 where lc denotes the amount
of time he devotes gathering coconuts and lf
denotes the time he spends catching fish. Overall,
he has 12 hours he can use to pursue these
activities.
Slide 12

How can we find the PPF now?

The production possibility frontier tells us
which combinations of fish and coconuts
are production efficient, that is, how we can
use Crusoes total time in such a way as to
maximize the amount of fish given that we
also want to produce a certain amount of
coconuts.
Slide 13

Finding the PPF

( )

max f l f s.t. c ( lc ) = c and l f + lc = 12

max l f 2l1/f 2 + 12 l f

1/ 2

Interior solution :
1

=0

l f = 12 c 2 , =

2c

1/ 2
f

2 12 l f

c = 12 l f

1/ 2

1/ 2

12 c

df
dc

PPF : f (c) = 2 12 c 2
Slide 14

Finding the PPF mathematically

Intuition
Remember we want to find a relationship between
fish and coconuts: If we produce that many
coconuts, what is the maximum amount of fish we
can produce?
E.g. produce 2 coconuts. Since c = lc1/2 , the
amount of time required to produce a certain
amount of coconuts is given by lc=c2. Thus, 4 hrs
are needed to produce 2 coconuts.
Whats the maximum amount of fish Crusoe can
produce given that he produces 2 coconuts?
Slide 15

Crusoe has 8 hrs left for catching fish. Since

f = 2 lf1/2 , Crusoe can catch 4*21/2 fish when
he wants to produce 2 coconuts also.
Repeat with various amounts of coconuts,
and you get the whole PPF.
Or, more generally, use amount of coconuts
as a parameter to find out how many fish
Crusoe can produce for any given number
of coconuts.

Slide 16

 Given amount of coconuts requires lc=c2

units of time.
Since lf = 12 lc , time left to produce fish
is lf =12 - c2.
Given this amount of time to catch fish,
amount of fish caught is f = 2 lf1/2 = 2 (12 c2)1/2 .
We now can relate any produced amount of
coconuts to a maximum amount of fish:
PPF is f = 2 (12 - c2)1/2 .
The PPF looks likes this:
Slide 17

Concave PPF

Slide 18

Pareto Efficient Allocation

Robinsons utility
increases

Slide 19

Pareto Efficient Allocation

In order to find the Pareto efficient
allocation, we need to set MRT is equal to absolute
value of slope of PPF

Also need to
make sure
that we really
are on the
PPF, hence
fish is
expressed as
a function of
coconuts in
MRS.

To find slope of PPF, take

derivative of equation
describing PPF with
respect to c.

Slide 20

10

Summing Up
We have looked at a very simple economy with
production.
We have learned how to find the PPF if there is
only one input.
We have learned how to find the Pareto efficient
interior allocation of goods if there is only one
consumer: (1) MRS = MRT and (2) need to be on
PPF.
In order to determine what is Pareto efficient we
need production efficiency. Production efficiency
is a necessary condition for Pareto efficiency. Slide 21

Assumptions for the 2x2

production model
Compared to our previous model, we now add one
more production factor (capital) and allow for
more than one consumer.
Two inputs: Capital K, Labor L
Two consumption goods: good X, good Y
Consumers: strictly convex indifference curves
(decreasing MRS between goods).
Producers: strictly convex isoquants (decreasing
marginal rate of technical substitution between
inputs). We also assume that production of the two
goods does not exhibit increasing returns to scale.
Only two people: Person 1 and person 2.
Slide 22

11

Problems the economy must

solve:
How to allocate the existing stock of capital
and labor efficiently between the production
of good X and the production of good Y.
How to distribute these goods efficiently
among the population once they are
produced.

Slide 23

Consumption Efficiency
You already know consumption efficiency
from the exchange economy.
A distribution of goods is consumption
efficient if it is not possible to reallocate
these goods and make at least one person in
the economy better off without making
someone else worse off.

Slide 24

12

Production Efficiency
An allocation of inputs (K and L) is
production efficient if it is not possible to
reallocate these inputs and produce more of
at least one good in the economy without
decreasing the amount of some other good
that is produced.

Slide 25

Where do the fixed amounts of

labor and capital come from?
They are determined by past actions of the society:
The amount of labor in the economy is determined by
previous amounts of births and deaths in the population,
and the size of the capital stock is determined by
previous amounts of investment and depreciation.

In any case, we consider the existing labor force

and capital stock as fixed elements that will not be
affected by anything we do in our analysis.
Slide 26

13

Production Efficiency in the 2x2

production model
Use the Edgeworth Box to depict the situation of
the production of two goods with capital and
labor.
Instead of consumer 1, we put good X on the
lower left hand corner. Instead of consumer 2, we
put good Y on the upper right hand corner.
The Edgeworth Box depicts any allocation of
labor and capital between the production of the
two goods, so that the labor inputs in the
production of both goods sum up to always the
same total amount. The same is true for capital.

Slide 27

Edgeworth Box of Production

capital

Isoquants of Y

Amount of
capital devoted
to production of
good X

Good Y

Isoquants of X

Good X

labor
Amount of labor devoted
to production of good X

Slide 28

14

Edgeworth Box of Production

Good Y

capital

A
Good X

Moving to e.g. this point

from point A we can
produce more of both
goods.

labor
Point A is not
production efficient.
Slide 29

Edgeworth Box of Production

capital

Good X

Good Y

labor

This point is production efficient: in order to produce

more of X we have to reduce production of Y and
vice versa.
Slide 30

15

How much labor, how much

capital should be used in the
production of both goods?
Analogy to the consumption efficiency.
Noting that the slope of the isoquants is the
marginal rate of technical substitution of
capital for labor, interior production
efficiency occurs when MRTSXK for
Y
L=MRTS K for L.
Slide 31

Production Efficiency
max f ( L ,K ) + ( f ( L L ,K K ) y )

L1 ,K1 ,

Interiorsolution :

f1
f
1 =0
L1
L 2
f1
f
1 =0
K1
K 2

y 2 = f 2 ( L L1,K K1 )
Slide 32

16

Condition for Interior Production

Efficiency
A given set of inputs available in an
economy should be allocated across a set of
producers until the marginal rate of
technical substitution for each pair of inputs
is equal for each producer.

Slide 33

Product Mix Efficiency

Which combination of goods will give us Paretoefficiency?
We can have efficiency in production and in
consumption, and yet there is still room for a
Pareto improvement, because we are producing
too much of one good and not enough of the other.
Product mix efficiency puts together both sides,
consumers and producers.
Slide 34

17

The Production Possibility

Frontier with 2 Inputs
While the set of Pareto efficient allocations
in the Edgeworth box of production makes
all the efficient input combinations visible,
the PPF gives us all the combinations of
goods that are production efficient.
The PPF is the value function of the
problem that gives us production efficient
allocations as its solution.
Slide 35

From Edgeworth Box of Production to PPF

Good Y

capital

X=12,
Y=28
Good X
Good Y
28

X=24,
Y=20

X=30,
Y=10

labor
PPF

20
10
12

24

30

Good X

Slide 36

18

The Slope of the PPF

Marginal rate of transformation (MRT) of good Y
into good X, indicates how many units of good Y
the economy would have to sacrifice (by
transferring inputs from the production of good Y
to the production of good X) in order to produce 1
more unit of good X.

Slide 37

Putting Production and

Consumption Together Graphically
We can draw an Edgeworth box from each
of the points on the PPF and identify the
consumption efficient allocations for each
combination of goods.
The MRS typically changes along the set of
Pareto efficient allocations. The selected
point on the PPF is product mix efficient if
MRS=MRT.
Slide 38

19

Pareto Efficiency in Graph

Person 2s highest
utility given X and Y

Good Y
X,Y
PPF

The green point gives

us an allocation of
goods that satisfies
production efficiency
and consumption
efficiency, but does it
satisfy product mix
efficiency?
Keep person 1 at
this utility level.

Good X
Slide 39

Pareto Efficiency in Graph

Good Y

PPF

X,Y

With X and Y, we have

found a point on the PPF
that allows us to increase
person 2s utility without
making person 1 worse
off as compared to X and
Y. Do we have
production efficiency
now?

Person 2s highest
utility given X and
Y
Keep person 1 at Good X
this utility level.

Slide 40

20

Pareto Efficiency in Graph

Good Y
Person 2s
highest
utility
given any
X and any
Y.

X,Y
PPF

By shifting to yet
another point on the
PPF, we can again
increase person 2s
utility without making
person 1 worse off.
X,Y

Keep person 1 at
this utility level.

Good X
Slide 41

Pareto Efficiency in Graph

Good Y
Person 2s
highest
utility
given any
X and any
Y.

Slope of PPF less steep

than slope of
indifference curves
Slope of PPF same as
slope of indifference
curves
Slope of PPF steeper
than slope of
indifference curves

Keep person 1 at
this utility level.

Good X
Slide 42

21

Suppose MRSY for X>MRTY for X.

To be more specific assume that MRSY for X=2 and

MRTY for X=1.
If we want to produce one more unit of good X,
we have to give up one unit of good Y.
Both consumers are the same off if they give up
two units of good Y and receive one more unit of
good X.
But this means that we will make both of them
better off by producing two more units of good X
and sacrificing 2 units of good Y!
Only if MRS=MRT is such a reallocation not
possible.
Slide 43

Solving for Pareto Efficient

Allocation
max u1 ( x1, y1 )

s.t. u2 ( x 2 , y 2 ) = u2

s.t. x1 + x 2 = f x ( Lx ,K x )

s.t. y1 + y 2 = f y Ly ,K y

s.t. Lx + Ly = L
s.t. K x + K y = K

Slide 44

22

Using PPF, the problem is

max u1 ( x1, y1 )

s.t. u2 ( x 2 , y 2 ) = u2

s.t. x1 + x 2 = x

s.t. y1 + y 2 = y ( x )

max u1 ( x1, y1 ) + ( u2 ( x x1, y ( x ) y1 ) u2 )

x1 ,y1 ,x,

Slide 45

Exercise
Suppose there are 2 consumers, Ara and Bahar,
and two goods, good X and good Y. Aras utility
function is given by UA=XY and Bahars utility
function is given by UB=X1/4Y3/4. Both goods are
produced with labor and capital and good Xs
production function is fX=(KXLX)1/2 while good
Ys production function is fY=(KYLY)1/2. Suppose
there are 8 units of labor and 8 units of capital in
this economy.

Slide 46

23

Exercise Contd
Suppose Ara receives one unit of good X.
How many units of good Y must Ara
receive and how many units of good X and
good Y must Bahar receive for the
allocation to be Pareto efficient?

Slide 47

Answer
Production efficiency: We have 8 units of labor
and eight units of capital. If for both goods the
capital labor ratio is equal to one, then KX/LX=1=
MPLX/MPKX and KY/LY=1= MPLY/MPKY so
MRTSX capital for labor = MRTSY capital for labor
Moreover PPF: Y= 8 X.

Slide 48

24

Answer Contd
Next we need to ensure that consumption
efficiency and product mix efficiency are satisfied.
For consumption efficiency
MRSAra Y for X = MRSBahar Y for X
We know that XB =X 1, YA + YB = 8-X
YA /XA=YB /3XB

Slide 49

Answer Contd
For product mix efficiency
MRS = MRT, YA /XA=YB /3XB = 1.
The allocation KX=LX=2.5, KY=LY=5.5,
XA=1 , XB=1.5 , YA=1, YB= 4.5 is Pareto
efficient.
We have shown that with this allocation of
resources and consumption goods all three
conditions of Pareto efficiency are satisfied.
Slide 50

25

Competitive Equilibrium
Now that we understand Pareto efficiency in
a general equilibrium model with
production, we want to find out if the
competitive equilibrium in this model is
Pareto efficient.
First discuss what happens in the
competitive equilibrium, then determine
whether its Pareto efficient.
Slide 51

Perfectly Competitive Markets Satisfy

the Conditions for Pareto Efficiency
Consumers maximize utility taking prices as
given. From utility max MRS=price ratio.
If consumers are price takers, they all face the
same prices and therefore all their marginal
rates of substitution have to be equal.
The competitive equilibrium satisfies
consumption efficiency.

Slide 52

26

Perfectly Competitive Markets Satisfy

the Conditions for Pareto Efficiency
Firms maximize profits and hence minimize
costs. From profit maximization,
MRTS=factor price ratio (because cost
minimization is a necessary condition for
profit maximization).
If all firms are price takers in the factor
markets, then all firms have equal MRTS.
The competitive equilibrium satisfies
production efficiency.
Slide 53

Perfectly Competitive Markets Satisfy

the Conditions for Pareto Efficiency
Firms maximize profits. From profit maximization
of competitive firms (if the number of firms is
sufficiently large) P=MC.
For any two goods, consumers set MRS=pX/pY.
From profit max a firm produces an amount of X where
pX=MCX, and a firm produces an amount of Y where
pY=MCY.
This implies pX/pY=MCX/MCY, but MCX/MCY=MRT
and therefore MRS=MRT.
The competitive equilibrium satisfies product mix
efficiency.
Slide 54

27

The Two Fundamental Theorems

of Welfare Economics
The First (FFTW): The competitive
equilibrium is Pareto efficient.
The Second (SFTW): Any Pareto efficient
allocation can be achieved by the
competitive equilibrium with the
appropriate redistribution of initial
endowments.
Slide 55

Market Failure and

Redistribution
Market failure addresses the issue when the
competitive equilibrium is not Pareto
efficient. Takes FFTW as starting point.
Redistribution (interventionist argument) is
unhappy with the distribution of goods
when economy is left to market forces
alone. Takes SFTW as starting point.
Slide 56

28

The Interventionist Argument

The Second Fundamental Theorem of Welfare
Economics is not very useful. It requires that
income be redistributed in such a way, that people
and firms cannot change their behavior in order to
receive more transfers/pay less taxes (only lumpsum taxes and transfers allowed). This is next to
impossible in the real world.
We then have to trade off equity for efficiency.
Slide 57

Reading Suggestion

Amarty Sen, one of the Nobel Prize winners in Economics,

has an article that examines the first and second
fundamental theorems of welfare economics. The title is
The Moral Standing of the Market, in Ellen Frankel
Paul, Fred D. Miller, Jr., and Jeffrey Paul (eds) (1985),
Ethics & Economics, pp.1-19, Basil Blackwell Publisher
Limited.
Slide 58

29

FFTW and Market Failure

Rather than equity considerations, this
approach questions whether the competitive
equilibrium is Pareto efficient.
We made several assumptions in order to
show that the competitive equilibrium is
Pareto efficient. If these assumptions do not
hold in the real world, competitive markets
are not efficient.
Slide 59

Assumptions in FFTW

Consumers and Producers are price takers. If not,

people have market power (e.g. oligopoly,
monopoly, monopsony).
Producers face DRS or CRS technology. If not,
natural monopoly.
Symmetric information. If not, people can take
advantage of their superior knowledge. Markets
may not exist, or may not be efficient.
Private goods. If not, markets provide too little of
public goods and goods with positive externalities
and too much of goods with negative externalities.
Slide 60

30