Chapter 16

General Equilibrium and Economic Efficiency

Topics to be Discussed

General Equilibrium Analysis Efficiency in Exchange Efficiency in Production

Chapter 16

Slide 2

General Equilibrium Analysis

Partial equilibrium analysis presumes that activity in one market is independent of other markets.

Chapter 16

Slide 3

General Equilibrium Analysis

General equilibrium analysis determines the prices and quantity in all markets simultaneously and takes the feedback effect into account.

Chapter 16

Slide 4

General Equilibrium Analysis

A feedback effect is a price or quantity adjustment in one market caused by price and quantity adjustments in related markets.

Chapter 16

Slide 5

General Equilibrium Analysis

Two Interdependent Markets--Moving to General Equilibrium

Scenario

The competitive markets of:

DVDs Movie theater tickets

Chapter 16

Slide 6

Two Interdependent Markets: Movie Tickets and DVDs

Price Assume the government imposes a $1 tax on each movie ticket. Price General Equilibrium Analysis: Increase in movie ticket prices increases demand for videos.

S*M

SM
$3.50

SV

$6.35

$3.00
$6.00

DV

DM
QM QM
Number of Movie Tickets

DV
QV QV
Number of Videos

Two Interdependent Markets: Movie Tickets and DVDs

Price The increase in the price of videos increases the demand for movies. Price The Feedback effects continue.

S*M
$6.82 $6.75 $6.35

SM
$3.58 $3.50

SV

$6.00

D*M DM DM
QM QM Q*M QM

$3.00

D*V DV

DV
QV QV Q*V
Number of Videos

Number of Movie Tickets

Two Interdependent Markets: Movie Tickets and DVDs

Observation

Without considering the feedback effect with general equilibrium, the impact of the tax would have been underestimated

This is an important consideration for policy makers.

Chapter 16

Slide 9

Two Interdependent Markets: Movie Tickets and Videocassette Rentals

Questions

What would be the feedback effect of a tax increase on one of two complementary goods? What are the policy implications of using a partial equilibrium analysis compared to a general equilibrium in this scenario?

Chapter 16

Slide 10

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 Trade

Trade between two parties is mutually beneficial.

Chapter 16

Slide 11

Efficiency in Exchange

Assumptions

Two consumers

Two goods
Both people know each others preferences

Exchanging goods involves zero transaction costs

James & Karen have a total of 10 units of food and 6 units of clothing.
Slide 12

Chapter 16

Efficiency in Exchange

The Edgeworth Box Diagram

Which trades can occur and which allocation will be efficient can be illustrated using a diagram called an Edgeworth Box.

Chapter 16

Slide 13

Exchange in an Edgeworth Box

Karens Food

10F 6C
The initial allocation before trade is A: James has 7F and 1C & Karen has 3F and 5C.

4F

3F

0K

The allocation after trade is B: James has 6F and 2C & Karen has 4F and 4C.

Jamess Clothing

Karens Clothing
B +1C

2C 1C

4C 5C
-1F A

6C 0J
Jamess Food

6F

7F

10F

Efficiency in Exchange

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.

Chapter 16

Slide 15

Efficiency in Exchange
10F 6C
A: UJ1 = UK1, but the MRS is not equal. All combinations in the shaded area are preferred to A.

Karens Food

0K

Jamess Clothing

D C B

Karens Clothing

UJ3
A

Gains from trade

UJ2 UJ1 6C 10F

Slide 16

UK3 UK2 0J
Chapter 16 Jamess Food

UK1

Efficiency in Exchange
10F 6C Is B efficient? Hint: is the MRS equal at B?
Jamess Clothing C Karens Food

0K

Karens Clothing

Is C efficient? and D?

UJ3
A

UJ2 UJ1 6C 10F

Slide 17

UK3 UK2 0J
Chapter 16 Jamess Food

UK1

Efficiency in Exchange

Efficient Allocations

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.

10F 6C

Karens Food

0K

Jamess Clothing

D C B A

Karens Clothing

UJ3 UJ2 UJ1 10F

0J

UK3 UK2 UK1

Jamess Food

6C

Chapter 16

Slide 18

Efficiency in Exchange

The Contract Curve

To find all possible efficient allocations of food and clothing between Karen and James, we would look for all points of tangency between each of their indifference curves.

Chapter 16

Slide 19

The Contract Curve

E, F, & G are Pareto efficient . If a change improves efficiency, everyone benefits. Karens Food

0K

Contract Curve

G
Jamess Clothing

F
E

Karens Clothing

0J
Chapter 16

Jamess Food Slide 20

Efficiency in Exchange

Observations 1) All points of tangency between the indifference curves are efficient. 2) The contract curve shows all allocations that are Pareto efficient.

Pareto efficient allocation occurs when trade will make someone worse off.

Chapter 16

Slide 21

Efficiency in Exchange

Consumer Equilibrium in a Competitive Market

Competitive 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.

Chapter 16

Slide 22

Efficiency in Exchange

Consumer Equilibrium in a Competitive Market

There are many Jameses and Karens. They are price takers Price of food and clothing = 1 (relative prices will determine trade)

Chapter 16

Slide 23

Competitive Equilibrium
Karens Food

10F

0K

6C
PP is the price line and shows possible combinations; slope is -1

Price Line
P

Begin at A: Each James buys 2C and sells 2F Each James would move from Uj1 to Uj2, which is preferred (A to C).

Jamess Clothing
Begin at A: Each Karen buys 2F and sells 2C. Each Karen would move from UK1 to UK2, which is preferred (A to C).

Karens Clothing

UJ2

A
UK2 UK1

UJ1

P 10F

6C

0J

Jamess Food

Competitive Equilibrium
Karens Food

10F

0K

6C
P

Price Line

At the prices chosen: Quantity food demanded (Karen) equals quantity food supplied (James)--competitive equilibrium.

Jamess Clothing
At the prices chosen: Quantity clothing demanded (James) equals quantity clothing supplied (Karen) --competitive equilibrium.

Karens Clothing

UJ2

A
UK2 UK1

UJ1

P 10F

6C

0J

Jamess Food

Efficiency in Exchange

Scenario

PF and 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
Slide 26

Chapter 16

Efficiency in Exchange

Questions

How would the market reach equilibrium? How does the outcome from the exchange with many people differ from the exchange between two people?

Chapter 16

Slide 27

Efficiency in Exchange

The Economic Efficiency of Competitive Markets

It can be seen at point C (as shown on the next slide) that the allocation in a competitive equilibrium is economically efficient.

Chapter 16

Slide 28

Competitive Equilibrium
Karens Food

10F 6C P Price Line

0K

Jamess Clothing

Karens Clothing

UJ2

A
UK2 UK1

UJ1

P 10F

6C

0J

Jamess Food

Chapter 16

Slide 29

Efficiency in Exchange

Observations concerning C: 1) Since the two indifference curves are tangent, the competitive equilibrium allocation is efficient. 2) The MRSCF is equal to the ratio of the prices, or MRSJFC = PC/PF = MRSKFC.

Chapter 16

Slide 30

Efficiency in Exchange

Observations concerning C: 3) If the indifference curves were not tangent, trade would occur. 4) The competitive equilibrium is achieved without intervention.

Chapter 16

Slide 31

Efficiency in Exchange

Observations concerning C: 5) In a competitive marketplace, all mutually beneficial trades will be completed and the resulting equilibrium allocation of resources will be economically efficient (the first theorem of welfare economics)

Chapter 16

Slide 32

Equity and Efficiency

Equity and Perfect Competition

A competitive equilibrium leads to a Pareto efficient outcome that may or may not be equitable.

Chapter 16

Slide 33

Equity and Efficiency

Points on the frontier are Pareto efficient.

Karens Utility

OJ & OK are perfect unequal distributions and Pareto efficient. To achieve equity (more equal distribution) must the allocation be efficient?

OJ

OK
Jamess Utility

Chapter 16

Slide 34

Efficiency in Production

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
Slide 35

Chapter 16

Efficiency in Production

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
Slide 36

Chapter 16

Efficiency in Production

Production in the Edgeworth Box

The Edgeworth box can be used to measure inputs to the production process.

Chapter 16

Slide 37

Efficiency in Production

Production in the Edgeworth Box

Each axis measures the quantity of an input Horizontal: Labor, 50 hours Vertical: Capital, 30 hours

Origins measure output OF = Food OC = Clothing

Slide 38

Chapter 16

Efficiency in Production
50L 30K
Efficiency A is inefficient Labor in clothing production Shaded area 30L is preferred to A 20L 40L 10L B and C are efficient The production contract curve shows 80F all combinations that are efficient

0C

25C

10C
20K
Capital in food production Each point 10K measures inputs to the production A: 35L and 5K--Food B: 15L and 25K--Clothing Each isoquant shows input combinations for a given output Food: 50, 60, & 80 Clothing: 10, 25, & 30

D 10K
Capital in clothing production

30C

C B A 60F
20K

50F
20L 30L 40L

0F

10L

30K 50L

Labor in Food Production

Efficiency in Production

Producer Equilibrium in a Competitive Input Market

Competitive markets create a point of efficient production.

Chapter 16

Slide 40

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.
Slide 41

Chapter 16

Efficiency in Production
50L 30K 40L Labor in clothing production 30L 20L 10L 0C

80F 25C
D 10K
Capital in clothing production

10C
20K
Capital in food production

30C

C B A 60F
20K

10K Discuss the adjustment process that would Move the producers from A to B or C.

50F
0F
10L 20L 30L 40L

30K 50L

Labor in Food Production

Efficiency in Production

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

Chapter 16

Slide 43

Production Possibilities Frontier

Clothing (units) OF 60

Why is the production possibilities frontier downward sloping? Why is it concave?

B, C, & D are other possible combinations.

B C

A
OF & OC are extremes.

D
OC 100

A is inefficient. ABC triangle is also inefficient due to labor market distortions.

Food (Units) Slide 44

Chapter 16

Production Possibilities Frontier

Clothing (units) OF 60
1C 1F

MRT = MCF/MCC

B D C
2C 1F

A
The marginal rate of transformation (MRT) is the slope of the frontier at each point.

D
OC 100 Food (Units) Slide 45

Chapter 16

Efficiency in Production

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
Slide 46

Chapter 16

Efficiency in Production

Assume

MRT = 1 and MRT = 2

Consumers will give up 2 clothes for 1 food

Cost of 1 food is 1 clothing Too little food is being produced Increase food production (MRS falls and MRT increases)
Slide 47

Chapter 16

Output Efficiency
Clothing (units) 60
MRS = MRT

How do you find the MRS = MRT combination with many consumers who have different indifference curves?

Production Possibilities Frontier

Indifference Curve

100
Chapter 16

Food (Units) Slide 48

Efficiency in Production

Efficiency in Output Markets

Consumers Budget Allocation

MRS PF PC

Profit Maximizing Firm

PF MC F and PC MC C

MC F PF MRT MRS MC C PC
Slide 49

Chapter 16

Competition and Output Efficiency

Clothing (units) 60 C1
1 1 PF / PC MRT @ A(C1 , F1 )
A shortage of food and surplus of clothing causes the price of food to increase and the price of clothing to decrease.

B
C2 C* C U2
Adjustment continues until PF = PF* and PC = PC*; MRT = MRS; QD = QS for food and clothing.

U1

F1 Chapter 16

F*

F2 100

Food (Units) Slide 50

An Overview---The Efficiency of Competitive Markets

Conditions Required for Economic Efficiency

Efficiency in Exchange

MRS
Chapter 16

J FC

MRS

K FC

Slide 51

An Overview---The Efficiency of Competitive Markets

Conditions Required for Economic Efficiency

Efficiency in Exchange (for a competitive market)

MRS
Chapter 16

J FC

PF / PC MRS
Slide 52

K FC

An Overview---The Efficiency of Competitive Markets

Conditions Required for Economic Efficiency

Efficiency in the Use of Inputs in Production

MRTS
Chapter 16

F LK

MRTS

C LK

Slide 53

An Overview---The Efficiency of Competitive Markets

Conditions Required for Economic Efficiency

Efficiency in the Use of Inputs in Production (for a competitive market)

MRTS
Chapter 16

F LK

w / r MRTS
Slide 54

C LK

An Overview---The Efficiency of Competitive Markets

Conditions Required for Economic Efficiency

Efficiency in the Output Market

MRTFC MRS FC (for all consumers)

Chapter 16

Slide 55

An Overview---The Efficiency of Competitive Markets

Conditions Required for Economic Efficiency

Efficiency in the Output Market (in a competitive market)

PF MC F , PC MC C MRTFC MC F / MC C PF / PC
Chapter 16 Slide 56

An Overview---The Efficiency of Competitive Markets

Conditions Required for Economic Efficiency

However, consumers maximize their satisfaction in competitive markets only if

PF / PC MRS FC (for all consumers) Therefore, MRS FC MRTFC

Chapter 16 Slide 57

Why Markets Fail

Market Power

In a monopoly in a product market, MR <P

MC

= MR output than a competitive market

Lower

Resources
Inefficient

allocated to another market

allocation

Chapter 16

Slide 58

Why Markets Fail

Market Power

Monopsony in the labor market

Restricted
wf

supply of labor in food

would rise, wL would fall input:

Clothing

MRTS C LK wc / r
Food

input:

C MRTS F w / r w / r MRTS LK F c LK
Chapter 16 Slide 59

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 parties which changes the cost and benefits of decisions and create inefficiencies.
Slide 60

Chapter 16

Summary

Partial equilibrium analyses of markets assume that related markets are unaffected, while general equilibrium analyses examine all markets simultaneously.

An allocation is efficient when no consumer can be made better off by trade without making someone else worse off.
Slide 61

Chapter 16

Summary

A competitive equilibrium describes a set of prices and quantities, so that when each consumer chooses his or her most preferred allocation, the quantity demanded is equal to the quantity supplied in every market.

The utility possibilities frontier measures all efficient allocations in terms of the levels of utility that each person achieves.
Slide 62

Chapter 16

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.

Chapter 16

Slide 63

Summary

The production possibilities frontier measures all efficient allocations in terms of the levels of output that can be produced with a given combination of inputs. Efficiency in the allocation of goods to consumers is achieved only when the MRS of one good for another in consumption is equal to the MRT of one good for another in production.
Slide 64

Chapter 16

End of Chapter 16 General Equilibrium and Economic Efficiency