Chapter 10

General Equilibrium
and Economic Welfare

Capitalism is the astounding belief that

the most wickedest of men will do the
most wickedest of things for the
greatest good of everyone.
John Maynard Keynes
Chapter 10 Outline

10.1 General Equilibrium

10.2 Trading Between Two People
10.3 Competitive Exchange
10.4 Production and Trading
10.5 Efficiency and Equity

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Chapter 10 Introduction
Market equilibrium is efficient if:
Consumption is efficient
If there is no reallocation to make someone better off
and no one worse off
Production is efficient
If not possible to produce more output at current cost
given current knowledge and technology
Pareto improvement: reallocation of goods
between people that helps at least one person
without harming anyone else
Pareto efficiency: no Pareto improvement
possible
Is outcome equitable? Requires value judgment

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10.1 General Equilibrium

Partial-equilibrium analysis: examination of one

market in isolation
General-equilibrium analysis: considers (all)
markets simultaneously
Especially important for closely related markets
Example:
Discovery of oil deposits in Alberta
Demand for labor in oil sector rises dramatically
Labor and capital become more expensive
Affects all markets in that province simultaneously (spillover
effects)

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Example: related labor markets
Suppose the supply of labor is
Labor demand in oil sector is and labor
demand in service sector is
What is the equilibrium?

Now demand in oil sector increases:

Employment in service sector decreases,

wage higher
(Does not take into account higher income)
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Clicker example

Two countries, free trade in goods

Demands
Supply
What is the new price in country 2 when
country 1 levies a tariff of $12 per unit?
Note that there are different prices in the
two countries now:

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10.2 Trading Between Two People

General-equilibrium model can be used to show that

free trade is Pareto efficient
After all voluntary trades have occurred, cannot
reallocate goods to make one person better off without
harming another
Consider example of neighbors, Jane and Denise, who
each have an initial endowment of firewood and candy
Jane: 30 cords of firewood and 20 candy bars
Denise: 20 cords of firewood and 60 candy bars
These endowments can be shown graphically using
indifference curves

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10.2 Trading Between Two People

Jane and Denise before they engage in trade

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10.2 Trading Between Two People

If Jane and Denise do not trade, can each only consume

their initial endowments
To see whether Jane and Denise would benefit from
trading, we use an Edgeworth box
An Edgeworth box illustrates trade between two
people with fixed endowments of two goods
It is useful in general equilibrium models because both
markets are being affected simultaneously

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10.2 Trading Between Two People

Initial endowments place Jane and Denise at point e,

but area B holds more preferred bundles for both.

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10.2 Trading Between Two People

Should Jane and Denise trade? Yes

We make four assumptions about tastes and behavior:
1.Utility maximization: Each person maximizes utility
2.Usual-shaped indifference curves: Each persons
indifference curves have usual convex shape
1. Completeness
2. Transitivity
3. Nonsatiation
3.No interdependence: Neither persons utility depends
on the others consumption and neither persons
consumption harms the other person

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10.2 Trading Between Two People
No further trade is possible at a bundle like f, which is:
A mutually beneficial trade (compared to e)
On the contract curve, and therefore Pareto optimal. Note that
Janes MRS is equal to Denises MRS at point f.

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RECAP
Pareto-improvement: make at least one
person better off and no one worse off
Pareto-efficient: no improvement possible
General equilibrium: markets are
interdependent
Trading with two people: if MRS different,
trade is beneficial
Voluntary trading occurs until MRS equal
(contract curve)

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10.2 Trading Between Two People
No further trade is possible at a bundle like f, which is:
A mutually beneficial trade (compared to e)
On the contract curve, and therefore Pareto optimal. Note that
Janes MRS is equal to Denises MRS at point f.

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10.2 Trading Between Two People

The contract curve is set of all Pareto-efficient

bundles:
Unwilling to engage in further trades, or contracts, only
at points along contract curve
Contract curve is derived by maximizing Janes utility
subject to leaving Denises utility unchanged (or vice
versa)
Implies that indifference curves have same slope:
MRSj = MRSd

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Today

Competitive Exchange
Production and Trading
Comparative Advantage

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10.3 Competitive Exchange

Without knowledge of trading process, we only know

that Jane and Denise trade to some allocation on
contract curve
With voluntary trades only, each person cannot be worse off than
at initial endowment
With knowledge of trading process, we can determine
final allocation
Consider competitive exchange, where each person
takes prices as given

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10.3 Competitive Exchange

Given prices of the two goods, price line can be added

to Edgeworth box
Price line represents all combinations of goods that
Jane could get by trading, given her endowment
(budget constraint)
Same for Denise
If price of firewood is $2 and price of candy bar is $1,
then price line indicates that Jane would choose to trade
wood for candy and move from e to f
Similarly, given those prices, Denise would prefer to
trade candy for wood and move from point e to f

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10.3 Competitive Exchange

Prices of candy and wood establish price line

At these prices, Jane sells wood to Denise, and Denise sells
candy to Jane. They trade to Pareto optimal allocation, f.

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10.3 Competitive Equilibrium
Prices that set this price line are not consistent with
competitive equilibrium

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Example: Edgeworth economy

Ken and Barby each have utility function

over dolls and doll houses :
Ken initially has 20 dolls and Barby has 4
houses and 4 dolls
Call the price of houses in terms of dolls
Demands for dolls are
and and total
Supply is , so or

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Clicker example

Ann and Bob each have utility function over

food and clothes :
Ann has initially 20 F and 10 C, whereas Bob
has 30 F and 10 C
Remember demands for clothes are

What is the relative price of clothes?

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10.4 Production and Trading

So far discussion of trade entirely about consumption,

but what about production?
Production capabilities can be summarized by
production possibility frontier (PPF)
PPF shows maximum combination of two outputs that
can be produced from given amount of input
In our example, assume:
Jane can use her labor to produce up to 3 candy bars
or 6 cords of firewood in a day
Denise can use her labor to produce up to 6 candy bars
or 3 cords of firewood in a day

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10.4 Production and Trading

PPF curves can be combined to show joint productive

capacity

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10.4 Production and Trading

Slope of production possibility frontier is the marginal

rate of transformation (MRT)
MRT indicates how much more wood can be produced if
production of candy is reduced by one bar
More generally, MRT shows how much it costs to
produce one good in terms of forgone production of the
other good

Comparative advantage in producing a good goes to

person who can produce good at lower opportunity cost
Jane has comparative advantage in producing wood
Denise has comparative advantage in producing candy

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RECAP
Competitive markets: no strategic buying or
selling, prices such that markets clear
Find income depending on prices
Find individual demands depending on income
and prices
Find aggregate demand and supply
Equate demand and supply, solve for price
Only relative prices matter; if all markets
but one clear, last one clears too [remember
that these are barter economics]

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Today

Production and trade

Comparative advantage
Efficiency of competitive markets
Efficiency versus equity (if time)

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10.4 Production and Trading

PPF curves can be combined to show joint productive

capacity

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10.4 Production and Trading

Slope of production possibility frontier is the marginal

rate of transformation (MRT)
MRT indicates how much more wood can be produced if
production of candy is reduced by one bar
More generally, MRT shows how much it costs to
produce one good in terms of forgone production of the
other good

Comparative advantage in producing a good goes to

person who can produce good at lower opportunity cost
Jane has comparative advantage in producing wood
Denise has comparative advantage in producing candy

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10.4 Benefits of Trade

Differences in MRTs imply that both can benefit from trade

Assume both like to consume wood and candy in equal
proportions
Without trade, each produces 2 candy bars and 2 cords of
wood each day
With trade:
Denise specializes in candy production and makes 6 candy bars
Jane specializes in firewood production and makes 6 cords of wood
If production is split equally, each gets 3 candy bars and 3 cords of
wood each day!
Trade improves welfare when comparative advantage is
followed

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10.4 The Number of Producers

With just two producers Jane and Denise PPF has

one kink
As other methods of production with different MRTs are
added, PPF gets more kinks
As number of different producers gets very large, PPF
becomes a smooth curve that is concave to the origin
MRT along this smooth PPF tells us about marginal cost
of producing one good relative to the other

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Comparative Advantage
You can cook one meal in two hours and do
one load of laundry in 5 hours
Your partner can cook one meal in one hour
and one load of laundry in 4.5 hours
Your partner has absolute advantage in both, but
comparative advantage in cooking
You have a comparative advantage for doing
laundry
If you trade, you should exchange along
the lines of comparative advantage
You do laundry for you partner, your partner
cooks for you
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Comparative Advantage II
Imagine you both have Cobb-Douglas utility
with demands and , your partner has 16
hours, you have 20 hours
What if each specializes? Your income is
then and your partners is 16
Total demand for cooking is and supply is 16,
so

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 Comparative Advantage III
Is our assumption, that each specializes, right?
You dont want to switch to cooking
(4x0.2>1x0.5) and your partner does not want to
switch to doing laundry (1x1>2/9x4)
Generally, for which range of prices would each
person want to do an activity?
If , both cook
If , partner cooks, you do laundry
If , both do laundry

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Clicker example

Britain produces 10 textiles per worker or 1

barrel of wine; it has 15 workers
Portugal produces 6 textiles per worker or 5
barrels of wine; it has 10 workers
Each countrys utility function is
Each country will specialize in its
comparative advantage
What is the price of wine (in textiles)?

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10.4 Optimal Product Mix

Individuals utility is maximized at point a, where PPF

touches indifference curve ()

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10.4 Competition

Each price-taking consumer picks a bundle of goods

such that:

If all relative prices are the same for all individuals in

competitive equilibrium, all will have equal MRSs and no
further trades can occur
The competitive equilibrium achieves consumption
efficiency
Impossible to redistribute goods to make one person
better off without making someone worse off

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10.4 Competition

Each competitive firm sells a quantity of candy (c) and wood

(w) such that price equals marginal cost:

Taking the ratio of these and combining with the fact that
MRT is the ratio of marginal costs yields:

Thus, competition insures an efficient product mix:

The rate at which firms can transform one good into another
equals the rate at which consumers are willing to substitute
between
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10.4 Competitive Equilibrium

At the competitive equilibrium, the relative prices that

firms and consumers face are the same.

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10.4 The Efficiency of Competition

General-equilibrium models can show that a competitive

market has two desirable properties:
1.Competitive equilibrium is efficient (1st welfare theorem)
i. No externalities
ii. Perfect competition (no market power)
iii. Perfect information
iv. Agents are rational
2.Any efficient allocation can be achieved by competition
through distribution (2nd welfare theorem)
i. Distribution of endowments only
ii. May not change behavior

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