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Chapter 12 Chapter 12 © 2006 Thomson Learning/South- Western General Equilibrium and Welfare

Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Page 1: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

Chapter 12Chapter 12

© 2006 Thomson Learning/South-Western

General Equilibrium and Welfare

Page 2: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

2

An Illustration of General Equilibrium

Figure 12-1 shows the market for tomatoes and three of the many other market related to it: The market for tomato pickers. The market for a related product --cucumbers. The market for cucumber pickers.

The initial equilibrium is shown by the darker demand and supply curves.

Page 3: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Price

P1

D

S

Tomatoes(a) Market for Tomatoes0

Wages

W1

D

S

Tomato pickers(b) Market for Tomato Pickers0

Price

P2

D

S

Cucumbers(c) Market for Cucumbers

0

Wages

W2

D

S

Cucumber pickers

(d) Market for Cucumber Pickers

0

FIGURE 12-1: The Market for Tomatoes and Several Related Markets

Page 4: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Disturbing the Equilibrium

Assume the government announces that tomatoes cure the common cold, resulting in an increase in demand. Initially, this would shift the demand curve for

tomatoes outward to D’. The increase in tomatoes prices brought

about by the increase in demand stimulates the demand for more tomato pickers which shifts outward to D’.

Page 5: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Disturbing the Equilibrium

The higher wages for tomato pickers increases the costs for tomato growers, shifting the tomato supply curve back to S’.

If the demand for cucumbers decreased because of the increase in demand for tomatoes.

This decreases the price of cucumbers and leads to less produced.

The demand for cucumber pickers falls, and their wages also decrease.

Page 6: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Reestablishing Equilibrium

Eventually we would expect each market to eventually reach a new equilibrium. The new equilibrium in Figure 12-1 is shown

by the lighter colored demand and supply curves.

There is a rise in tomato prices (to P3), an increase in tomato picker wages (to w3), a fall in cucumber prices (to P4), and a fall in cucumber picker wages (to w4).

Page 7: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Price

P3

P1

S’

D’D

S

Tomatoes(a) Market for Tomatoes0

Wages

W3

W1

D’

D

S

Tomato pickers(b) Market for Tomato Pickers0

Price

P2

P4

D’D

S

Cucumbers(c) Market for Cucumbers

0

Wages

W4

W2

D’D

S

Cucumber pickers(d) Market for Cucumber Pickers

0

FIGURE 12-1: The Market for Tomatoes and Several Related Markets

Page 8: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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An Efficient Mix of Outputs

A technically efficient allocation of resources in which the output combination also reflects people’s preferences is an economically efficient allocation of resources.

Figure 12-2 illustrates the requirements for economic efficiency in the mix of outputs.

Page 9: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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A Simple General Equilibrium Model

The best use of resources is achieved at point E.

This point is the utility maximizing choice where the person’s indifference curve is tangent to the production possibility frontier.

Point E is defined as an economically efficient allocation of resources.

Page 10: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Quantityof Y

per weekP

G

U1

U2

U3

E

F

Quantity of X per week0

P’

FIGURE 12-2: Efficiency of Output Mix

Page 11: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Efficiency in Output Mix

Profit maximizing firms will equate the rate at which they can trade X for Y in production to the equilibrium price ratio.

Utility maximizing people will equate their MRS to the equilibrium price ratio.

Thus, RPT equals MRS, which, when demand equals supply, meets the requirements for economic efficiency.

Page 12: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Efficiency of Perfect Competition

With an arbitrary initial price ratio, in Figure 12-3, profit maximizing firms will produce the output combination X1, Y1.

Societies’ budget constraint, CC, must go through this point since the value of income must equal the value of output.

Page 13: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Quantityof Y

per week

Y1

P

Y*

Y’1

C

C

Initial prices

Quantity of X per weekX10 X*

U2

U3

X’1P’

FIGURE 12-3: How Perfectly Competitive Prices Bring about Efficiency

Page 14: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Quantityof Y

per week

Y1

P

Y*

Y’1

C*

C*

E

C

C

Efficient prices

Initial prices

Quantity of X per weekX10 X*

U2

U3

X’1P’

FIGURE 12-3: How Perfectly Competitive Prices Bring about Efficiency

Page 15: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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A Graphic Demonstration

The market will cause prices to move toward their equilibrium levels P*X and P*Y.

People will respond to the changes in prices by substituting Y for X in their consumption choices.

These action will eliminate the excess demand for X and the excess supply for Y.

Equilibrium is reached at X*, Y* with equilibrium prices P*

X and P*Y.

Page 16: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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A Graphic Demonstration

At this price ratio, supply and demand are equilibrated for both goods.

Profit maximizing firms will produce X* and Y*. With the income generated, individuals will

maximize utility by choosing X* and Y*. Competitive market have generated an

efficient allocation of resources.

Page 17: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Why Markets Fail to Achieve Economic Efficiency--Imperfect Competition

Imperfect competition is a market situation in which buyers or sellers have some influence on the prices of goods or services.

In this case, the firm is not a price taker so marginal revenue does not equal price.

Relative prices do not reflect relative marginal costs, and inefficiency can result (for example, monopoly dead-weight loss).

Page 18: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Externalities represent additional costs--those that arise from the external damage.

The firm, however, only responds to private input costs, it disregards the social costs of pollution.

This results in a gap between market price and social marginal cost, which leads to a misallocation of resources.

Why Markets Fail to Achieve Economic Efficiency-- Externalities

Page 19: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Price cannot equal marginal cost (which is zero), since the fixed cost of providing the good would not be covered.

The incentive is for people to refuse to pay for the good hoping others will purchase, and thus provide the good.

This causes society to not allocate enough resources to public goods.

Why Markets Fail to Achieve Economic Efficiency-- Public Goods

Page 20: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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It has been assumed that economic actors are fully informed, especially about equilibrium market prices.

Without this information, the “invisible hand” results do not hold.

Without perfect information, a consumer would have problems (costs) finding quality and the prices charged by different firms.

Why Markets Fail to Achieve Economic Efficiency-- Imperfect Information

Page 21: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Efficiency and Equity

Equity is the fairness of the distribution of goods or utility.

A primary problem with this concept is developing an accepted definition of “fair” or “unfair” allocations of resources.

Opinions vary from, an allocation is fair if no laws are broken in obtaining it to a fair allocation requires all people share equally.

Page 22: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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The Edgeworth Box Diagram

The Edgeworth box diagram is a graphic device for illustrating all of the possible allocations of two goods (or two inputs) that are in fixed supply. It can be used to show how the production

possibility frontier is constructed. It can also be adapted to illustrate voluntary

exchange between two individuals.

Page 23: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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The Edgeworth Box Diagram for Exchange

For consumer Smith, quantities of X are measured along the horizontal axis rightward from her axis OS, and quantities of Y are shown along the vertical axis above OS.

Consumption for the other consumer, Jones, is shown starting from the origin OJ.

At point E, for example, Smith gets XES, YE

S and Jones gets XE

J, YEJ.

Page 24: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Total X

Total Y

YS

E

XS

E

YJ

E

XJ

E

OS

OJ

E

FIGURE 12-4: Edgeworth Box Diagram

Page 25: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Mutually Beneficial Trades

Smith’s indifference curve map is drawn with origin OS. Movements in the northeasterly direction

represent higher levels of utility for Smith. Jones’s indifference curve map is drawn

with origin OJ. Movements in a southwesterly direction

represent higher levels of utility for Jones.

Page 26: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Total Y

Smith’s Y

Jones’s Y

Smith’s X

Jones’s X

Total XOS

OJ

US4

UJ

4US

3

3

2

1

M1

M2

M3

M4

US

2

US

1E

F

UJ

UJ

UJ

FIGURE 12-5: Edgeworth Box diagram of Pareto Efficiency in Exchange

Page 27: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Mutually Beneficial Trades

Any point for which the MRS for Smith is unequal to that for Jones represents an allocation where mutually beneficial trades can take place.

Such a point, E, is shown where the indifference curves intersect.

Any point inside the oval-shaped area represent mutually beneficial trades.

Page 28: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Efficiency in Exchange

When the marginal rates of substitution are equal, such as points M1 through M4, mutually beneficial trades are no longer possible. Movements away from these tangency positions

result in at least one person being made worse off. The movement from M2 to E, for example, makes

Smith worse off and Jones no better off.

Page 29: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Contract Curve

The contract curve is the set of efficient allocations of the existing goods in an exchange situation. Points off that curve are necessarily inefficient, since individuals can be made unambiguously better-off by moving to the curve. In Figure 12-5, this curve is the set of points,

such as M2, on the line connecting OS to OJ.

Page 30: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Contract Curve

A movement to the curve from off the curve represents mutually beneficial trades, but a movement along the curve does not since one of the parties is always worse off.

If the contract curve is interior to the Edgeworth box, the individuals’ MRS will be equal along the curve.

Page 31: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Smith’s Y

Jones’s Y

Smith’s X

Jones’s X

OS

OJ

M2

M1

M3 3

M4

E

A

Total X

4

4

3

UJ

2

1

US

2

1

Tota

l Y

UJ

UJ

UJ

US

US

US

FIGURE 12-6: Voluntary Transactions May Not Result in Equitable Allocations

Page 32: Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

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Efficiency and Equity

Point E lies outside of the region on the contract curve, between M2 and M3, which is mutually preferable to point A.

Smith would not voluntarily agree to point E since she would be made worse off.

With unbalanced initial endowment, a equal allocation is not possible through mutually beneficial trade.