Chapter 16 Slide 1

General Equilibrium Analysis

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

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

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

DVDM

Two Interdependent Markets (Movie Tickets and Videocassette Rentals) Moving to General Equilibrium

Price

Numberof Videos

Price

Number ofMovie Tickets

SMSV

$6.00

QMQV

$3.00

$6.35

Q’M

S*M

Assume the governmentimposes a $1 tax on

each movie ticket.

Q’V

D’V

$3.50

General Equilibrium Analysis:Increase in movie ticket pricesincreases demand for videos.

DVDM

Two Interdependent Markets (Movie Tickets and Videocassette Rentals) Moving to General Equilibrium

Price

Numberof Videos

Price

Number ofMovie Tickets

SMSV

$6.00

QMQV

$3.00

The Feedback effects continue.

$3.58

Q*V

D*V

$6.35

Q’M

D*M

$6.82

Q*M

S*M

Q’V

D’V

$3.50

D’M

Q”M

$6.75

The increase in the priceof videos increases the

demand for movies.

Chapter 16 Slide 4

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 TradeTrade between two parties is mutually

beneficial.

Chapter 16 Slide 5

Efficiency in Exchange

AssumptionsTwo consumers (countries)Two goodsBoth people know each others

preferencesExchanging goods involves zero

transaction costsJames & Karen have a total of 10 units of

food and 6 units of clothing.

Chapter 16 Slide 6

The Advantage of Trade

James 7F, 1C -1F, +1C 6F, 2C

Karen 3F, 5C +1F, -1C 4F, 4C

Individual Initial Allocation Trade Final Allocation

Karen’s MRS of food for clothing is 3.James’s MRS of food for clothing is 1/2.

Karen and James are willing to trade: Karentrades 1C for 1F. When the MRS is not equal,there is gain from trade. The economically

efficient allocation occurs when the MRS is equal.

Exchange in an Edgeworth Box

10F 0K

0J

6C

10F

6C

James’sClothing

Karen’sClothing

Karen’s Food

James’s Food

2C

1C 5C

4C

4F 3F

7F6F

+1C

-1F

The allocation after trade is B: James

has 6F and 2C & Karen has 4F and 4C.

A

B

The initial allocation before trade is A: James has 7F and 1C & Karen

has 3F and 5C.

Chapter 16 Slide 8

A

A: UJ1 = UK

1,but the MRSis not equal.

All combinationsin the shaded

area arepreferred to A.

Gains fromtrade

Karen’sClothing

Karen’s Food

UK1UK

2UK3

James’sClothing

James’s Food

UJ1

UJ2

UJ3

B

C

D

Efficiency in Exchange

10F 0K

0J

6C

10F

6C

Is B efficient?Hint: is theMRS equal

at B?

Is C efficient?and D?

Chapter 16 Slide 9

Efficiency in Exchange

A

Karen’sClothing

Karen’s Food

UK1UK

2UK3

James’sClothing

James’s Food

UJ1

UJ2

UJ3

B

C

D

10F 0K

0J

6C

10F6C

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.

The Contract Curve: to find all possible efficient allocations of food and clothing between Karen and James, we look for all points of tangency between each of their indifference curves.

Chapter 16 Slide 10

The Contract Curve

0J

James’sClothing

Karen’sClothing

0KKaren’s Food

James’s Food

E

F

G

ContractCurve

E, F, & G arePareto efficient . If a change improvesefficiency, everyonebenefits.

Chapter 16 Slide 11

Efficiency in Exchange

Application: The policy implication of Pareto efficiency when removing import quotas:

1) Remove quotas Consumers gain Some workers lose

2) Subsidies to the workers that cost less than the gain to consumers

Chapter 16 Slide 12

Efficiency in Exchange

Equilibrium in a Competitive MarketCompetitive 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.

There are many Jameses and Karens.

They are price takers

Price of food and clothing = 1 (relative prices will determine trade)

UK1UK

2

P

Price Line

P’

PP’ is the price lineand shows possible

combinations; slope is -1

UJ1

UJ2

Competitive Equilibrium

10F 0K

0J

6C

10F

6C

James’sClothing

Karen’sClothing

Karen’s Food

James’s Food

C

A

Begin at A:Each James buys 2C and sells 2FEach James would move fromUj1 to Uj2, which is preferred (A to C).

Begin at A:Each Karen buys 2F and sells 2C. Each Karen would move fromUK1 to UK2, which is preferred (A to C).

At the prices chosen: Qdclothing (James) = Qsclothing (Karen) – competitive equilibrium.

At the prices chosen: Qd food (K) = Qs food (J) – competitive equilibrium.

Chapter 16 Slide 14

Competitive Equilibrium

10F 0K

0J

6C

10F

6C

James’sClothing

Karen’sClothing

Karen’s Food

James’s Food

P

Price Line

UJ1

UK1

A

P’

UJ2

UK2

C

Point C shows that theallocation in a competitiveequilibrium is economicallyefficient. If the ICs were nottangent, trade would occur. The competitive equilibriumIs achieved w/o intervention.

The MRSCF is equal to the ratio of the prices, or MRSJ

FC = PC/PF = MRSK

FC.

Chapter 16 Slide 15

Equity and Efficiency

In a competitive market, all mutually beneficial trades take place and the resulting equilibrium allocation of resources will be economically efficient (the first theorem of welfare economics)

Is an efficient allocation also an equitable allocation?Economists and others disagree about how to

define and quantify equity.

Chapter 16 Slide 16

H

*Movement from one combination to another (E to F) reduces one person’s utility.*All points on the frontier are efficient.

Utility Possibilities Frontier

James’s Utility

OJ

OK

E

F

G

Karen’sUtility

L

*Any point inside the frontier (H) is inefficient.*Combinations beyond the frontier (L) are not obtainable.

Lets compare H to E&F. E&F are efficient: E&F make one person

better off without making the other worse off.

The Utility Possibilities Frontier indicates the level of satisfaction that each of two people achieve when they have traded to an efficient outcome on the contract curve.

Chapter 16 Slide 17

Equity and Efficiency

Is H equitable?

Assume the only choices are H & G

Is G more equitable? It depends on one’s perspective.

At G James’ total utility > Karen’s total utility

H may be more equitable because the distribution is more equal, therefore, an inefficient allocation may be more equitable.

James’s Utility

Karen’sUtility

OJ

OK

E

F

HG

Chapter 16 Slide 18

Equity and Efficiency

Equity & Perfect Comp.: A competitive equilibrium leads to a Pareto efficient outcome that may or may not be equitable.

Points on the frontier are Pareto efficient.

OJ & OK are perfect unequal distributions and Pareto efficient.

To achieve equity (more equal distribution) must the allocation be efficient?

James’s Utility

Karen’sUtility

OJ

OK

Chapter 16 Slide 19

Efficiency in Production

AssumeFixed 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

Chapter 16 Slide 20

Efficiency in Production

Production in the Edgeworth BoxEach axis measures the quantity of an

inputHorizontal: Labor, 50 hoursVertical: Capital, 30 hours

Origins measure outputOF = FoodOC = Clothing

60F

50F

40L 30L

Labor in clothing production

Efficiency in Production

50L 0C

0F

30K

Capitalin clothingproduction

20L 10L

20K

10K

10L 20L 30L 40L 50L

Capitalin food

production

10K

20K

30K

30C

25C

10C

80F

Labor in Food Production

B

C

D

A

Each point measures inputs to the production A: 35L and 5K--FoodB: 15L and 25K--ClothingEach isoquant shows inputcombinations for a given outputFood: 50, 60, & 80Clothing: 10, 25, & 30

EfficiencyA is inefficientShaded area is preferred to AB and C are efficientThe production contract curve shows all combinations that are efficient

Chapter 16 Slide 22

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.

Chapter 16 Slide 23

Efficiency in Production: Production Possibilities Frontier (derived from the contract curve)

Food(Units)

Clothing(units)

OF & OC are extremes.

Why is the productionpossibilities frontier

downward sloping? Why is it concave?

B, C, & D areother possiblecombinations.

AA is inefficient. ABC

triangle is also inefficientdue to labor market

distortions.

60

100

OF

OC

B

C

D

Chapter 16 Slide 24

IndifferenceCurve

Output Efficiency

Food(Units)

Clothing(units)

60

100

ProductionPossibilitiesFrontier

MRS = MRT

C

How do you find theMRS = MRT combination

with many consumerswho have different

indifference curves?

Goods must be produced at minimum cost and in combinations that match people’s WTP. The efficient output and Pareto efficient allocation occurs where MRS = MRT

Chapter 16 Slide 25

Efficiency in Production

Efficiency in Output MarketsConsumer’s Budget Allocation

Profit Maximizing Firm

CF PP MRS

CCFF MCP and MCP

MRSMC

MC MRT

C

F C

F

P

P

Chapter 16 Slide 26

Conditions Required for Economic EfficiencyEfficiency in Exchange (for a

competitive market)

KFCCF

JFC MRSPPMRS /

Overview: The Efficiency of Competitive Markets

Chapter 16 Slide 27

Conditions Required for Economic EfficiencyEfficiency in the Use of Inputs in

Production (for a competitive market)

CLKMRTS/MRTS rwF

LK

Overview: The Efficiency of Competitive Markets

Chapter 16 Slide 28

Conditions Required for Economic EfficiencyEfficiency in the Output Market (in a

competitive market)

CFCF

CFF

PP

PP

/MC/MC MRT

MC ,MC

FC

C

Overview: The Efficiency of Competitive Markets

Chapter 16 Slide 29

Conditions Required for Economic EfficiencyHowever, consumers maximize their

satisfaction in competitive markets only if

FCFC

FCCF PP

MRT MRS Therefore,

consumers) all(for MRS /

Overview: The Efficiency of Competitive Markets