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Economic Principles I

Lecture 19:

General Equilibrium and EconomicEfficiency

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Partial and General Equilibrium

Analysis of individual markets in isolation is called partial equilibrium analysis

Analysis of markets simultaneously is calledgeneral equilibrium analysis

A general equilibrium is when supply equates todemand in all markets in the economy

So an event which disturbs one market may spillover to others

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A simple general equilibriumsystem

Product Market

Labour Market

Firms Households

Output DemandOutput Supply

Input SupplyInput Demand

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Important questions

Is it possible for all markets to be simultaneouslyin equilibrium?

What conditions would need to hold?How can we assess how well an economic systemworks in practice?

Allocative efficiency it produces what people

want at least costEquity the distribution of resources andrewards is fair

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An example of generalequilibrium adjustment

Demand for servicesshifts outwards from D X0 to D X1

Demand for

manufactured goodsshifts inwards from D Y0 to DY1

Economic profits inservices; losses in

manufacturingFirms exit manufacturingand move to serviceseventually eliminatingprofits and losses

Industry X: Services

Industry Y: Manufacturing0

P

Q

0

P

Q

S1X

S1Y

p1X

D1X

Q 1X

p1Y

D1Y

Q 1Y

Q 0X

p0

X

D0X

S0X MCX

ATCX

q0X

profit

q1X

p0Y

D0Y

S0Y

Q 0Y

MCY ATCY

q0Y

loss

q1Y

0

q

0

q

Firm in Industry X

Firm in Industry Y

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Conditions of general equilibrium

Equilibrium in the economy requires theestablishment of equilibrium in both sectorsResources in the economy shift to follow thechange in consumer preferencesConsequently employment shifts from themanufacturing to the service sectorIs there a set of prices that will equate supply anddemand in all markets simultaneously?

Using advanced maths Arrow and Debreu have shownthat in theory there is.

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Allocative efficiency in a competitiveeconomy

AssumptionsAll firms and households are price takers

Households have perfect information about productquality and pricesFirms have perfect knowledge about input prices andtechnology

No externalities or public goodsIf these hold then the competitive economy isallocatively efficient

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The Pareto Condition

Allocative efficiency means that we use availableresources to maximise social well-beingHow do we know if social well-being is maximised?

Pareto efficiencyAn economy is Pareto-efficient if we cannot makeanyone better off without making someone else worseoffA competitive economy, with perfect information andno externalities, is Pareto-efficient

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A value-freeperspective?

But nearly all changes in the economy havewinners and losers?

If the value of the gains to the winners exceedthe value of the losses to the losers then areallocation is potentially efficient

An allocation may be efficient but is it fair?

Fairness is a value judgement

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What will be produced ?

The key condition is that all goods andservices will be produced up to the pointwhere P x=MCx for all Xs If Px>MCx society gains from producingmore X

If Px

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How will it be produced?

Firms must use the lowest cost technology(technical efficiency)Inputs must be allocated across firms in the bestpossible wayThis means every firm must hire workers up tothe point where: cost of an extra worker (wage) =value of extra output produced

If not, we could move workers between firms andincrease total output for no increase in total cost

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Who will get what is produced?

All households will choose combinations ofgoods at the point where MRS=P x/P y

Consumer valuations of goods are revealedin household market behaviourFree and open markets are essential

All households maximise satisfaction(subject to budget) and all firms maximiseprofit

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Problems with generalequilibrium

But the world just isnt like this? Monopolies and oligopolies

ExternalitiesPublic goods

Uncertainty and lack of

informationSo what is the use of generalequilibrium theory

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Efficiency benchmarking

The ideal competitive economy provides abenchmark

Problems such as monopoly and externalitiesintroduce inefficiencies

The ideal allows to evaluate the consequences (interms of lost efficiency) of market failure and toassess the potential benefits of governmentintervention to make things better

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Conclusion

In this lecture we looked at general equilibriumIdeal competitive economies are Pareto-efficient

Relaxing the assumptions of the perfectcompetitive economy, in order to describe theworld more realistically, reveals the problemsthat the free market does not solve for itself.

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Economic Principles I

Lecture 19:

General Equilibrium and EconomicEfficiency