CHAPTER 12

GENERAL EQUILIBRIUM AND THE EFFICIENCY OF PERFECT

COMPETITION

CHAPTER OUTLINE

General Equilibrium AnalysisA Technological Advance: The Electronic

CalculatorMarket Adjustment to Changes in DemandFormal Proof of a General Competitive

Equilibrium

Allocative Efficiency and Competitive Equilibrium

Pareto EfficiencyThe Efficiency of Perfect CompetitionPerfect Competition versus Real Markets

The Sources of Market FailureImperfect MarketsPublic GoodsExternalitiesImperfect Information

Evaluating the Market Mechanism

THE CİRCULAR FLOW DİAGRAM

Input and output markets cannot be

considered separately or as if

they operated independently.

While it is important to

understand the decisions of

individual firms and households and the

functioning of individual markets,

we now need to add it all up, to

look at the operation of the

system as a whole.

perfectly competitive marketA market with many sellers and

buyers of a homogeneous product

and no barriers to entry.

GENERAL EQUILIBRIUM AND THE EFFICIENCY OF PERFECT

COMPETITION

Five features of a perfectly competitive market:

There are many sellers.

There are many buyers.

The product is homogeneous.

There are no barriers to market

entry.

Both buyers and sellers are price

takers.

PERFECT COMPETITION

GENERAL EQUILIBRIUM AND THE EFFICIENCY OF PERFECT

COMPETITION

partial equilibrium analysis The process of examining the equilibrium conditions in individual markets and for

households and firms separately.

general equilibrium The condition that exists when all markets in an economy are in simultaneous equilibrium.

efficiency The condition in which the economy is

producing what people want at least possible cost.

CALCULATOR EXAMPLE

1960s developed by Wang Lab $ 1500

1970s Silicon chip Costs fell dramatically

AN EARLY TECHNOLOGICAL ADVANCE: THE ELECTRONIC CALCULATOR

In the 1970s and 1980s, major technological changes occurred in the calculator industry.

In 1975, 18.1 million calculators were sold at an average price of $62. As technology made it possible to produce at lower costs, cost curves

shifted downward.As new firms entered the industry and existing firms expanded, output rose and market price dropped. In 1983, 30.9 million calculators were

produced and sold at an average price of under $30.

MARKET ADJUSTMENT TO CHANGES IN DEMAND

Initially, demand for X shifts from DX to DX. This shift pushes the

price of X up to PY creating profits.

Demand for Y shifts down from DY to DY,

pushing the price of Y down to PY and

creating losses. Firms have an

incentive to leave sector Y and an

incentive to enter sector X.

Exiting sector Y shifts supply in that industry to SY, raising price and

eliminating losses. Entry shifts supply in X to SX thus reducing

and eliminating profits.

The economy will produce an efficient allocation of resources if :

1. output markets are perfectly competitive2. input markets are perfectly competitive3. households have perfect information on product quality and on all prices available4. firms have perfect knowledge of technologies and input prices5. decision makers consider all the costs and benefits of their decisions

ALLOCATIVE EFFICIENCYAND COMPETITIVE EQUILIBRIUM

Pareto efficiency or Pareto optimality

A condition in which no change is

possible that will make some members of society better off without making

some other members of society worse off.

This very precise concept of efficiency is known as allocative efficiency.

ALLOCATIVE EFFICIENCYAND COMPETITIVE EQUILIBRIUM

THE EFFICIENCY OF PERFECT COMPETITION

The three basic questions discussed previously included:

What gets produced? What determines the final mix of output?

How is it produced? How do capital, labor, and land get divided up among firms? In other words, what is the allocation of resources among producers?

Who gets what is produced? What determines which households get how much? What is the distribution of output among consuming households?

To demonstrate that the perfectly competitive system leads to an efficient, or Pareto optimal,

allocation of resources, we need to show that no changes are possible that will make some people

better off without making others worse off.

THE EFFICIENCY OF PERFECT COMPETITION

Efficient Allocation of Resources Among Firms:

Perfectly competitive firms have incentives to use the best available technology.

With a full knowledge of existing technologies, firms will choose the technology that produces the output they want at the least cost.

Each firm uses inputs such that MRPL = PL. The marginal value of each input to each firm is just equal to its market price.

Answer to the question of “How to Produce.”

Efficient Distribution Of Outputs Among Households :

Within the constraints imposed by income and wealth, households are free to choose among all the goods and services available

in output markets. Utility value is revealed in market behavior.

As long as everyone shops freely in the same markets, no redistribution of final outputs among people will make them

better off.Answer to the question of “Who will get

what is produced”

THE EFFICIENCY OF PERFECT COMPETITION

Producing What People Want — The Efficient Mix Of Output :

Answer to the question of “What to produce”.

THE EFFICIENCY OF PERFECT COMPETITION

Efficiency in perfect competition follows from a weighing of values by both households and

firms.

THE EFFICIENCY OF PERFECT COMPETITION

PERFECT COMPETITION VERSUS REAL MARKETS

We have built a model of a perfectly competitive market system that produces

an efficient allocation of resources, an efficient mix of output, and an efficient

distribution of output. The perfectly competitive model is built on a set of

assumptions, all of which must hold for our conclusions to be fully valid.

These assumptions do not always hold in real-world markets.

THE SOURCES OF MARKET FAILURE

Market failure occurs when resources are misallocated,

or allocated inefficiently. The result is waste or lost value.

Evidence of market failure is revealed by the existence of:

Imperfect markets Public goods Externalities Imperfect information

THE SOURCES OF MARKET FAILURE

IMPERFECT MARKETSimperfect condition

An industry in which single firms have some control over price and competition. Imperfectly competitive

industries give rise to an inefficient allocation of resources.

monopoly An industry composed of only one firm that produces a product for which there are no close substitutes and

in which significant barriers exist to prevent new firms from entering the industry.In all imperfectly competitive industries, output is lower—the

product is underproduced—and price is higher than it would be under perfect competition.

The equilibrium condition P = MC does not hold, and the system does not produce the most efficient product mix.

THE SOURCES OF MARKET FAILURE

PUBLIC GOODS

public goods, or social goods Goods or services that bestow collective benefits

onmembers of society. Generally, no one can be

excluded from enjoying their benefits. The classic example is national defense.

private goods Products produced by firms for sale to individual

households.Private provision of public goods fails. A completely laissez-faire market will not produce everything that all members of

a society might want. Citizens must band together to ensure that desired public goods are produced, and this is

generally accomplished through government spending financed by taxes.

THE SOURCES OF MARKET FAILURE

EXTERNALITIES

externality A cost or benefit resulting from some activity or

transaction that is imposed or bestowed on parties outside the activity or transaction.

The market does not always force consideration of all the costs and benefits of decisions. Yet for an economy to

achieve an efficient allocation of resources, all costs and benefits must be weighed.

THE SOURCES OF MARKET FAILURE

IMPERFECT INFORMATION

imperfect information The absence of full knowledge concerning product

characteristics, available prices, and so forth.

The conclusion that markets work efficiently rests heavily on the assumption that consumers and producers have full

knowledge of product characteristics, available prices, and so forth. The absence of full information can lead to

transactions that are ultimately disadvantageous.

EVALUATING THE MARKET MECHANISM

Freely functioning markets in the real world do

not always produce an efficient allocation of resources, and this result

provides a potentialrole for government in the economy.