General Equilibrium and the Efficiency of Perfect Competition

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

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Prepared by: Fernando Prepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano

General Equilibrium and the General Equilibrium and the Efficiency of Perfect Efficiency of Perfect

CompetitionCompetition


Firm and Household DecisionsFirm and Household Decisions

• Input and output Input and output markets cannot be markets cannot be considered separately considered separately or as if they operated or as if they operated independently.independently.


Partial Equilibrium AnalysisPartial Equilibrium Analysis

• Partial equilibrium analysisPartial equilibrium analysis is is the process of examining the the process of examining the equilibrium conditions in equilibrium conditions in individual markets, and for individual markets, and for households and firms, households and firms, separately.separately.


General EquilibriumGeneral Equilibrium

• General equilibriumGeneral equilibrium is the is the condition that exists when all condition that exists when all markets in an economy are in markets in an economy are in simultaneous equilibrium.simultaneous equilibrium.


EfficiencyEfficiency

• In judging the performance of an In judging the performance of an economic system, two criteria used economic system, two criteria used are efficiency and equity (fairness).are efficiency and equity (fairness).

• EfficiencyEfficiency is the condition in is the condition in which the economy is producing which the economy is producing what people want at the least what people want at the least possible cost.possible cost.


Formal Proof of aFormal Proof of aGeneral Competitive EquilibriumGeneral Competitive Equilibrium

• This section explains why perfect This section explains why perfect competition is efficient in dividing competition is efficient in dividing scarce resources among alternative scarce resources among alternative uses.uses.

• If the assumptions of a perfectly If the assumptions of a perfectly competitive economic system hold, the competitive economic system hold, the economy will produce an efficient economy will produce an efficient allocation of resources.allocation of resources.


The Efficiency of Perfect CompetitionThe Efficiency of Perfect Competition

• The three basic questions in a The three basic questions in a competitive economy are:competitive economy are:

1.1. What will be produced?What will be produced? What What determines the final mix of output?determines the final mix of output?

2.2. How will it be produced?How will it be produced? How do How do capital, labor, and land get divided up capital, labor, and land get divided up among firms?among firms?

3.3. Who will get what is produced?Who will get what is produced? What What is the distribution of output among is the distribution of output among consuming households?consuming households?



• As we will see, in a perfectly As we will see, in a perfectly competitive economic system:competitive economic system:

1.1. resources are allocated among firms resources are allocated among firms efficiently,efficiently,

2.2. final products are distributed among final products are distributed among households efficiently, and households efficiently, and

3.3. the system produces the things that the system produces the things that people want.people want.


Pareto EfficiencyPareto Efficiency

• Pareto efficiency,Pareto efficiency, or or Pareto Pareto optimality,optimality, is a condition in which no is a condition in which no change is possible that will make some change is possible that will make some members of society better off without members of society better off without making some other members of society making some other members of society worse off.worse off.

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



Efficient Allocation of Resources:Efficient Allocation of Resources:

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

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

• Each firm uses inputs such that Each firm uses inputs such that MRPMRPLL = = PPLL. .

The marginal value of each input to each The marginal value of each input to each firm is just equal to its market price.firm is just equal to its market price.



• Within the constraints imposed by income Within the constraints imposed by income and wealth, households are free to choose and wealth, households are free to choose among all the goods and services available among all the goods and services available in output markets. Utility value is revealed in in output markets. Utility value is revealed in market behavior.market behavior.

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

Efficient Distribution of Outputs Among Efficient Distribution of Outputs Among Households:Households:



• Society will produce the Society will produce the efficient mix of output if all efficient mix of output if all firms equate price and firms equate price and marginal cost.marginal cost.

Producing What People WantProducing What People Want—the Efficient Mix of Output:—the Efficient Mix of Output:


The Key Efficiency Condition: Price The Key Efficiency Condition: Price Equals Marginal CostEquals Marginal Cost

If If PPXX > > MCMCXX, society gains value by producing more, society gains value by producing more X XIf If PPXX < < MCMCXX, society gains value by producing less, society gains value by producing less X X

The value placed on good X by society through the market, or the social value of a marginal unit of X.

Market-determined value of resources needed to produce a marginal unit of X. MCX is equal to the opportunity cost of those resources: lost production of other goods or the value of the resources left unemployed (leisure, vacant land, etc).


Efficiency in Perfect CompetitionEfficiency in Perfect Competition

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


The Sources of Market FailureThe Sources of Market Failure

• Market failureMarket failure occurs when resources occurs when resources are misallocated, or allocated are misallocated, or allocated inefficiently. The result is waste or lost inefficiently. The result is waste or lost value. Evidence of market failure is value. Evidence of market failure is revealed by the existence of:revealed by the existence of:

• Imperfect marketsImperfect markets

• Public goodsPublic goods

• ExternalitiesExternalities

• Imperfect information Imperfect information


Imperfect MarketsImperfect Markets

• Imperfect competitionImperfect competition is an industry in is an industry in which single firms have some control which single firms have some control over price and competition.over price and competition.

• Imperfectly competitive industries give Imperfectly competitive industries give rise to an inefficient allocation of rise to an inefficient allocation of resources.resources.



• MonopolyMonopoly is an industry composed is an industry composed of only one firm that produces a of only one firm that produces a product for which there are no close product for which there are no close substitutes and in which significant substitutes and in which significant barriers exist to prevent new firms barriers exist to prevent new firms from entering the industry.from entering the industry.



• In all imperfectly competitive industries, In all imperfectly competitive industries, output is lower—the product is output is lower—the product is underproduced—and price is higher underproduced—and price is higher than it would be under perfect than it would be under perfect competition.competition.

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


Public GoodsPublic Goods

• Public goodsPublic goods, or , or social goodssocial goods are are goods and services that bestow goods and services that bestow collective benefits on members of collective benefits on members of society.society.

• Generally, no one can be excluded from Generally, no one can be excluded from enjoying their benefits. The classic enjoying their benefits. The classic example is national defense.example is national defense.


Public GoodsPublic Goods

• Private goodsPrivate goods are products produced are products produced by firms for sale to individual by firms for sale to individual households.households.

• Private provision of public goods fails. A Private provision of public goods fails. A completely laissez-faire market will not completely laissez-faire market will not produce everything that all members of a produce everything that all members of a society might want. Citizens must band society might want. Citizens must band together to ensure that desired public together to ensure that desired public goods are produced, and this is generally goods are produced, and this is generally accomplished through government accomplished through government spending financed by taxes.spending financed by taxes.


ExternalitiesExternalities

• An An externalityexternality is a cost or benefit is a cost or benefit resulting from some activity or resulting from some activity or transaction that is imposed or bestowed transaction that is imposed or bestowed on parties outside the activity or on parties outside the activity or transaction.transaction.

• The market does not always force The market does not always force consideration of all the costs and benefits of consideration of all the costs and benefits of decisions. Yet for an economy to achieve decisions. Yet for an economy to achieve an efficient allocation of resources, all costs an efficient allocation of resources, all costs and benefits must be weighed.and benefits must be weighed.


Imperfect InformationImperfect Information

• Imperfect informationImperfect information is the absence is the absence of full knowledge concerning product of full knowledge concerning product characteristics, available prices, and so characteristics, available prices, and so forth.forth.

• The absence of full information can lead to The absence of full information can lead to transactions that are ultimately transactions that are ultimately disadvantageous.disadvantageous.

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General Equilibrium and the Efficiency of Perfect Competition