Chapter 12Chapter 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.
3
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
4
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’.
5
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.
6
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).
7
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
8
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.
9
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.
10
Quantityof Y
per weekP
G
U1
U2
U3
E
F
Quantity of X per week0
P’
FIGURE 12-2: Efficiency of Output Mix
11
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.
12
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.
13
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
14
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
15
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.
16
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.
17
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).
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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
19
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
20
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
21
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.
22
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.
23
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.
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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
25
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.
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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
27
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.
28
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.
29
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.
30
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.
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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
32
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.
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