Introduction to Economics

General Equilibrium and Welfare

Economics
 Outline
 Introduction
 Market interdependence and Excess demand
 Horizontal equilibrium across final goods markets
 Vertical Equilibrium across input and output
markets
 General equilibrium in a competitive economy
 Introducing welfare economics
 Introduction
 Very important in microeconomics
 Rational behavior
 Meaning of equilibrium
– Rational individuals can coincide in such a way that
none of them have an incentive to change the outcome
 Partial equilibrium focuses on the state of one
market
– The ceteris paribus assumption is important here
 Introduction
 General equilibrium focuses on the entire
economy.
– Price of a good depends on prices of other
goods
– The quantity of labor supplied affects the level
of wages, income and industry supply but is
dependent on prices of other goods
– The point is that markets are interconnected and
affect each other.
 Introduction
 What is general equilibrium?
– It refers to an existence of a set of prices for
which all rational plans –across goods and
factors –are in harmony or coincide.
– The existence of this equilibrium is the prime
driving force behind the efficiency of the free
market economy.
– It suggest that a decentralized system with
rational agents can work well
 Dimensions of general
equilibrium
 Horizontal dimension
– The relationship between equilibria across final goods
markets
– These are connected directly through consumer demand
– Inter-market equilibrium
 Vertical equilibrium
– Relationships between markets connected through
production (intra – market)
– The relationship between consumer income and the
supply of final goods
 Horizontal Equilibrium
 Page 219
 To what extent are markets connected?
 Final goods are connected through
consumer demand
 Consumer chooses a bundle of goods to
maximize utility
 Demanding more of one good may mean
demanding more or less of another
 Horizontal Equilibrium
 Recall the consumer equilibrium using IC analysis
(page 220)
 The actual price of good X depends on the results
of the equilibrium conditions in the market for X.
 This is partial equilibrium which does not explain
how changes in the equilibrium conditions in one
market may influence the equilibrium conditions
in another.
 Everything in the economy is interconnected,
changes create a domino effect.
 Example - Mathematics
 Suppose Demand for X
– Xd = Dx(Px,Py)=a-bPx +ePy
– A=100, b =-3, e=1
 Suppose also the Supply of X is Xs
– Xs = c Px-dw
– c=2 and d=4
 Market equilibrium for X, depends on Py
and w, say both equals 5 (diagram on page
222).
 Excess Demand Functions
 The Excess Demand function for good X
(ED) is the difference between quantity
demanded and quantity supplied.
 When two goods are gross substitutes and
increase in Py will cause and increase in the
demand for X and an increase in ED.
 The ED curve shifts upwards with increases
in Py, which means that the equilibrium Px
also increases as Py increases (page 224)
 Excess Demand Function
 The relationship between Py and equilibrium Px
can be depicted as an increasing function as shown
(page 225)
 A similar equilibrium function can be obtained for
good Y
 The point of intersection of these two equilibrium
functions is of particular interest.
 At This point the markets for X and Y can be said
to be in general equilibrium (page 228)
 Horizontal equilibrium
 This point can be obtained algebraically by solving the set
simultaneous equations
– Xd –Xs =0, Yd –Ys =0
– These include both endogenous variables (determined
in the model – Px and Py)
– Exogenous variables whose values are known in
advance (taste, technology, wages)
– Page 228
 The equilibrium exist once the equations can be solved
 It is stable once there are forces in the economy moving
the system to the equilibrium. (page 229)
 Vertical considerations
 Relationship between consumer income and the
supply of final goods
 The supply of labor determines consumer income.
 The supply of labor also has an impact on the
wage rate when it is combined with firms
technology.
 In this way the supply of labor to one market
could impact on demand and supply of output in
others.
 Vertical dimension
 The vertical dimension of general
equilibrium is the relationship between the
consumption decision and the supply of
factor decisions, which determines the
availability of goods for consumption.
 The Robinson Crusoe economy (page 231)
 PPF –production possibility frontier
 Indifference curves.
 Robinson Crusoe
 Slope of the PPF = dL/dX = 1/MPLX, the
opportunity cost of leisure in terms of work.
 Diminishing marginal rate of substitution
 PPF is a constraint on production and
consumption
 Slope of IC, willingness to pay for X in
terms of leisure , MUx/MUL
 Both slopes are equal for general
equilibrium
 Exchange Economy
 dL/dX = 1/MPLX = MUx/MUL=Px/w
 w= Px MPLX
 The consumer chooses his supply of labor and demand for
consumption according to the principle which equates the
subjective rate of substitution with the market rate of
exchange.
 Produces will produce according to the profit
maximization principle, equating marginal rate of
technological substitution with the market rate of exchange
for factors
 The market for factors is linked to the goods market by the
rates of exchange.
 The distribution of Surplus
 Production is efficient when it is impossible
to increase production of any good without
producing less of another.
 No Pareto improvements are possible.
 What is Pareto efficiency?
 Pareto Efficiency
 Pareto efficiency requires that it must not be
possible to change the allocation of
resources in such a way that someone is
made better off and no one is made worse
off.
 Two dimensions
– Technical or Productive efficiency
» Points on the PPF are technically efficient in that it
is not possible to increase the output of one good
without decreasing the output of another.
 Pareto Efficiency
– Allocative efficiency exist when it is not possible to
being about a Pareto improvement by changing the
product mix
– When the slope of the production boundary is equal to
the rate at which consumers as a whole are just
prepared to substitute one good for another then at this
point there will be Pareto efficiency.
– Social utility function and the distribution of surplus ,
producers and consumer’s surplus. (page 235)
Conditions for Pareto Efficiency
 Perfect competition in all markets
 No externalities
 No public goods
 No market failure connected with
uncertainty