Chapter 16. GENERAL EQUILIBRIUM AND MARKET EFFICIENCY McGraw-Hill/IrwinCopyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter.

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GENERAL EQUILIBRIUM

AND MARKET EFFICIENCY

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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Chapter Outline

• A Simple Exchange Economy• Efficiency In Production• Efficiency In Product Mix• Gains From International Trade• Taxes In General Equilibrium• Other Sources Of Inefficiency

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A Simple Exchange Economy

• General equilibrium analysis: the study of how conditions in each market in a set of related markets affect equilibrium outcomes in other markets in that set.

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Figure 16.1: Two interdependent markets: Movie Tickets and DVDs

0 0

3028

24

20

Price(R)

Price(R)

Number ofMovie tickets

Number ofDVDs

1615

12

DMOV DDVD

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A Simple Exchange Economy

• Simple economy in which there are only two consumers—Jacob and Thabo— and two goods, food and clothing.– Allocation: an assignment of these total amounts

between Jacob and Thabo.– Initial endowments: the amounts of the two

goods with which Jacob and Thabo begin each time period.

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Figure 16.2: An EdgeworthExchange Box

Thabo’s quantity of clothing

Th

ab

o’s

qu

an

tity o

f food

Jacob

’s q

uan

tity o

f food

Jacob’s quantity of clothingOJ

OT

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Edgeworth Exchange Box

• Edgeworth exchange box: a diagram used to analyze the general equilibrium of an exchange economy.

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Figure 16.3: Gains from Exchange

Thabo’s quantity of clothingTh

ab

o’s

qu

an

tity o

f food

Jacob’s quantity of clothing

Jacob

’s q

uan

tity o

f food

OJ

OT

IT1

IJ3

IJ2

IJ1

IT2

IT3

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Figure 16.4: Further Gainsfrom Exchange

OJ

OT

Jacob

’s q

uan

tity o

f food

Thabo’s quantity of clothing

Jacob’s quantity of clothing

Th

ab

o’s

qu

an

tity o

f food

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Figure 16.5: A Pareto-Optimal Allocation

Thabo’s quantity of clothing

OTTh

ab

o’s

qu

an

tity o

f food

Jacob’s quantity of clothingOJ

Jacob

’s q

uan

tity o

f food

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The Pareto Criterion

• Pareto superior allocation: an allocation that at least one individual prefers and others like at least as well.

• Pareto optimal: the term used to describe situations in which it is impossible to make one person better off without making at least some others worse off.

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The Contract Curve

• Contract curve: a curve along which all final, voluntary contracts must lie.– Identifies all the efficient ways of dividing the two

goods between the two consumers.

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Figure 16.6: The Contract Curve

OJ

OT

IT1

IT2

IT3

IJ3

IJ2

IJ1

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Figure 16.7: Initial Endowments Constrain Final Outcomes

OJ

OT

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Figure 16.8: A DisequilibriumRelative Price Ratio

Thabo’s quantity of clothingTh

ab

o’s

qu

an

tity o

f food

OT

Jacob

’s q

uan

tity o

f food

Jacob’s quantity of clothingOJ

Food supplied by Thabo

Food supplied by Jacob

Clothing demanded by Jacob

Clothing demanded by Thabo IJ0

IT0

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Figure 16.9: General Equilibrium

Thabo’s quantity of clothing

Jacob

’s q

uan

tity o

f food

Jacob’s quantity of clothing

Th

ab

o’s

qu

an

tity o

f food

OJ

OT

Food supplied by Thabo

Clothing demanded by Thabo

Clothing suppliedby Jacob

Food demanded by JacobJ*

T*

IT

IJ

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The Invisible Hand Theorem

• Theorem of the invisible hand: an equilibrium produced by competitive markets will exhaust all possible gains from exchange.– Equilibrium in competitive markets is Pareto

optimal.

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Figure 16.10: Sustaining Efficient Allocations

Thabo’s quantity of clothing

OT

Th

ab

o’s

qu

an

tity o

f food

Jacob

’s q

uan

tity o

f food

Jacob’s quantity of clothing

IT1

IT2

IT3

IJ1

IJ2

IJ3

OJ

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Second Theorem

• The second theorem of welfare economics says that, under relatively unrestrictive conditions:– Any allocation on the contract curve can be sustained as a

competitive equilibrium.

• The significance of the second welfare theorem is that the issue of equity in distribution is logically separable from the issue of efficiency in allocation.

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Efficiency In Production

• Suppose we now add a productive sector to our exchange economy, one with two firms, each of which employs two inputs—capital (K) and labour (L)—to produce either of two products, food (F) or clothing (C).– Suppose firm C produces clothing and firm F produces

food.– The marginal rates of technical substitution for the two

firms will be equal in competitive equilibrium.

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Figure 16.11: An EdgeworthProduction Box

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Efficiency In Production

• The marginal rates of technical substitution for the two firms will be equal in competitive equilibrium.

• Competitive general equilibrium is efficient not only in the allocation of a given endowment of consumption goods, but also in the allocation of the factors used to produce those goods.

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Efficiency In Product Mix

• Production possibilities frontier: the set of all possible output combinations that can be produced with a given endowment of factor inputs.

• Marginal rate of transformation (MRT): the rate at which one output can be exchanged for another at a point along the production possibilities frontier.

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Figure 16.12: Generating the Production Possibilities Frontier

0

Firm F’s Labour

Firm C’s Labour

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Efficiency in the Product Mix

• For an economy to be efficient in terms of its product mix, it is necessary that the marginal rate of substitution for every consumer be equal to the marginal rate of transformation.

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Figure 16.13: An Inefficient Product Mix

0 0

Jacob’s food

Jacob’s clothing

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Figure 16.14: MRT Equals the Ratioof Marginal Costs

0

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Figure 16.15: Competition and output efficiency

0

Food(units)

Clothing(units)

F*

F 2

F 1

C 1 C 2 C*

I 2

I 1

A

B

C

/

//

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Gains From International Trade

• The fact that the international budget constraint contains the original competitive equilibrium point means that it is possible to make everyone better off than before. – But the impersonal workings of international

trading markets provide no guarantee that every single person will in fact be made better off by trade.

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Figure 16.16: Gains fromInternational Trade

0

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Figure 16.17: Taxes Affect Product Mix

0

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Taxes In General Equilibrium

• A tax on food does not alter the fact that consumers will all have a common value of MRS in equilibrium.– Nor does it alter the fact that producers will all have a

common value of MRTS.

• The real problem created by the tax is that it causes producers to see a different price ratio from the one seen by consumers.

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Other Sources Of Inefficiency

• Monopoly– Market power

• Externalities– Positive– Negative

• Public Goods– Non-rival & non-excludable– Free riders