General Equilibrium

and Welfare
Economics 2541
Mr. Mudzanani Ronewa
Office D03, Mobile office complex
General equilibrium model
• General equilibrium model :An economic model of a complete system
of markets.
A PERFECTLY COMPETITIVE PRICE SYSTEM
• The most common type of general equilibrium model assumes that
the entire economy works through a series of markets.
• Not only are all goods allocated through millions of competitive
markets but also all inputs have prices that are established through
the workings of supply and demand.
• In all of these many markets, a few basic principles are assumed to
hold:
• All individuals and firms take prices as given—they are price takers.
• All individuals maximize utility.
• All firms maximize profits.
• All individuals and firms are fully informed; there are no transactions
costs, and there is no uncertainity.
• One consequence of the assumptions(and a few others) is that it can
be shown that when all markets work this way they establish
equilibrium prices for all goods.
• At these prices, quantity supplied equals quantity demanded in every
market.
A SIMPLE GENERAL EQUILIBRIUM
MODEL
• One way to give the flavor of general equilibrium analysis is to look at a simple
supply-demand model of two goods together. Ingeniously, we will call these two
goods X and Y.
• The ‘‘supply’’ conditions for the goods are shown by the production possibility
frontier PP0 in Figure 10.2.
• This curve shows the various combinations of X and Y that this economy can
produce if its resources are employed efficiently.
• The curve also shows the relative opportunity cost of good X in terms of good Y.
• Therefore, it is similar to a ‘‘supply curve’’ for good X (or good Y).
• Economically efficient allocation of resources An allocation of resources in which
the sum of consumer and producer surplus is maximized. Reflects the best (utility
maximizing) use of scarce resources.
• Notice that the description of economic efficiency in Figure 10.2 is based only on the
available resources (as shown by the production possibility frontier) and on the
preferences of consumers (as shown by the indifference curves).
• As the definition of ‘‘economics’’ makes clear, the problem faced by any economy is
how to make the best use of its available resources. Here,the term‘‘bestuse’’is
synonymous with ‘‘utility maximizing.’’
• That is, the best use of resources is the one that provides the maximum utility to
people.
• The fact that such an efficient allocation aligns the technical trade-offs that are
feasible with the trade-offs people are willing to make (as shown by the tangency at
point E in Figure 10.2) also suggests that finding an efficient allocation may have
some connection to the correct pricing of goods and resources—a topic to which we
now turn
• Figure 10.2 shows a series of indifference curves representing the
preferences of the consumers in this simple economy for the goods X
and Y.
• These indifference curves represent the ‘‘demand’’ conditions in our
model. Clearly, in this model, the best use of resources is achieved at
point E where production is X*, Y*.
• This point provides the maximum utility that is available in this
economy given the limitations imposed by scarce resources (as
represented by the production possibility frontier).
• As in Chapter 9, we define this to be an economically efficient
allocation of resources. Notice that this notion of efficiency really has
two components.
• First, there is a ‘‘supply’’ component—X*,Y*is on the production
possibility frontier.
• Any point inside the frontier would be inefficient because it would provide less utility
than can potentially be achieved in this situation.
• The efficiency of X*, Y* also has a ‘‘demand’’ component because, from among all
those points on PP0, this allocation of resources provides greatest utility.
• This reinforces the notion that the ultimate goal of economic activity is to improve the
welfare of people. Here, people decide for themselves which allocation is the best.
• The efficient allocation shown at point E in Figure 10.2 is characterized by a tangency
between the production possibility frontier and consumer’s indifference curve.
• The increasingly steep slope of the frontier shows that X becomes relatively more
costly as its production is increased.
• On the other hand, the slope of an indifference curve shows how people are willing to
trade one good for another in consumption (the marginal rate of substitution).
• That slope flattens as people consume more X because they seek balance in what they
have
• The tangency in Figure 10.2 therefore shows that one sign of
efficiency is that the relative opportunity costs of goods in production
should equal the rate at which people are willing to trade these goods
for each other.
• In that way, an efficient allocation ties together technical information
about relative costs from the supply side of the market with
information about preferences from the demand side.
• If these slopes were not equal(say at point F) the allocation of
resources would be inefficient(utility would be U1 instead of U2).
THE EFFICIENCY OF PERFECT
COMPETITION
• In this simple model, the ‘‘economic problem’’ is how to achieve this
efficient allocation of resources.
• One of the most important discoveries of modern welfare economics
is to show that, under certain conditions, competitive markets can
bring about this result.
• Because of the importance of this conclusion, it is sometimes called
the first theorem of welfare economics
• First theorem of welfare economics A perfectly competitive price
system will bring about an economically efficient allocation of
resources.
• Now assume that goods X and Y are traded in perfectly competitive markets and that
the initial prices of the goods are P1 X and P1 Y, respectively.
• With these prices, profit-maximizing firms will choose to produce X1, Y1 because, from
among all the combinations of X and Y on the production possibility frontier, this one
provides maximum revenue and profits.
• On the other hand, given the budget constraint represented by line CC, individuals
collectively will demand X0 1, Y0 1.
• Consequently, at this price ratio, there is excess demand for good X (people want to
buy more than is being produced), whereas there is an excess supply of good Y.
• The workings of the market place will cause P1 X to rise and P1 Y to fall.
• The price ratio PX/PY will rise; the price line will move clockwise along the production
possibility frontier.
• That is, firms will increase their production of good X and decrease their production of
good Y.
• Similarly, people will respond to the changing prices by substituting Y for X in their
consumption choices.
• The actions of both firms and individuals simultaneously eliminate the
excess demand for X and the excess supply of Y as market prices
change. Equilibrium is reached at X*,Y*,with an equilibrium price ratio
of P*X/P*X.
• With this price ratio, supply and demand are equilibrated for both good
X and good Y.
• Firms, in maximizing their profits, given P* X and P* Y, will produce X*
and Y*. Given the income that this level of production provides to
people, they will purchase precisely X* and Y*.
• Not only have markets been equilibrated by the operation of the price
system, but the resulting equilibrium is also economically efficient.
• As we showed previously, the equilibrium allocation X*, Y* provides
the highest level of utility that can be obtained given the existing
production possibility frontier
Some Numerical Examples
Self study page 353-355
 WHY MARKETS FAIL TO ACHIEVE
ECONOMIC EFFICIENCY?
• Showing that perfect competition is economically efficient depends crucially on all of
the assumptions that underlie the competitive model. Several conditions that may
prevent markets from generating such an efficient allocation.
1. Imperfect Competition
-Imperfect competition A market situation in which buyers or sellers have some
influence on the prices of goods or services.
-Imperfect competition in a broad sense includes all those situations in which economic
actors (that is, buyers or sellers) exert some market power in determining price.
-The essential aspect of all these situations is that marginal revenue is different from
market price since the firm is no longer a price taker.
-Because of this, relative prices no longer accurately reflect marginal costs, and the price
system no longer carries the information about costs necessary to ensure efficiency.
2. Externalities
-Externality The effect of one party’s economic activities on another party that is not
taken into account by the price system.
-A price system can also fail to allocate resources efficiently when there are cost
relationships among firms or between firms and people that are not adequately
represented by market prices.
-Examples of these are numerous. Perhaps the most common is the case of a firm that
pollutes the air with industrial smoke and other debris. This is called an externality.
-The firm’s activities impose costs on other people, and these costs are not taken
directly into account through the normal operation of the price system.
-The basic problem with externalities is that firms’ private costs no longer correctly
reflect the social costs of production.
-In the absence of externalities, the costs a firm incurs accurately measure social costs.
The prices of the resources the firm uses represent all the opportunity costs involved in
production
• Public Goods
-Public goods: Goods that are both nonexclusive and nonrival
-A third potential failure of the price system to achieve efficiency stems
from the existence of certain types of goods called public goods. These
goods have two characteristics that make them difficult to produce
efficiently through private markets.
-First, the goods can provide benefits to one more person at zero marginal
cost. In this sense the goods are ‘‘nonrival,’’ in that the cost of producing
them cannot necessarily be assigned to any specific user.
-Second, public goods are ‘‘nonexclusive’’—no person can be excluded
from benefiting from them.
-That is, people gain from the good being available, whether they actually
pay for it or not. See example on text book P.357
• Imperfect Information
- Self reading and make notes P357
 EFFICIENCY AND EQUITY
• Equity The fairness of the distribution of goods or utility
• We show not only that it is very difficult to define what an equitable distribution of
resources is but also that there is no reason to expect that allocations that result
from a competitive price system(or from practically any other method of allocating
resources, for that matter) will be equitable.
Defining and Achieving Equity
• A primary problem with developing an accepted definition of ‘‘fair’’ or ‘‘unfair’’
allocations of resources is that not everyone agrees as to what the concept means.
• Some people might call any allocation ‘‘fair’’ providing no one breaks any laws in
arriving at it—these people would call only acquisition of goods by theft ‘‘unfair.’’
• Others may base their notions of fairness on a dislike for inequality.
• Only allocations in which people receive about the same levels of utility (assuming
these levels could be measured and compared) would be regarded as fair
Equity and Competitive Markets
• Even if everyone agreed on what a fair allocation of resources (and,
ultimately, of people’s utility) is, there would still be the question of how
such a situation should be achieved.
• Can we rely on voluntary transactions among people to achieve fairness, or
will something more be required?
• Some introspection may suggest why voluntary solutions will not succeed.
If people start out with an unequal distribution of goods, voluntary trading
cannot necessarily erase that inequality.
• Those who are initially favored will not voluntarily agree to make
themselves worse off.
• Similar lessons apply to participation in competitive market transactions.
Because these are voluntary, they may not be able to erase initial
inequalities, even while promoting efficient outcomes.
THE EDGEWORTH BOX DIAGRAM FOR EXCHANGE
 Mutually Beneficial Trades
• Any point in the Edgeworth box represents an allocation of the available goods
between Smith and Jones, and all possible allocations are contained some where in
the box.
• To discover which of the allocations offer mutually beneficial trades, we must
introduce these people’s preferences. In Figure 10.6, Smith’s indifference curve
map is drawn with origin Os.
• Movements in a northeasterly direction represent higher levels of utility to Smith.
• In the same figure, Jones’s indifference curve map is drawn with the corner OJ as
an origin.
• We have taken Jones’s indifference curve map, rotated it 180 degrees, and fit it into
the northeast corner of the Edgeworth box.
• Movements in a southwesterly direction represent increases in Jones’s utility level
• Using these superimposed indifference curve maps, we can identify the
allocations from which some mutually beneficial trades might be made.
• Any point for which the MRS for Smith is unequal to that for Jones
represents such an opportunity. Consider an arbitrary initial allocation
such as point E in Figure10.5.
• This point lies on the point of intersection of Smith’s indifference curve U1
S and Jones’s indifference curve U3 J.
• Obviously, the marginal rates of substitution(the slopes of the indifference
curves) are not equal at E.
• Any allocation in the oval-shaped area in Figure 10.6 represents a mutually
beneficial trade for these two people—they can both move to a higher
level of utility by adopting a trade that gets them into this area.
 Efficiency in Exchange
• When the marginal rates of substitution of Smith and Jones are equal,
however, such mutually beneficial trades are not available.
• The points M1, M2, M3, and M4 in Figure 10.6 indicate tangencies of these
individuals’ indifference curves, and movement away from such points must
make at least one of the people worse off.
• A move from M2 to E, for example, reduces Smith’s utility from U2 S to U1 S,
even though Jones is made no worse off by the move.
• Alternatively, a move from M2 to F makes Jones worse off but keeps the
Smith utility level constant.
• In general, then, these points of tangency do not offer the promise of
additional mutually beneficial trading
• Such points are called Pareto efficient allocations after the Italian scientist
Vilfredo Pareto (1878–1923), who pioneered in the development of the
formal theory of exchange.
• Notice that the Pareto definition of efficiency does not require any
interpersonal comparisons of utility; we never have to compare Jones’s gains
to Smith’s losses, or vice versa.
• Rather, individuals decide for themselves whether particular trades improve
utility.
• For efficient allocations, there are no such additional trades to which both
parties would agree.
• Pareto efficient allocation An allocation of available resources in which no
mutually beneficial trading opportunities are unexploited. That is, an
allocation in which no one person can be made better off without someone
else being made worse off.
 Contract Curve
• The set of all the efficient allocations in an Edgeworth box diagram is called
the contract curve. In Figure 10.6, this set of points is represented by the
line running
• from OS to OJ and includes the tangencies M1, M2, M3, and M4 (and many
other such tangencies).
• Points off the contract curve (such as E or F) are inefficient, and mutually
beneficial trades are possible.
• But, as its name implies, moving onto the contract curve exhausts all such
mutually beneficial trading opportunities.
• A move along the contract curve (say, from M1 to M2) does not represent a
mutually beneficial trade because there will always be a winner (Smith) and
a loser (Jones).
 Efficiency and Equity
• The Edgeworth box diagram not only allows us to show Pareto efficiency, but also illustrates the
problematic relationship between efficiency and equity.
• Suppose Smith and Jones start out at point A—at which Smith is in a fairly favorable situation.
• As we described previously, any allocation between M2 and M3 is preferable to point A because
both people would be better off by voluntarily making such a move.
• In this case, however, the point of equal utility (E) does not fall in this range. Smith would not
voluntarily agree to move to point E since that would make her worse off than at point A.
• Smith would prefer to refrain from any trading rather than accept the ‘‘fair’’ allocation E. In the
language of welfare economics, the initial endowments (that is, the starting place for trading) of
Smith and Jones are so unbalanced that voluntary agreements will not result in the desired equal
allocation of utilities.
• If point E is to be achieved, some coercion (such as taxation) must be used to get Smith to accept it.
• The idea that redistributive taxes might be used together with competitive markets to yield
allocations of resources that are both efficient and equitable has proven to be a tantalizing prospect
for economists, as Application 10.3: The Second Theorem of Welfare Economics illustrates.
Equity and Efficiency with Production
• Examining the relationship between equity and efficiency is more
complex in a model in which production occurs. In our discussion so
far, the size of the Edgeworth Box has been fixed, and we have only
looked at how a given supply of two goods can be allocated between
two people.
• After we allow for production, the size of the Edgeworth Box is no
longer given but will depend on how much is actually produced in the
economy.
• Of course, we can still study the utility that people get from various
potential ways in which this production might be distributed.
• But now looking at the effects of redistribution of initial endowments
becomes more complicated because such redistribution may actually
affect how much is produced
• For example, if we were considering a plan that would redistribute income
from a person with an ‘‘initial endowment’’ of skills to a person with few
skills, we would have to consider whether such a plan would affect the high-
skilled person’s willingness to work.
• We should also think about whether receipt of income by a person with few
skills might also affect this person’s behavior.
• Although the size of such effects is largely an empirical question, it seems
likely that such attempts at redistribution would have some (probably
negative) effect on production.
• On a conceptual level then it is unclear whether such redistribution would
actually raise the utility of the low-skilled person—production could decrease
by enough that both people could be worse off(for an example, see
Problem10.10).
• Even if such a large effect would appear to be unlikely, it is still important to
know what the effects of redistribution policy on production are so that
potential trade-offs between equity and efficiency can be better understood.