Copyright 2002, Pearson Education Canada1 General Equilibrium and the Efficiency of Perfect Competition Chapter 12

Copyright 2002, Pearson Education Canada1

General Equilibrium and the Efficiency of Perfect Competition

Chapter 12


Partial Equilibrium Analysis

Partial equilibrium analysis refers to the process of examining the equilibrium conditions in individual markets and for households and firms separately.


General Equilibrium and Efficiency

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

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


Technological Change and the Economy

A significant - if not sweeping - technological change in a single industry affects many markets. Households face a different structure of prices and must adjust their consumption of many products. Labour reacts to new skill requirements and is reallocated. Capital is also reallocated.


Cost-Saving Technological Change in the Calculator Industry

As technology made it possible to produce at lower costs in the calculator industry, cost curves shifted downwards. As new firms entered the industry and existing firms expanded, output rose and market price dropped.


General Equilibrium Impacts of a Shift in Consumer Preferences (Table 12.1)

Consumer preferences in Canada shifted dramatically towards wine between 1965 and 1980. This has dramatic effects on a two industry economy; wine industry (X) and other industries (Y).


Adjustment in an Economy with Two Sectors: Wine Industry Impact (Figure 12.3)

Initially, demand for X shifts from D0x to D1

x. This shift pushes the price of X up to P1

x, creating economic profits. Firms enter and expand in sector X which shifts supply to S1

x, reducing price and eliminating profits.


Adjustment in an Economy with Two Sectors: Other Industry Impact (Figure 12.3)

Initially, demand for Y shifts from D0y to D1

y. This shift pushes the price of Y down to P1

y, creating economic losses. Firms exit sector Y which shifts supply to S1

y, increasing price and eliminating the losses.


Allocative Efficiency and Competitive Equilibrium

Competitive Market Assumptions Both output markets and input markets are

perfectly competitive. Firms and households are price takers. Households have perfect information and firms

have perfect knowledge. Decision-makers consider all costs and

benefits; there are no externalities.


Pareto Efficiency

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


The Three Basic Questions of a Competitive Economy

What will be produced? How will it be produced? Who will get what is produced?


Efficient Allocation of Resources under Perfect Competition

Firms have incentives to use the best available technology.

Individual firms maximize profits, and so they must minimize costs.

Each firm uses inputs such that MRPa = Pa.Therefore, the marginal value of each

input to each firm is just equal to its market price.


Efficient Distribution of Outputs under Perfect Competition

Households shop freely in the same markets.

Households attempt to maximize their own utility.

Each household maximizes utility where MUa / MUb = Pa / Pb.

Therefore, the marginal rate of substitution for each household is equal to the price ratio.


Efficient Mix of Output under Perfect Competition

Firms find their profit maximizing levels of output where MC = P.

MC represents the marginal value of the other things that could be produced with the same resources.

P represents the marginal value of the product to society.

Under these conditions no changes can improve social welfare.


Market Failure

A market failure occurs when resources are misallocated, or allocated inefficiently. The result is waste or lost value.


Sources of Market Failure

Imperfect competition Public goods Externalities Imperfect information


Imperfect Competition

Imperfect competition refers to an industry in which single firms have some control over price and competition. Imperfectly competitive industries give rise to an inefficient allocation of resources.

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


Public Goods

Public goods, or social goods are goods or services that bestow collective benefits on members of society; they are, in a sense, collectively consumed.

Generally, no one can be excluded from their benefits.

Classic example: national defense.


Externalities

An externality is a cost or benefit resulting from some activity or transaction that is imposed or bestowed upon parties outside of the activity or transaction.


A Classic Example of a Negative Externality is Air Pollution

Country Metric Tonnes per person

Canada 13.8United States 20.0Germany 10.5China 2.8India 1.1Chad 0.0


Imperfect Information

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

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

Buyers of services that require expertise often have imperfect information e.g. car repair.


Review Terms & Concepts

efficiency externality general equilibrium imperfect competition imperfect information market failure

monopoly Pareto efficiency Pareto optimality partial equilibrium

analysis private goods public goods

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Copyright 2002, Pearson Education Canada1 General Equilibrium and the Efficiency of Perfect Competition Chapter 12