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Chapter 16
GeneralEquilibrium and
EconomicEfficiency
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Chapter 16 Slide 2
Topics to be Discussed
General Equilibrium Analysis
Efficiency in Exchange
Efficiency in Production
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Chapter 16 Slide 3
General Equilibrium Analysis
Partial equilibrium analysis presumes
that activity in one market is
independent of other markets.
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Chapter 16 Slide 4
General Equilibrium Analysis
General equilibrium analysis
determines the prices and quantity in
all markets simultaneously and takesthe feedback effectinto account.
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Chapter 16 Slide 5
General Equilibrium Analysis
A feedback effectis a price or
quantity adjustment in one market
caused by price and quantityadjustments in related markets.
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Chapter 16 Slide 6
General Equilibrium Analysis
Two Interdependent Markets--Moving
to General Equilibrium
ScenarioThe competitive markets of:
DVDs
Movie theater tickets
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DVDM
Two Interdependent Markets:Movie Tickets and DVDs
Price
Numberof Videos
Price
Number ofMovie Tickets
SMSV
$6.00
QM QV
$3.00
The Feedbackeffects continue.
$3.58
Q*V
D*V
$6.35
QM
D*M
$6.82
Q*M
S*M
QV
DV
$3.50
DM
QM
$6.75
The increase in the price
of videos increases thedemand for movies.
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Observation
Without considering the feedback effect
with general equilibrium, the impact ofthe tax would have been
underestimated
This is an important consideration for
policy makers.
Two Interdependent Markets:Movie Tickets and DVDs
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Questions
What would be the feedback effect of a
tax increase on one of twocomplementary goods?
What are the policy implications of using
a partial equilibrium analysis compared
to a general equilibrium in this scenario?
Two Interdependent Markets:Movie Tickets and Videocassette Rentals
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Efficiency in Exchange
Exchange increases efficiency until
no one can be made better off
without making someone else worse
off (Pareto efficiency).
The Advantages of Trade
Trade between two parties is mutuallybeneficial.
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Chapter 16 Slide 12
Efficiency in Exchange
Assumptions
Two consumers
Two goods Both people know each others
preferences
Exchanging goods involves zerotransaction costs
James & Karen have a total of 10 unitsof food and 6 units of clothing.
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Chapter 16 Slide 13
Efficiency in Exchange
The Edgeworth Box Diagram
Which trades can occur and which
allocation will be efficient can beillustrated using a diagram called an
Edgeworth Box.
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Exchange in an Edgeworth Box
10F 0K
0J
6C
10F
6C
JamessClothing
KarensClothing
Karens Food
Jamess Food
2C
1C 5C
4C
4F 3F
7F6F
+1C
-1F
The allocationafter trade is B: James
has 6F and 2C & Karenhas 4F and 4C.
A
B
The initial allocationbefore trade is A : Jameshas 7F and 1C & Karen
has 3F and 5C.
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Chapter 16 Slide 15
Efficiency in Exchange
Efficient Allocations
If Jamess and Karens MRS are the
same at Bthe allocation is efficient.This depends on the shape of their
indifference curves.
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Chapter 16 Slide 16
A
A : UJ1 = UK
1,but the MRSis not equal.
All combinationsin the shaded
area arepreferred to A.
Gains fromtrade
KarensClothing
Karens Food
UK1UK
2UK3
JamessClothing
Jamess Food
UJ1
UJ2
UJ3
B
C
D
Efficiency in Exchange
10F 0K
0J
6C
10F
6C
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Chapter 16 Slide 17
A
KarensClothing
Karens Food
UK1UK
2UK3
JamessClothing
Jamess Food
UJ1
UJ2
UJ3
B
C
D
Efficiency in Exchange
10F 0K
0J
6C
10F
6C
Is Befficient?Hint: is the
MRS equalat B?
Is Cefficient?
and D?
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Chapter 16 Slide 18
Efficiency in Exchange
A
KarensClothing
Karens Food
UK1
UK2
UK3
JamessClothing
Jamess Food
UJ1
UJ2
UJ3
B
C
D
10F 0K
0J
6C
10F
6C
Efficient Allocations
Any move outside theshaded area will makeone person worse off(closer to their origin).
Bis a mutually beneficialtrade--higher indifferencecurve for each person.
Trade may be beneficialbut not efficient.
MRS is equal whenindifference curves aretangent and the allocationis efficient.
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Chapter 16 Slide 19
Efficiency in Exchange
The Contract Curve
To find all possible efficient allocations
of food and clothingbetween Karen andJames, we would look for all points of
tangency between each of their
indifference curves.
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Chapter 16 Slide 20
The Contract Curve
0J
JamessClothing
KarensClothing
0KKarens Food
Jamess Food
E
F
G
ContractCurve
E, F, & G arePareto efficient . Ifa change improvesefficiency, everyonebenefits.
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Chapter 16 Slide 21
Efficiency in Exchange
Observations
1) All points of tangency between the
indifference curves are efficient.2) The contract curve shows all
allocations that are Pareto efficient.
Pareto efficient allocation occurs when
trade will make someone worse off.
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Chapter 16 Slide 22
Efficiency in Exchange
Consumer Equilibrium in aCompetitive Market
Competitive markets have many actualor potential buyers and sellers, so ifpeople do not like the terms of anexchange, they can look for anotherseller who offers better terms.
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Chapter 16 Slide 23
Efficiency in Exchange
Consumer Equilibrium in aCompetitive Market
There are many Jameses and Karens.
They are price takers
Price of food and clothing = 1 (relativeprices will determine trade)
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UK1UK
2
P
Price Line
P
PPis the price lineand shows possible
combinations; slope is -1
UJ1
UJ2
Competitive Equilibrium
10F 0K
0J
6C
10F
6C
JamessClothing
KarensClothing
Karens Food
Jamess Food
C
A
Begin at A:Each James buys2C and sells 2FEach James wouldmove fromUj1 to Uj2, which
is preferred (A to C).
Begin at A:Each Karen buys 2F andsells 2C. Each Karen
would move fromUK1 to UK2, whichis preferred (A to C).
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UK1UK
2
P
Price Line
P
UJ1
UJ2
Competitive Equilibrium
10F 0K
0J
6C
10F
6C
JamessClothing
KarensClothing
Karens Food
Jamess Food
At the prices chosen:Quantity fooddemanded (Karen)equals quantityfood supplied
(James)--competitiveequilibrium.
At the prices chosen:Quantity clothing demanded(James) equals quantity
clothing supplied (Karen)--competitive equilibrium.
C
A
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Chapter 16 Slide 26
Efficiency in Exchange
Scenario
PFand PC= 3
Jamess MRS of clothing for food is 1/2.
Karens MRS of clothing for food is 3.
James will not trade.
Karen will want to trade.
The market is in disequilibrium. Surplus of clothing
Shortage of food
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Chapter 16 Slide 27
Efficiency in Exchange
Questions
How would the market reachequilibrium?
How does the outcome from theexchange with many people differ fromthe exchange between two people?
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Chapter 16 Slide 28
Efficiency in Exchange
The Economic Efficiency ofCompetitive Markets
It can be seen at point C (as shown onthe next slide) that the allocation in acompetitive equilibrium is economicallyefficient.
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Chapter 16 Slide 29
Competitive Equilibrium
10F0K
0J
6C
10F
6C
JamessClothing
KarensClothing
Karens Food
Jamess Food
P
Price Line
UJ1
UK1
A
P
UJ2
UK2
C
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Chapter 16 Slide 30
Efficiency in Exchange
Observations concerning C:
1) Since the two indifference curves
are tangent, the competitiveequilibrium allocation is efficient.
2) The MRSCFis equal to the ratio of
the prices, or MRSJFC= PC/PF=MRSKFC.
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Chapter 16 Slide 31
Efficiency in Exchange
Observations concerning C:
3) If the indifference curves were not
tangent, trade would occur.4) The competitive equilibrium is
achieved without intervention.
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Chapter 16 Slide 32
Efficiency in Exchange
Observations concerning C:
5) In a competitive marketplace, all
mutually beneficial trades will becompleted and the resulting
equilibrium allocation of resources
will be economically efficient (thefirst theorem of welfare economics)
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Chapter 16 Slide 33
Equity and Efficiency
Equity and Perfect Competition
A competitive equilibrium leads to a
Pareto efficient outcome that may or
may not be equitable.
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Chapter 16 Slide 34
Equity and Efficiency
Points on the frontier
are Pareto efficient.
OJ
& OK
are perfect
unequal distributions
and Pareto efficient.
To achieve equity
(more equal
distribution) must the
allocation be
efficient?Jamess Utility
KarensUtility
OJ
OK
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Chapter 16 Slide 35
Efficiency in Production
Assume
Fixed total supplies of two inputs; labor
and capital
Produce two products; food and clothing
Many people own and sell inputs for
income Income is distributed between food and
clothing
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Chapter 16 Slide 36
Efficiency in Production
Observations
Linkage between supply and demand
(income and expenditures)
Changes in the price of one input
triggers changes in income and demand
which establishes a feedback effect.
Use general equilibrium analysis with
feedback effects
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Chapter 16 Slide 37
Efficiency in Production
Production in the Edgeworth Box
The Edgeworth box can be used to
measure inputs to the production
process.
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Chapter 16 Slide 38
Efficiency in Production
Production in the Edgeworth Box
Each axis measures the quantity of aninput
Horizontal: Labor, 50 hours
Vertical: Capital, 30 hours
Origins measure output
OF= Food
OC= Clothing
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60F
50F
40L 30L
Labor in clothing production
Efficiency in Production
50L 0C
0F30K
Capitalin clothingproduction
20L 10L
20K
10K
10L 20L 30L 40L 50L
Capitalin food
production
10K
20K
30K
30C
25C
10C
80F
Labor in Food Production
B
C
D
A
Each point measures inputs
to the production
A : 35L and 5K--FoodB: 15L and 25K--Clothing
Each isoquant shows input
combinations for a given output
Food: 50, 60, & 80
Clothing: 10, 25, & 30
Efficiency
A is inefficient
Shaded area is preferred to AB and Care efficient
The product ion contract curveshows
all combinations that are efficient
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Chapter 16 Slide 40
Efficiency in Production
Producer Equilibrium in a
Competitive Input Market
Competitive markets create a point ofefficient production.
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Chapter 16 Slide 41
Efficiency in Production
Competitive Market Observations The wage rate (w) and the price of capital (r) will be
the same for all industries.
Minimize production cost MPL/MPK= w/r
w/r = MRTSLK
MRTS = slope of the isoquant
Competitive equilibrium is on the productioncontract curve.
Competitive equilibrium is efficient.
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60F
50F
40L 30L
Labor in clothing production
Efficiency in Production
50L 0C
0F30K
Capitalin clothingproduction
20L 10L
20K
10K
10L 20L 30L 40L 50L
Capitalin food
production
10K
20K
30K
30C
25C
10C
80F
Labor in Food Production
B
C
D
A
Discuss the adjustment process that would
Move the producers from A to B or C.
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Chapter 16 Slide 43
Efficiency in Production
The Production Possibilities Frontier
Shows the various combinations of food
and clothing that can be produced with
fixed inputs of labor and capital.
Derived from the contract curve
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Chapter 16 Slide 44
Production Possibilities Frontier
Food(Units)
Clothing(units)
OF& OCare extremes.
Why is the productionpossibilities frontier
downward sloping?
Why is it concave?
B, C, & Dareother possiblecombinations.
AA is inefficient. ABC
triangle is also inefficient
due to labor marketdistortions.
60
100
OF
OC
B
C
D
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Chapter 16 Slide 45
Production Possibilities Frontier
Food(Units)
Clothing(units)
60
100
OF
OC
A
B
C
D
B
1C
1F
D
2C
1F
MRT = MCF/MCC
The marginal rate of
transformation (MRT)is the slope of the
frontier at each point.
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Chapter 16 Slide 46
Efficiency in Production
Output Efficiency
Goods must be produced at minimum
cost and must be produced in
combinations that match peoples
willingness to pay for them.
Efficient output and Pareto efficient
allocation
Occurs where MRS = MRT
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Chapter 16 Slide 47
Efficiency in Production
Assume
MRT = 1 and MRT = 2
Consumers will give up 2 clothes for 1food
Cost of 1 food is 1 clothing
Too little food is being produced
Increase food production (MRS falls and
MRT increases)
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Chapter 16 Slide 48
IndifferenceCurve
Output Efficiency
Food(Units)
Clothing(units)
60
100
ProductionPossibilitiesFrontier
MRS = MRT
C
How do you find theMRS = MRT combination
with many consumerswho have different
indifference curves?
ff
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Chapter 16 Slide 49
Efficiency in Production
Efficiency in Output Markets
Consumers Budget Allocation
Profit Maximizing Firm
CF PPMRS
CCFF MCPandMCP
MRSMC
MCMRT
C
F
C
F
P
P
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Chapter 16 Slide 50
U2
),(@MRT/ 1111 FCAPP CF
Competition and Output Efficiency
Food(Units)
Clothing(units)
60
100
AC1
F1
B
C2
F2
Ashortage offood and surplusof clothing causesthe price of foodto increase and
the price ofclothing to decrease.
CC*
F*
Adjustment continues untilPF= PF* and PC= PC*;
MRT = MRS; QD= QS for
food and clothing.U1
An Overview---The Efficiency
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Chapter 16 Slide 51
An Overview The Efficiencyof Competitive Markets
Conditions Required for Economic
Efficiency
Eff ic iency in Exchange
K
FC
J
FC
MRSMRS
An Overview---The Efficiency
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Chapter 16 Slide 52
Conditions Required for Economic
Efficiency
Eff ic iency in Exchange (for acompet it ive market)
K
FCCF
J
FC MRSPPMRS /
An Overview The Efficiencyof Competitive Markets
An Overview---The Efficiency
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Chapter 16 Slide 53
Conditions Required for Economic
Efficiency
Eff ic iency in the Use of Inputs inProduct ion
C
LKMRTSMRTS F
LK
An Overview The Efficiencyof Competitive Markets
An Overview---The Efficiency
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Chapter 16 Slide 54
Conditions Required for Economic
Efficiency
Eff ic iency in the Use of Inputs inProduct ion (for a com pet i tive market)
C
LKMRTS/MRTS rwF
LK
An Overview The Efficiencyof Competitive Markets
An Overview---The Efficiency
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Chapter 16 Slide 55
Conditions Required for Economic
Efficiency
Eff ic iency in the Output Market
consumers)all(forFCFC
MRSMRT
An Overview The Efficiencyof Competitive Markets
An Overview---The Efficiency
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Chapter 16 Slide 56
Conditions Required for Economic
Efficiency
Eff ic iency in the Output Market (in acompet it ive market)
CFCF
CFF
PP
PP
/MC/MCMRT
MC,MC
FC
C
An Overview The Efficiencyof Competitive Markets
An Overview---The Efficiency
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Chapter 16 Slide 57
Conditions Required for Economic
Efficiency
However, consumers maximize theirsat is fact ion in compet it ive markets
only i f
FCFC
FCCF PP
MRTMRSTherefore,
consumers)all(forMRS/
An Overview The Efficiencyof Competitive Markets
Wh M k t F il
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Chapter 16 Slide 58
Why Markets Fail
Market Power
In a monopoly in a product market, MR
< P
MC = MR
Lower output than a competitive market
Resources allocated to another market
Inefficientallocation
Wh M k t F il
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Chapter 16 Slide 59
Why Markets Fail
Market Power
Monopsony in the labor market
Restricted supply of labor in foodwfwould rise, wLwould fall
Clothing input:
Food input:
rwc
C
LK/MRTS
C
LKcF
F
LK rwrw MRTS//MRTS
Wh M k t F il
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Chapter 16 Slide 60
Why Markets Fail
Incomplete Information
Lack of information creates a barrier to
resource mobility.
Externalities
When consumption or production
creates cost and benefits to third partieswhich changes the cost and benefits of
decisions and create inefficiencies.
S
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Chapter 16 Slide 61
Summary
Partial equilibrium analyses of markets
assume that related markets are
unaffected, while general equilibrium
analyses examine all marketssimultaneously.
An allocation is efficient when no
consumer can be made better off by trade
without making someone else worse off.
Summary
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Chapter 16 Slide 62
Summary
A competitive equilibrium describes a set
of prices and quantities, so that when each
consumer chooses his or her most
preferred allocation, the quantitydemanded is equal to the quantity supplied
in every market.
The utility possibilities frontier measures allefficient allocations in terms of the levels of
utility that each person achieves.
Summary
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Chapter 16 Slide 63
Summary
An allocation of production inputs is
technically efficient if the output of
one good cannot be increased
without increasing the output of some
other good.
Summary
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Chapter 16 Slide 64
Summary
The production possibilities frontiermeasures all efficient allocations in termsof the levels of output that can beproduced with a given combination ofinputs.
Efficiency in the allocation of goods toconsumers is achieved only when the
MRS of one good for another inconsumption is equal to the MRT of onegood for another in production.
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End of Chapter 16
GeneralEquilibrium and
EconomicEfficiency