19/09/16 Outline Chapter 8
1.  General Equilibrium Analysis 2.  Efficiency in Exchange: 2 theorems of welfare economics General Equilibrium and Economic Efficiency 3.  Equity and Efficiency ; Efficiency in ProducGon; The Gains from Free Trade (Ricardo theory); Markets Failures (externality, public goods, imperfect informaGon…) 2 www.unamur.be
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1. General Equilibrium Analysis •  Up to this point, we have been focused on parGal equilibrium analysis –  AcGvity in one market has liTle or no effect on other markets •  Market interrelaGonships already hinted –  Complements and subsGtutes –  Increase in firms’ input demand can cause market price of the input and output to rise General Equilibrium Analysis •  To study how markets interrelate, we can use general equilibrium analysis –  Simultaneous determinaGon of the prices and quanGGes in all relevant markets, taking into account feedback effects –  The feedback effect is the price or quanGty adjustment in one market caused by price and quanGty adjustments in related markets 3 www.unamur.be
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Two Interdependent Markets Two Interdependent Markets •  Scenario •  Scenario –  The compeGGve markets of: –  Equilibrium price of movies is $6.00 –  Equilibrium price of DVD rentals is $3.00 –  Government places a $1.00 tax on each movie Gcket –  Need to look at effect of tax on •  DVD rentals •  Movie theater Gckets –  These goods are subsGtutes –  Changing prices in one market are likely to affect the other market •  Market for DVDs •  Feedback effects in movie market 5 www.unamur.be
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1 19/09/16 Two Interdependent Markets $1 tax on each movie ticket
causes supply to fall
Price
S*M
Price
Two Interdependent Markets General Equilibrium Analysis:
Increase in movie ticket prices
increases demand for DVD.
SV
SM
S*M
$6.82
$6.75
$3.50
$6.35
The increase in the price
of DVD increases the
demand for movies.
Price
DM
Number of
Movie Tickets
D*M
$6.00
QV Q’V
D’V
D’M
DM
DV
Number
of DVD
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Q’M Q”M
Q*M QM
8 Number of
Movie Tickets
DV
QV Q’V Q*V
Number
of DVD
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Two Interdependent Markets •  ObservaGon –  Without considering the feedback effect with general equilibrium, the impact of the tax would have been underes'mated –  This is an important consideraGon for policy makers •  You can check for yourself that in the market for complements, the tax would be overesGmated Interdependent Markets-­‐
Reaching General Equilibrium •  Must be able to determine the equilibrium price of both movies and DVDs simultaneously –  We must simultaneously find two prices that equate quanGty demanded and quanGty supplied in all related markets –  This requires to find the soluGon to four equaGons: demand and supply for DVDs and movies 9 www.unamur.be
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The Interdependence of InternaGonal Markets •  Brazil and the United States compete in the world soybean market, so one market can affect the other •  Brazil limited exports of soybeans in the late 1960’s and early 1970’s, causing price in Brazil to fall •  Eventually the export controls were to be removed, and Brazilian exports were expected to increase The Interdependence of InternaGonal Markets •  ExpectaGon was based on parGal equilibrium analysis –  The limited export policy had the effect to increase the price and producGon of soybeans in US as well as US exports –  This caused Brazil to have difficulGes exporGng even aier control was removed 11 www.unamur.be
D*V
$3.00
D’V
7 SV
SM
$6.35
$6.00
QM
General Equilibrium Analysis:
The Feedback effects continue.
$3.58
$3.50
$3.00
Q’M
Price
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2 19/09/16 Soybean Exports – Brazil and US 2. Efficiency in Exchange •  We showed before that compe77ve markets are efficient because consumer and producer surpluses are maximized •  We can study this in more detail by examining an exchange economy –  Between two (or more) consumers trading two (or more) goods among themselves –  Between two countries 13 www.unamur.be
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Efficiency in Exchange •  An alloca7on of goods is efficient if no one can be made be1er off without making someone else worse off è Pareto efficiency •  Voluntary trade between two parGes is mutually beneficial and increases economic efficiency (raGonal individuals) Advantages of Trade (Exchange) •  AssumpGons –  Two consumers (countries) –  Two goods –  Both people know each other’s preferences –  Exchanging goods involves zero transacGon costs –  James and Karen have a total of 10 units of food and 6 units of clothing è let’s show that voluntary exchange between these two persons is for both a beTer situaGon than iniGally 15 www.unamur.be
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Advantage of Trade (Exchange) Advantage of Trade (Exchange) Karen’s Food
IniGally: •  Karen has a lot of clothing and liTle food (3,5); and James has (7,1) = their endowment •  Karen’s MRS (of food for clothing) is 3 (for 1 unit of F, give up 3 units of C); James’ MRS is ½ (for 1 unit of F, give up ½ unit of C) è How do they exchange? 10F
3F
3F
0K
6C
2C
4C
James’
Clothing
Karen’s
Clothing
MRSJ (of food for clothing)= 1/2 for 1 unit of F, give up 1/2 units of C 1C
1C
0J
5C
5C
6C
A
6F
7F
7F
10F
MRSK (of food for clothing)= 3 for 1 unit of F, give up 3 units of C 17 www.unamur.be
4F
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3 19/09/16 Advantage of Trade (Exchange) •  There is room for trade –  James values clothing more than Karen –  Karen values food more than James –  Karen is willing to give up 3 units of clothing to get 1 unit of food, and James is willing to take ½ unit of clothing giving away 1 unit of food The Advantage of Trade •  Suppose Karen offers James 1 unit of clothing for 1 unit of food –  James will have more clothing, which he values more than food –  Karen will have more food, which she values more •  Whenever two consumers’ MRSs are different, there is room for mutually beneficial trade •  Actual terms of trade are determined through bargaining –  IniGal allocaGon of resources was inefficient 19 20 www.unamur.be
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Exchange in an Edgeworth Box The Advantage of Trade è An alloca'on of goods is efficient only if the goods are distributed so that the MRS between any pair of goods is the same for all consumers Karen’s Food
10F
5C
A
6C
0J
7F
10F
22 James’ Food
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Efficiency in Exchange Efficiency in Exchange 6C
Karen’s Food
10F
James’s
Clothing
0J
0K
A: UJ1 = UK1,
but the MRS
is not equal.
All combinations
in the shaded
area are
preferred to A.
23 Karen’s Food
10F
0K
D
Karen’s
Clothing
James’s
Clothing
A
At points C, &
D : MRSs are
equal and
allocation is
efficient
UJ1
6C
0J
10F
James’s Food
24 Karen’s
Clothing
C
UJ3
B
A
UK3
UK1
James’s Food
6C
Point B is on
higher IC but
is not
efficient
Gains from
trade
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Karen’s
Clothing
1C
diagram showing all possible allocaGons of either two goods between two people or of two inputs between two producGon processes www.unamur.be
0K
The initial allocation
before trade is A: James
has 7F and 1C & Karen
has 3F and 5C.
James’
Clothing
è Let’s represent it graphically with the Edgeworth Box: 3F
6C
UK2
UJ2
UJ1
UK1
6C
10F
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4 19/09/16 Efficient AllocaGons Efficiency in Exchange •  The Contract Curve •  How do these parGes reach an efficient allocaGon? –  When there is no more room for trade –  When their MRSs are equal –  They will keep trading, reaching higher indifference curves, unGl they can no longer do so and sGll make each beTer off –  This is when indifference curves are tangent – they have the same slope and same MRS –  To find all possible efficient allocaGons of food and clothing between Karen and James, we would look for all points of tangency between each of their indifference curves –  The contract curve shows all the efficient allocaGons of goods between two consumers, or of two inputs between two producGon funcGons 25 26 www.unamur.be
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The Contract Curve Karen’s Food
E, F, & G are
Pareto efficient.
Contract Curve •  All points of tangency between the indifference curves are efficient 0K
Contract
Curve
–  MRS of individuals is the same –  No more room for trade G
James’
Clothing
Karen’s
Clothing
F
E
•  The contract curve shows all allocaGons that are Pareto efficient –  Pareto efficient allocaGon occurs when further trade will make someone worse off 0J
James’
27 Food
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Consumer Equilibrium in a CompeGGve Market Consumer Equilibrium in a CompeGGve Market •  There are many Jameses and Karens •  They are price takers •  RelaGve price of food and clothing = 1 –  Trade depends on relaGve prices, not actual prices è  Equilibrium if : MRS J
FC
=
PC
PF
10F
Begin at A:
Each Karen buys 2F and
sells 2C moving from
UK1 to UK2, which
is preferred (A to C).
Begin at A:
Each James buys 2C and sells 2F
moving from UJ1 to UJ2, which
is preferred (A to C).
Price Line
P
Karen’s
Clothing
C
James’
Clothing
UJ2
K
= MRS FC
A
UK2
0J
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0K
Karen’s Food
6C
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James’ Food
UK1
UJ1
P’
6C
10F
30 5 19/09/16 Consumer Equilibrium in a CompeGGve Market Consumer Equilibrium in a CompeGGve Market è Adam Smith’s invisible hand: In a general equilibrium seqng where all markets are perfectly compeGGve, the economy will automaGcally allocate all resources efficiently without need for regulatory control •  A compe77ve equilibrium is a set of prices at which the quanGty demanded equals the quanGty supplied in every market –  Not all prices lead to equilibrium; If the MRSs of the players are not equal, then we are not in equilibrium –  Disequilibrium is only temporary in a compeGGve market; Supports argument for less government intervenGon and more highly compeGGve markets Excess demand will cause price to rise; Excess supply will cause price to fall 31 www.unamur.be
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First Theorem of Welfare Economics: equilibrium and efficiency An equilibrium alloca7on of resources obtained when everyone trades in a compe77ve marketplace, is automaGcally efficient •  all mutually beneficial trades will be completed •  Efficient does not mean equitable… •  Note: Efficient outcomes can also be achieved by centralized system Second Theorem of Welfare Economics: equilibrium and efficiency If all agents have convex preferences, there will always exist prices such that all Pareto efficient allocaGon of ressources is a compeGGve equilibrium obtained from iniGal endowment. 33 www.unamur.be
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