Chapter 16
General Equilibrium
General Equilibrium Analysis
 To study how markets interrelate, we can
use general equilibrium analysis
 The feedback effect is the price or
quantity adjustment in one market
caused by price and quantity adjustments
in related markets
©2005 Pearson Education, Inc.
Chapter 16
2
Two Interdependent Markets –
Moving to General Equilibrium
 Scenario
The competitive markets of:
 DVD
rentals
 Movie theater tickets
Changing prices in one market are likely to
affect the other market
©2005 Pearson Education, Inc.
Chapter 16
3
Two Interdependent Markets –
Moving to General Equilibrium
 Scenario
Equilibrium price of movies is $6.00
Equilibrium price of DVD rentals are $3.00
Government places a $1.00 tax on each
movie ticket
Need to look at effect of tax on
 Market
for DVDs
 Feedback effects in Movie market
©2005 Pearson Education, Inc.
Chapter 16
4
Two Interdependent Markets –
Movies and DVDs
Price
$1 tax on each movie
ticket causes supply to fall
S*M
Price
General Equilibrium Analysis:
Increase in movie ticket prices
increases demand for videos.
SV
SM
$3.50
$6.35
$3.00
D’V
$6.00
DM
Q’M
©2005 Pearson Education, Inc.
QM
Number of
Movie Tickets
DV
QV Q’V
Number
of Videos
5
Two Interdependent Markets –
Movies and DVDs
Price
The increase in the price
of videos increases the
demand for movies.
S*M
$6.82
$6.75
Price
General Equilibrium Analysis:
The Feedback effects continue.
SV
SM
$3.58
$3.50
$6.35
D*V
$3.00
D*M
$6.00
D’V
D’M
DM
Q’M Q”M Q*M QM
©2005 Pearson Education, Inc.
Number of
Movie Tickets
Chapter 16
DV
QV Q’V Q*V
Number
of Videos
6
Two Interdependent Markets –
Movies and DVDs
 Observation
Without considering the feedback effect with
general equilibrium, the impact of the tax
would have been underestimated
This is an important consideration for policy
makers.
©2005 Pearson Education, Inc.
Chapter 16
7
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 quantity demanded and quantity
supplied in all related markets
This requires finding the solution to four
equations: demand and supply for DVDs
and Movies
©2005 Pearson Education, Inc.
Chapter 16
8
The Advantages of Trade
 Assumptions
Two consumers (countries)
Two goods
Zero transaction costs
James & Karen have a total of 10 units of
food and 6 units of clothing.
©2005 Pearson Education, Inc.
Chapter 16
9
The Advantage of Trade
Individual Initial
Trade
Allocation
James
7F, 1C
-1F, +1C
Karen
©2005 Pearson Education, Inc.
3F, 5C
Chapter 16
+1F, -1C
Final
Allocation
6F, 2C
4F, 4C
10
The Advantage of Trade
 There is room for trade
James values clothing more than Karen
Karen values food more than James
 Actual terms of trade are determined
through bargaining
©2005 Pearson Education, Inc.
Chapter 16
11
The Advantage of Trade
 From this analysis we obtain an
important result:
An allocation of goods is efficient only if
the goods are distributed so that the
marginal rate of substitution between
any pair of goods is the same for all
consumers.
©2005 Pearson Education, Inc.
Chapter 16
12
The Edgeworth Box Diagram
 A diagram showing all possible
allocations of either two goods between
two people is called an Edgeworth Box
©2005 Pearson Education, Inc.
Chapter 16
13
The Edgeworth Box Diagram
 Each point describes the market baskets
of both consumers
James has 7 units of food and 1 unit of
clothing – point A
Karen has 3 units of food and 5 units of
clothing – point A from different axis
©2005 Pearson Education, Inc.
Chapter 16
14
Exchange in an Edgeworth Box
Karen’s Food
10F
3F
0K
6C
James’s
Clothing
The initial allocation
before trade is A: James
has 7F and 1C & Karen
has 3F and 5C.
Karen’s
Clothing
1C
5C
A
6C
0J
©2005 Pearson Education, Inc.
7F
James’s Food
10F
15
Exchange in an Edgeworth Box
Karen’s Food
10F
6C
4F
3F
0K
The allocation
after trade is B: James
has 6F and 2C & Karen
has 4F and 4C.
James’s
Clothing
Karen’s
Clothing
B
2C
4C
+1C
1C
5C
A
-1F
6C
0J
©2005 Pearson Education, Inc.
6F
James’sChapter
Food 16
7F
10F
16
Efficient Allocations
 A trade from A to B makes both Karen
and James better off
 If James’s and Karen’s MRS are the
same at B the allocation is efficient.
©2005 Pearson Education, Inc.
Chapter 16
17
Efficient Allocations
 We can see both parties are better off at
point B since they both end up on a
higher indifference curve
 Although a trade might make both parties
better off, the new allocation is not
necessarily efficient
©2005 Pearson Education, Inc.
Chapter 16
18
Efficiency in Exchange
Karen’s Food
10F
0K
6C
James’s
Clothing
A: UJ1 = UK1,
but the MRS
is not equal.
All combinations
in the shaded
area are
preferred to A.
Karen’s
Clothing
Gains from
trade
0J
A
UJ1
UK1
10F
James’s Food
©2005 Pearson Education, Inc.
6C
Chapter 16
19
Efficiency in Exchange
Karen’s Food
10F
0K
6C
D is also a
At
point
C,
Point
B is on
possible
MRSs
higher
ICare
but
efficient
equal
and
is allocation
not efficient
allocationon
is
depending
bargaining
efficient
James’s
Clothing
D
Karen’s
Clothing
C
UJ3
B
A
UK3
UK
2
0J
UK1
6C
10F
James’s Food
©2005 Pearson Education, Inc.
UJ2
UJ1
Chapter 16
20
Efficiency in Exchange
 Any move outside the
shaded area will make
one person worse off
(closer to their origin).
 B is a mutually beneficial
trade--higher indifference
curve for each person.
 Trade may be beneficial
but not efficient.
 MRS is equal when
indifference curves are
tangent and the allocation
is efficient.
©2005 Pearson Education, Inc.
Karen’s Food
10F
0K
6C
James’s
Clothing
Chapter 16
D
Karen’s
Clothing
C
UJ3
B
A
0J
UJ2
UJ1
6C
UK3 UK2 UK1
James’s Food
10F
21
Efficiency in Exchange
 The Contract Curve
To find all possible efficient allocations 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
allocations of goods between two consumers,
or of two inputs between two production
functions
©2005 Pearson Education, Inc.
Chapter 16
22
The Contract Curve
Karen’s Food
E, F, & G are
Pareto efficient .
0K
Contract
Curve
G
James’s
Clothing
F
Karen’s
Clothing
E
0J
James’s Food
©2005 Pearson Education, Inc.
Chapter 16
23
Contract curve
 All points of tangency between the
indifference curves are efficient.
MRS of individuals is the same
No more room for trade
 The contract curve shows all allocations
that are Pareto efficient.
Pareto efficient allocation occurs when
further trade will make someone worse off.
©2005 Pearson Education, Inc.
Chapter 16
24
Consumer Equilibrium in a
Competitive Market
 We can show opportunities for trade for
many consumers
When prices of food and clothing are equal,
we can show the price line, PP’ with a slope
of –1
James buys 2 clothing for 2 food: A to C
Karen buys 2 food for 2 clothing: A to C
Both increase satisfaction
©2005 Pearson Education, Inc.
Chapter 16
25
Consumer Equilibrium in a
Competitive Market
10F
6C
Begin at A:
Each Karen buys 2F and
sells 2C moving from
UK1 to UK2, which
is preferred (A to C).
0K
Karen’s Food
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’s
Clothing
UJ2
A
UK2
0J
P’
6C
10F
James’s Food
©2005 Pearson Education, Inc.
UK1
UJ1
Chapter 16
26
Consumer Equilibrium in a
Competitive Market
 The amount of clothing that Karen
wanted to sell is equal to the amount of
clothing that James wanted to buy
 An equilibrium is a set of prices at which
the quantity demanded equals the
quantity supplied in every market
Also called competitive equilibrium
©2005 Pearson Education, Inc.
Chapter 16
27
Consumer Equilibrium in a
Competitive Market
 In a general equilibrium setting where all
markets are perfectly competitive, we can
show the same result
Best example of Adam Smith’s invisible hand
Economy will automatically allocate all
resources efficiently without need for
regulatory control
©2005 Pearson Education, Inc.
Chapter 16
28
Consumer Equilibrium in a
Competitive Market
 Competitive equilibrium
1. Because the indifference curves are tangent, all
MRSs are equal between consumers
2. Because each indifference curve is tangent to
the price line, each person’s MRS is equal to
the price ratio of the two goods
MRS
©2005 Pearson Education, Inc.
J
FC

PC
PF
Chapter 16
 MRS
K
FC
29
Consumer Equilibrium in a
Competitive Market
 Difficult for efficient allocation with many
consumer and producers unless all
markets are perfectly competitive
 Efficient outcomes can also be achieved
by centralized system
©2005 Pearson Education, Inc.
Chapter 16
30
Equity and Efficiency
 Although there are many efficient
allocations, some may be fairer than
others
 The difficult question is what is the most
equitable allocation?
 There is no reason to believe that
efficient allocation from competitive
markets will give an equitable allocation
©2005 Pearson Education, Inc.
Chapter 16
31
The Utility Possibilities Frontier
 From the Edgeworth box we showed a
two person exchange
 The utility possibilities frontier represents
all allocations that are efficient in terms of
the utility levels of the two individuals
©2005 Pearson Education, Inc.
Chapter 16
32
The Utility Possibilities Frontier
Karen’s
Utility
OJ – James has zero utility
OK – Karen has zero utility
E, F, G – points on contract
curve
H – inefficient – can do better
in shaded area
L - unobtainable
OJ
L
E
F
H
G
OK
James’ Utility
©2005 Pearson Education, Inc.
Chapter 16
33
The Utility Possibilities Frontier
Karen’s
Utility
Are all efficient points equitable?
•Efficient points E or F make both
persons better off without making
one worse off from H
•If only possible points are H and
G, can argue that one is more
equitable to James and one to
Karen
OJ
E
F
H
G
OK
James’ Utility
©2005 Pearson Education, Inc.
Chapter 16
34
The Utility Possibilities Frontier
 From previous example, we can see that
an inefficient allocation might be more
equitable than an efficient one.
 But how do we define an equitable
allocation?
©2005 Pearson Education, Inc.
Chapter 16
35
Four Views of Equity
Egalitarian
All members of society receive equal
amount of goods
Rawlsian
Maximize the utility of the least-welloff person
Utilitarian
Maximize the total utility of all
members of society
Market Oriented
The market outcome is the most
equitable
©2005 Pearson Education, Inc.
Chapter 16
36
Equity and Perfect Competition
 A competitive equilibrium can occur at
any point on the contract curve
depending on the initial allocation.
 Since not all competitive equilibriums are
equitable, we rely on the government to
help reach equity by redistributing
income.
Taxes
Pubic services
©2005 Pearson Education, Inc.
Chapter 16
37
Efficiency in Production
 We can extend to the efficient use of
inputs used for production.
 Assume:
Two fixed inputs: capital and labor
Produce same two goods: food and clothing
Many consumers own inputs to production
and earn income from selling them
Income allocated between goods
©2005 Pearson Education, Inc.
Chapter 16
38
Efficiency in Production
 Using the Edgeworth box diagram, we
can show efficient use of inputs in
production
Labor on horizontal axis
Capital on vertical axis
50 hours of labor and 30 hours of capital
available
©2005 Pearson Education, Inc.
Chapter 16
39
Production in an Edgeworth Box
Labor in Clothing Production
50L
15L
0C
30K
Capital in Food
Production
The initial allocation is A.
Every combination of labor
and capital used to produce
two goods is represented
as point in box
5K
Capital in
Clothing
Production
25K
A
30K
0F
©2005 Pearson Education, Inc.
35L
Labor in Food Production
50L
40
Production in an Edgeworth Box
 Can use production isoquants to show
levels of output produced with each
combination of inputs
3 isoquants representing 50, 60 and 80 units
of food
3 isoquants representing 10, 25 and30 units
of clothing
©2005 Pearson Education, Inc.
Chapter 16
41
B
Production in an Edgeworth Box
Labor in Clothing Production
50L
15L
0C
30K
3 isoquants representing
food production
clothing
production
Capital in Food
Production
25C
10C
Capital in
Clothing
Production
30C
60F
A
5K
25K
50F
30K
0F
©2005 Pearson Education, Inc.
35L
Labor in Food Production
50L
42
Production in an Edgeworth Box
 To find efficient production, we must find
different combinations of inputs used to
produce the two outputs
 An allocation of inputs is technically
efficient if the output of one good cannot
be increased without decreasing the
output of another goods
©2005 Pearson Education, Inc.
Chapter 16
43
Production in an Edgeworth Box
Labor in Clothing Production
50L
15L
0C
30K
Can place
move in
from
A to B
or
Any
shaded
area
C increase
which increases
will
efficiency
fromefficiency.
allocation A.
D
Capital in Food
Production
25C
10C
30C
Capital in
Clothing
Production
C
B
60F
A
5K
25K
50F
30K
0F
©2005 Pearson Education, Inc.
35L
Labor in Food Production
50L
44
Production in an Edgeworth Box
 Points B and C are efficient allocations
and therefore lie on the production
contract curve
Curve showing all technically efficient
combinations of inputs.
Curve connects the origins, OF and OC
All points on curve are tangencies between
two isoquants
©2005 Pearson Education, Inc.
Chapter 16
45
Production in an Edgeworth Box
Labor in Clothing Production
50L
15L
0C
30K
Capital in Food
Production
Production
Contract
Curve
D
25C
10C
30C
Capital in
Clothing
Production
C
B
60F
A
5K
25K
50F
30K
0F
©2005 Pearson Education, Inc.
35L
Labor in Food Production
50L
46
Producer Equilibrium –
Competitive Input Markets
 If input markets are competitive, an
efficient point will be achieved
 In competitive input markets
Wage rate, w, will be equal in all industries
Rental rate of capital, r, will be equal in all
industries
©2005 Pearson Education, Inc.
Chapter 16
47
Producer Equilibrium –
Competitive Input Markets
 If producers minimize costs, they will
choose inputs to the point where the ratio
of the marginal products of the two inputs
is equal to the ratio of input prices:
MPL w

MPK
r
©2005 Pearson Education, Inc.
Chapter 16
48
Producer Equilibrium –
Competitive Input Markets
 Ratio of marginal products is the same as
the marginal rate of technical substitution
of labor for capital:
MPL w
  MRTS LK
MPK
r
©2005 Pearson Education, Inc.
Chapter 16
49
Producer Equilibrium –
Competitive Input Markets
 The MRTS is the slope of the isoquant,
so competitive equilibrium exists only if:
Slopes of the isoquants are equal to one
another
These also equal the ratio of the prices of
two inputs
 Competitive equilibrium lies on the
production contract curve, and the
competitive equilibrium is efficient in
production
©2005 Pearson Education, Inc.
Chapter 16
50
Production Possibilities Frontier
 PPF shows the various combinations of
two goods that can be produced with
fixed quantities of inputs.
 Frontier is derived from the production
contract curve
 Points on PPF show efficiently produced
levels of both goods
©2005 Pearson Education, Inc.
Chapter 16
51
Production Possibilities Frontier
Clothing
(units)
•Point A is inefficient
•Points B, C and D are efficient
•All points in triangle ABC
completely utilize capital and
labor but distortion in labor
market leads to inefficient use
OF
B
A
C
D
OC
©2005 Pearson Education, Inc.
Chapter 16
Food
(units)
52
Production Possibilities Frontier
 PPF is downward sloping
In order to produce more of one good, must
give up producing some of the other good
 PPF is concave
Slope is the MRTS which increases as the
level of production of food increases
©2005 Pearson Education, Inc.
Chapter 16
53
Production Possibilities Frontier
 Marginal rate of transformation (MRT) of
food for clothing is the magnitude of the
slope of the frontier at each point
How much clothing must be given up to
produce one additional unit of food
As we increase the production of food my
moving along the PPF, the MRT increases
©2005 Pearson Education, Inc.
Chapter 16
54
Marginal Rate of Transformation
 The productivity of labor and capital
differs depending on whether the inputs
are used to produce more food or
clothing.
Starting where only clothing is produced, MP
of labor and capital are relatively low
Transferring some to food production where
MP are relatively high
As we do this, MP in food decreases and MP
in clothing increases
©2005 Pearson Education, Inc.
Chapter 16
55
Production Possibilities Frontier
Clothing
(units)
OF
MRT < 1
B  MRT = 1
D  MRT = 2
MRT > 1
OC
©2005 Pearson Education, Inc.
Chapter 16
Food
(units)
56
Marginal Rate of Transformation
 Can also describe in terms of costs
When producing at OF the MC of food is very low
and MC of clothing is very high
When MRT is low, so is the ratio of the MC of
producing food to clothing
Slope of PPF measures the MC of producing one
good relative to the MC of producing the other
MC F
MRT 
MC C
©2005 Pearson Education, Inc.
Chapter 16
57
Output Efficiency
 For efficiency,
MRS = consumer’s WTP for additional food
by consuming less clothing
MRT = cost of additional unit of food in terms
of producing less clothing
 Efficiency means MRS = MRT
©2005 Pearson Education, Inc.
Chapter 16
58
Output Efficiency
MRS = MRT
Clothing
(units)
60
PPF
Indifference Curve
100
©2005 Pearson Education, Inc.
Chapter 16
Food
(units)
59
Efficiency in Output Markets
 For perfectly competitive markets, all
consumers allocate their budgets so their MRS
between two good are equal to the ratio of
prices
 Profit maximizing firms produce output to the
point where price is equal to MC
 MRT is equal to the MRS
MRT 
©2005 Pearson Education, Inc.
MC F
MC C
Chapter 16

PF
PC
 MRS
60
The Gains from Free Trade
 We have showed gains from trade in an
Edgeworth box, but what about gains
from trade with two countries where one
has the comparative advantage
A country has a comparative advantage over
another country in the production of a good if
the first country can produce the good at a
lower opportunity cost than the other country
©2005 Pearson Education, Inc.
Chapter 16
61
The Gains from Free Trade
 EX: Two countries producing two goods
Holland and Italy
Cheese and Wine
Holland has comparative advantage in
cheese production
Italy as comparative advantage in wine
production
Trade is good for both countries
©2005 Pearson Education, Inc.
Chapter 16
62
The Gains from Free Trade
Hours of Labor Required to
Produce Cheese and Wine
Cheese
Wine
(1 LB)
(1 GAL)
Holland
1
2
Italy
6
3
©2005 Pearson Education, Inc.
Chapter 16
63
The Gains from Free Trade
 When there is comparative advantage,
free trade allows the country to consume
outside their PPF
 Before trade
Produces at A on indifference curve U1
where MRT and pre-trade price ratio is 2
Holland would want to export 2 pounds of
cheese for 1 gallon of wine
©2005 Pearson Education, Inc.
Chapter 16
64
The Gains from Free Trade
 After trade
Suppose they choose to trade 1 gallon of
wine for 1 pound of cheese
Holland will produce at the point of tangency
on the 1/1 price line and PPF – point B
Consumption will occur at D, on a higher
indifference curve U2 tangent to the trade
price line
©2005 Pearson Education, Inc.
Chapter 16
65
The Gains from Trade
Cheese
(lbs)
World Prices Pre-Trade Prices
CB
•Trade allows
Holland to consume
outside PPF
B
Exports
A
D
CD
U2
U1
WB
©2005 Pearson Education, Inc.
Imports
Chapter 16
WD
Wine
(gal)
66
Overview – Efficiency of
Competitive Markets
1. Efficiency in Exchange
 MRSJFC = MRSKFC
 MRSJFC = PF/PC = MRSKFC
2. Efficiency in the use of inputs in
production
 MRTSFLK = MRTSCLK
 MRTSFLK = w/r = MRTSCLK
©2005 Pearson Education, Inc.
Chapter 16
67
Overview – Efficiency of
Competitive Markets
3. Efficiency in the output market




MRTFC = MRSPC (for all consumers)
PF = MCF, PC = MCC resulting in
MRTFC = MCF/MCC = PF/PC; therefore
MRSFC = MRTFC
©2005 Pearson Education, Inc.
Chapter 16
68
Why Markets Fail
 Market Power
Those with market power choose the price
and quantity
Less output is sold than in competitive
markets
Inefficiency
©2005 Pearson Education, Inc.
Chapter 16
69
Why Markets Fail
 Incomplete Information
Consumers must have accurate information
about market prices or production quality for
markets to operate efficiency
Lack of information can change supply
Some markets may never develop
©2005 Pearson Education, Inc.
Chapter 16
70
Why Markets Fail
 Externalities
Consumption or production has indirect
effect on other consumption or production
not reflected in market prices
©2005 Pearson Education, Inc.
Chapter 16
71
Why Markets Fail
 Public Goods
Nonexclusive, nonrival good that can be
made available cheaply but which, once
available, is difficult to prevent others from
consuming
Company thinking about researching a new
technology if can’t get patent
 Once
©2005 Pearson Education, Inc.
it’s made pubic, others can duplicate it
Chapter 16
72