Microeconomics
Claudia Vogel
EUV
Winter Term 2009/2010
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
1 / 20
General Equilibrium and Economic Eciency
Lecture Outline
Part IV Information, Market Failure and the Role of Government
13 General Equilibrium and Economic Eciency
General Equilibrium Analysis
Eciency in Exchange
Equity and Eciency
Why Markets Fail
Summary
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
2 / 20
General Equilibrium and Economic Eciency General Equilibrium Analysis
General Equilibrium Analysis
partial equilibrium analysis
: Determination of equilibrium prices and
quantities in a market independent of eects from other markets.
general equilibrium analysis
: Simultaneous determination of the prices and
quantities in all relevant markets, taking feedback eects into account.
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
3 / 20
General Equilibrium and Economic Eciency General Equilibrium Analysis
Two Independent Markets - Moving to General Equilibrium
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
4 / 20
General Equilibrium and Economic Eciency General Equilibrium Analysis
Example: The Global Market for Ethanol
If U.S. taris on ethanol produced abroad were to be removed, Brazil would export much
more ethanol to the United States, displacing much of the more expensive corn-based
ethanol produced domestically.
As a result, the price of ethanol in the U.S. would fall, beneting U.S. consumers.
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
5 / 20
General Equilibrium and Economic Eciency Eciency in Exchange
Eciency in Exchange
exchange economy
: Market in which two or more consumers trade two
goods among themselves.
ecient
(or
Pareto ecient allocation
)
: Allocation of goods in which no
one can be made better o unless someone else is made worse o.
The Advantages of Trade
Individual
Initial Allocation
Trade
Final Allocation
James
7F, 1C
-1F, +1C
6F, 2C
Karen
3F, 5C
+1F, -1C
4F, 4C
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
6 / 20
General Equilibrium and Economic Eciency Eciency in Exchange
The Edgeworth Box Diagram
Edgeworth box
: Diagram showing all possible allocations of either two
goods between two people or two inputs between two production processes.
Each point in the Edgeworth box simultaneously represents Jame's and Karen's
market baskets of food and clothing.
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
7 / 20
General Equilibrium and Economic Eciency Eciency in Exchange
Ecient Allocations
The Edgeworth box illustrates the possibilities for both consumers to increase
their satisfaction by trading goods.
If A gives the initial allocation of resources, the shaded area describes all mutually
benecial trades.
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
8 / 20
General Equilibrium and Economic Eciency Eciency in Exchange
The Contract Curve
contract curve
: Curve showing all ecient allocations of goods between two
consumers, or of two inputs between two production functions.
Every point on the curve is ecient because one person cannot be better o
without the other person worse o.
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
9 / 20
General Equilibrium and Economic Eciency Eciency in Exchange
Consumer Equilibrium in a Competitive Market
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
10 / 20
General Equilibrium and Economic Eciency Eciency in Exchange
The Economic Eciency of Competitive Markets
welfare economics
: Normative evaluation of markets and economic policy
If everyone trades in the competitive marketplace, all mutually benecial trades
will be completed and the resulting equilibrium allocation of resources will be
economically ecient.
Let's summarize what we know about a competitive equilibrium from the
consumer's perspective:
1
Because the indierence curves are tangent, all marginal rates of substitution
between consumers are equal.
2
Because each indierence curve is tangent to the price line, each person's
MRS of clothing for food is equal to the ratio of the prices of the two goods.
MRSFCJ = PPCF = MRSFCK
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
11 / 20
General Equilibrium and Economic Eciency Eciency in Exchange
The Utility Possibilities Frontier
utility possibilities frontier
: Curve showing all ecient allocations of
resources measured in terms of the utility levels of two individuals.
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
12 / 20
General Equilibrium and Economic Eciency Equity and Eciency
Social Welfare Functions
social welfare function
: Measure describing the well-being of society as a
whole in terms if the utilities of individual members.
Four Views of Equity
1
Egalitarian - all members of society receive equal amounts of goods
2
Rawlsian - maximize the utility of the least-well-o person
3
Utilitarian - maximize the total utility of all members of society
4
Market-oriented - the market outcome is the most equitable
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
13 / 20
Winter Term 2009/2010
14 / 20
General Equilibrium and Economic Eciency Why Markets Fail
Why Markets Fail
Market Power
Incomplete Information
Externalities
Public Goods
Claudia Vogel (EUV)
Microeconomics
General Equilibrium and Economic Eciency Summary
Summary 1/2
Partial equilibrium analyses of markets assume that related markets are
unaected. General equilibrium analyses examine all markets simultaneously,
taking into account feedback eects of other markets on the market being
studied.
An allocation is ecient when no consumer can be made better o by trade
without making someone else worse o. When consumers make all mutually
advantageous trades, the outcome is Pareto ecient and lies on the contract
curve.
A competitive equilibrium describes a set of prices and quantities: When each
consumer chooses her most preferred allocation, the quantity demanded is
equal to the quantity supplied in every market. All competitive equilibrium
allocations lie on the exchange contract curve and are Pareto ecient.
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
15 / 20
General Equilibrium and Economic Eciency Summary
Summary 2/2
Th utility possibilities frontier measures all ecient allocations in terms of
the levels of utility that each person achieves. Although both individuals
prefer some allocations to an inecient, not every ecient allocation must be
so preferred. Thus an inecient allocation can be more equitable than an
ecient one.
Because a competitive equilibrium need not be equitable, the government
may wish to help redistribute wealth from rich to poor. Because such
redistribution is costly, there is some conict between equity and eciency.
Competitive markets may be inecient for four reasons. First, rms or
consumers may have market power in input or output markets. Second,
consumers or producers may have incomplete information and may therefore
err in their consumption and production decisions. Third, externalities may be
present. Fourth, some socially desirable public goods may not be produced.
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
16 / 20
Exerxises 11
Problem 1
1
Why can feedback eects make a general equilibrium analysis substantially
dierent from a partial equilibrium analysis?
2
In the Edgeworth box diagram, explain how one point can simultaneously
represent the market basket owned by two consumers.
3
In the analysis of exchange using the Edgeworth box diagram, explain why
both consumers' marginal rates of substitution are equal at every point on
the contract curve.
4
Because all points on a contract curve are ecient, they are all equally
desirable from a social point of view. Do you agree with this statement?
5
How does the utility possibilities frontier relate to the contract curve?
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
17 / 20
Exerxises 11
Problem 2
Suppose gold (G) and silver (S) are substitutes for each other because both serve
as hedges against ination. Suppose also that the supplies of both are xed in the
QG =
short run (
75 and
QS =
300) and that the demands for gold and silver are
given by the following equations:
PG =
975
Q
P
− G + 0.5 S
and
PS =
600
Q
P
− S + 0.5 G
1
What are the equilibrium prices of gold and silver?
2
What if a new discovery of gold doubles the quantity supplied to 150. How
will this discovery aect the prices of both gold and silver?
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
18 / 20
Problem 3
Exerxises 11
Using general equilibrium analysis, and taking into account feedback eects,
analyze the following:
1
The likely eects of outbreaks of disease on chicken farms on the markets for
chicken and pork.
2
The eects of increased taxes on airline tickets on travel to major tourist
destinations such as Florida and California and on the hotel rooms in those
destinations.
Claudia Vogel (EUV)
Problem 4
Microeconomics
Winter Term 2009/2010
19 / 20
Exerxises 11
Jane has 3 litres of soft drinks and 9 sandwiches. Bob, on the other hand, has 8
litres of soft drinks and 4 sandwiches. With these endowments, Jane's marginal
rate of substitution (MRS) of soft drinks for sandwiches is 4 and Bob's MRS is
equal to 2. Draw an Edgeworth box diagram to show whether this allocation of
resources is ecient. If it is, explain why? If it is not, what exchanges will make
both parties better o ?
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
20 / 20