Eaton Micro 6e Ch13

7/27/2019 Eaton Micro 6e Ch13

1/32


2/32

2005 Pearson Education Canada Inc.13.2

General Equilibrium

Earlier chapters dealt with a partial equilibriumframework (characterized by a market-tomarket equilibrium).

This chapter widens the perspective by fittingall the analytical pieces together into one largepicture of efficiency in an economy widecontext.

This framework considers all markets in theeconomy simultaneously and is known as ageneral equilibrium analysis.


3/32


Preference Assumptions

1. Indifference curves are convex tothe appropriate origin.

2. Indifference curves are smooth.

3. Both goods are essential for allconsumers.

4. The thing that affects well-beingare the quantities of the two goodsconsumed.


4/32


Figure 13.1 The Edgeworth box diagram


5/32


6/32


Efficiency in Consumption

Given the assumptions previouslystated:

An allocation of goods is Pareto-optimal in a many person exchangeeconomy if MRS is identical for allindividuals.


7/32


8/32


Figure 13.2 The contract curve


9/32


Figure 13.3 Budget lines in an exchange economy


10/32


Figure 13.4 Competitive equilibrium in

an exchange economy


11/32


From Figure 13.4

The initial allocation is at point A.

Given the announced price, line AE* isthe budget line for Shelly and Marvin.

Since they will both choose E*, theannounced price is a competitiveequilibrium price and E* is a competitive

allocation.Since E* is on the contract curve, the

competitive equilibrium is Pareto-optimal.


12/32


Walras Law

When there are n markets in ageneral equilibrium model, Walraslaw states that if demand is equal to

supply in n-1 markets, then thedemand is equal to supply in the nthmarket as well.


13/32


First Theorem of Welfare

Economics

Given the assumptions made, thecompetitive equilibrium allocation ofa many person exchange economy is

Pareto-optimal.

In other words, all gains from tradeare realized in a competitive

equilibrium.


14/32


Second Theorem of Welfare

Economics

With the assumed preferences, given anyPareto-optimal allocation, there is an initialallocation such that, given the initial

allocation, the Pareto-optimal allocation isthe competitive equilibrium allocation.

(From Figure 13.4, this says that anyallocation on the budget line will produce E*,

the competitive equilibrium).


15/32


Efficiency in General Equilibrium

with Production

Production Assumptions:

1. Isoquants are smooth and convex.

2. Both inputs are essential inproducing both goods.

3. Production functions exhibit

constant returns to scale.4. Production involves no externalities.


16/32


Efficiency in Consumption

Condition

Efficiency in consumption requiresthat MRS is identical for allindividuals.

In other words, the allocation toindividual consumers of the goodsproduced in an economy must be

Pareto-optimal.


17/32


Figure 13.5 The production possibilities set


18/32


Efficiency In Production

Efficiency in production requires thatthe combination of goods actuallyproduced must be on the production

possibility frontier (PPF).

Efficiency in production Condition:

Efficiency in production requires thatthe MRTS must be identical for allfirms.


19/32


Figure 13.6 An Edgeworth box for production


20/32


Efficiency in the Product Mix

This condition concerns the interfacebetween production and consumption.

The absolute value of the slope of the PPF

is known as the marginal rate oftransformation (MRT).

The MRTmeasures the opportunity cost

of the economy as a whole for a smallincrease in the amount of good 1 relativeto good 2.


21/32


Figure 13.7 The marginal rate of transformation


22/32


Marginal Rate of Transformation

The marginal rate of transformationcan be expressed in terms of themarginal products in two different

but equivalent ways:

MRTS=MP12/MP1

1 = MP22/MP2

1


23/32


Efficiency in the Product Mix

Efficiency in the Product Mix Condition:

Efficiency in the product mix requiresthat each consumers MRS be identicalto the economys MRT.


24/32


Figure 13.8 Efficiency in product mix


25/32


Efficient Allocation of resources

Each of the three efficiency conditions isnecessary for an efficient allocation ofresources:

1.

Efficiency in consumption requires that MRS isidentical for all individuals.

2. Efficiency in production requires that theMRTS must be identical for all firms.

3. Efficiency in the product mix requires thateach consumers MRS be identical to theeconomys MRT.


26/32


27/32


Figure 13.9 Efficiency in product mix for

general competitive equilibrium


28/32


29/32


Figure 13.10 Trade between Two Countries


30/32


Sources of Inefficiency

What produces an inefficient allocationof resources?

There are many potential sources ofinefficiencies, one is a monopoly.


31/32


32/32

2005 Pearson Education Canada Inc.13 32

Monopoly and Inefficiency

For a monopoly the inefficiencyarises from a distortion of theproduct mix.

The inefficiency arises because theprofit maximizing monopolistproduces where MRMRT and the allocation ofresources is inefficient.

Documents

Eaton Micro 6e Ch13