Introduction to EconomicsIntroduction to Economics

General Equilibrium and Welfare General Equilibrium and Welfare EconomicsEconomics

OutlineOutline

IntroductionIntroduction Market interdependence and Excess demandMarket interdependence and Excess demand Horizontal equilibrium across final goods marketsHorizontal equilibrium across final goods markets Vertical Equilibrium across input and output Vertical Equilibrium across input and output

marketsmarkets General equilibrium in a competitive economyGeneral equilibrium in a competitive economy Introducing welfare economicsIntroducing welfare economics

IntroductionIntroduction

Very important in microeconomicsVery important in microeconomics Rational behaviorRational behavior Meaning of equilibriumMeaning of equilibrium

– Rational individuals can coincide in such a way that Rational individuals can coincide in such a way that none of them have an incentive to change the outcomenone of them have an incentive to change the outcome

Partial equilibrium focuses on the state of one Partial equilibrium focuses on the state of one marketmarket– The ceteris paribus assumption is important hereThe ceteris paribus assumption is important here

IntroductionIntroduction

General equilibrium focuses on the entire General equilibrium focuses on the entire economy.economy.– Price of a good depends on prices of other Price of a good depends on prices of other

goodsgoods– The quantity of labor supplied affects the level The quantity of labor supplied affects the level

of wages, income and industry supply but is of wages, income and industry supply but is dependent on prices of other goodsdependent on prices of other goods

– The point is that markets are interconnected and The point is that markets are interconnected and affect each other.affect each other.

Introduction Introduction

What is general equilibrium?What is general equilibrium?– It refers to an existence of a set of prices for It refers to an existence of a set of prices for

which all rational plans –across goods and which all rational plans –across goods and factors –are in harmony or coincide.factors –are in harmony or coincide.

– The existence of this equilibrium is the prime The existence of this equilibrium is the prime driving force behind the efficiency of the free driving force behind the efficiency of the free market economy.market economy.

– It suggest that a decentralized system with It suggest that a decentralized system with rational agents can work wellrational agents can work well

Dimensions of general Dimensions of general equilibriumequilibrium

Horizontal dimensionHorizontal dimension– The relationship between equilibria across final goods The relationship between equilibria across final goods

marketsmarkets

– These are connected directly through consumer demandThese are connected directly through consumer demand

– Inter-market equilibriumInter-market equilibrium

Vertical equilibriumVertical equilibrium– Relationships between markets connected through Relationships between markets connected through

production (intra – market)production (intra – market)

– The relationship between consumer income and the The relationship between consumer income and the supply of final goodssupply of final goods

Horizontal EquilibriumHorizontal Equilibrium

Page 219 Page 219 To what extent are markets connected?To what extent are markets connected? Final goods are connected through Final goods are connected through

consumer demandconsumer demand Consumer chooses a bundle of goods to Consumer chooses a bundle of goods to

maximize utilitymaximize utility Demanding more of one good may mean Demanding more of one good may mean

demanding more or less of anotherdemanding more or less of another

Horizontal EquilibriumHorizontal Equilibrium

Recall the consumer equilibrium using IC analysis Recall the consumer equilibrium using IC analysis (page 220)(page 220)

The actual price of good X depends on the results The actual price of good X depends on the results of the equilibrium conditions in the market for X.of the equilibrium conditions in the market for X.

This is partial equilibrium which does not explain This is partial equilibrium which does not explain how changes in the equilibrium conditions in one how changes in the equilibrium conditions in one market may influence the equilibrium conditions market may influence the equilibrium conditions in another.in another.

Everything in the economy is interconnected, Everything in the economy is interconnected, changes create a domino effect.changes create a domino effect.

Example - MathematicsExample - Mathematics

Suppose Demand for XSuppose Demand for X– XXdd = D = Dxx(P(Pxx,P,Pyy)=a-bP)=a-bPx x +eP+ePyy

– A=100, b =-3, e=1A=100, b =-3, e=1 Suppose also the Supply of X is XSuppose also the Supply of X is Xss

– XXs s = c P= c Pxx-dw-dw– c=2 and d=4c=2 and d=4

Market equilibrium for X, depends on PMarket equilibrium for X, depends on Pyy and w, say both equals 5 (diagram on page and w, say both equals 5 (diagram on page 222).222).

Excess Demand FunctionsExcess Demand Functions

The Excess Demand function for good X The Excess Demand function for good X (ED) is the difference between quantity (ED) is the difference between quantity demanded and quantity supplied.demanded and quantity supplied.

When two goods are gross substitutes and When two goods are gross substitutes and increase in Py will cause and increase in the increase in Py will cause and increase in the demand for X and an increase in ED.demand for X and an increase in ED.

The ED curve shifts upwards with increases The ED curve shifts upwards with increases in Py, which means that the equilibrium Px in Py, which means that the equilibrium Px also increases as Py increases (page 224)also increases as Py increases (page 224)

Excess Demand FunctionExcess Demand Function

The relationship between Py and equilibrium Px The relationship between Py and equilibrium Px can be depicted as an increasing function as shown can be depicted as an increasing function as shown (page 225)(page 225)

A similar equilibrium function can be obtained for A similar equilibrium function can be obtained for good Ygood Y

The point of intersection of these two equilibrium The point of intersection of these two equilibrium functions is of particular interest.functions is of particular interest.

At This point the markets for X and Y can be said At This point the markets for X and Y can be said to be in general equilibrium (page 228)to be in general equilibrium (page 228)

Horizontal equilibriumHorizontal equilibrium

This point can be obtained algebraically by solving the set This point can be obtained algebraically by solving the set simultaneous equationssimultaneous equations– Xd –Xs =0, Yd –Ys =0Xd –Xs =0, Yd –Ys =0– These include both endogenous variables (determined These include both endogenous variables (determined

in the model – Px and Py) in the model – Px and Py) – Exogenous variables whose values are known in Exogenous variables whose values are known in

advance (taste, technology, wages)advance (taste, technology, wages)– Page 228Page 228

The equilibrium exist once the equations can be solvedThe equilibrium exist once the equations can be solved It is stable once there are forces in the economy moving It is stable once there are forces in the economy moving

the system to the equilibriumthe system to the equilibrium. (page 229). (page 229)

Vertical considerationsVertical considerations

Relationship between consumer income and the Relationship between consumer income and the supply of final goodssupply of final goods

The supply of labor determines consumer income.The supply of labor determines consumer income. The supply of labor also has an impact on the The supply of labor also has an impact on the

wage rate when it is combined with firms wage rate when it is combined with firms technology.technology.

In this way the supply of labor to one market In this way the supply of labor to one market could impact on demand and supply of output in could impact on demand and supply of output in others.others.

Vertical dimensionVertical dimension

The vertical dimension of general The vertical dimension of general equilibrium is the relationship between the equilibrium is the relationship between the consumption decision and the supply of consumption decision and the supply of factor decisions, which determines the factor decisions, which determines the availability of goods for consumption.availability of goods for consumption.

The Robinson Crusoe economy (page 231)The Robinson Crusoe economy (page 231) PPF –production possibility frontierPPF –production possibility frontier Indifference curves.Indifference curves.

Robinson CrusoeRobinson Crusoe

Slope of the PPF = dL/dX = 1/MPSlope of the PPF = dL/dX = 1/MPLLXX, the , the

opportunity cost of leisure in terms of work.opportunity cost of leisure in terms of work. Diminishing marginal rate of substitutionDiminishing marginal rate of substitution PPF is a constraint on production and PPF is a constraint on production and

consumptionconsumption Slope of IC, willingness to pay for X in Slope of IC, willingness to pay for X in

terms of leisure , MUterms of leisure , MUxx/MU/MULL

Both slopes are equal for general Both slopes are equal for general equilibriumequilibrium

Exchange EconomyExchange Economy

dL/dX = 1/MPdL/dX = 1/MPLLXX = MU = MUxx/MU/MULL=P=Pxx//ww

w=w= PPx x MPMPLLXX

The consumer chooses his supply of labor and demand for The consumer chooses his supply of labor and demand for consumption according to the principle which equates the consumption according to the principle which equates the subjective rate of substitution with the market rate of subjective rate of substitution with the market rate of exchange.exchange.

Produces will produce according to the profit Produces will produce according to the profit maximization principle, equating marginal rate of maximization principle, equating marginal rate of technological substitution with the market rate of exchange technological substitution with the market rate of exchange for factors for factors

The market for factors is linked to the goods market by the The market for factors is linked to the goods market by the rates of exchange.rates of exchange.

The distribution of SurplusThe distribution of Surplus

Production is efficient when it is impossible Production is efficient when it is impossible to increase production of any good without to increase production of any good without producing less of another. producing less of another.

No Pareto improvements are possible.No Pareto improvements are possible. What is Pareto efficiency?What is Pareto efficiency?

Pareto EfficiencyPareto Efficiency

Pareto efficiency requires that it must not be Pareto efficiency requires that it must not be possible to change the allocation of possible to change the allocation of resources in such a way that someone is resources in such a way that someone is made better off and no one is made worse made better off and no one is made worse off.off.

Two dimensionsTwo dimensions– Technical or Productive efficiency Technical or Productive efficiency

» Points on the PPF are technically efficient in that it Points on the PPF are technically efficient in that it is not possible to increase the output of one good is not possible to increase the output of one good without decreasing the output of another.without decreasing the output of another.

Pareto EfficiencyPareto Efficiency

– Allocative efficiency exist when it is not possible to Allocative efficiency exist when it is not possible to being about a Pareto improvement by changing the being about a Pareto improvement by changing the product mixproduct mix

– When the slope of the production boundary is equal to When the slope of the production boundary is equal to the rate at which consumers as a whole are just the rate at which consumers as a whole are just prepared to substitute one good for another then at this prepared to substitute one good for another then at this point there will be Pareto efficiency.point there will be Pareto efficiency.

– Social utility function and the distribution of surplus , Social utility function and the distribution of surplus , producers and consumer’s surplus. (page 235)producers and consumer’s surplus. (page 235)

Conditions for Pareto EfficiencyConditions for Pareto Efficiency

Perfect competition in all marketsPerfect competition in all markets No externalitiesNo externalities No public goodsNo public goods No market failure connected with No market failure connected with

uncertaintyuncertainty