Chapter 12 © 2006 Thomson Learning/South-Western General Equilibrium and Welfare

2 An Illustration of General Equilibrium Figure 12-1 shows the market for tomatoes and three of the many other market related to it: The market for tomato pickers. The market for a related product --cucumbers. The market for cucumber pickers. The initial equilibrium is shown by the darker demand and supply curves.

3 Price P1P1 D S Tomatoes (a) Market for Tomatoes 0 Wages W1W1 D S Tomato pickers (b) Market for Tomato Pickers 0 Price P2P2 D S Cucumbers (c) Market for Cucumbers 0 Wages W2W2 D S Cucumber pickers (d) Market for Cucumber Pickers 0 FIGURE 12-1: The Market for Tomatoes and Several Related Markets

4 An Illustration of General Equilibrium The initial set of equilibrium prices are: P 1 for tomatoes. W 1 for tomato pickers. P 2 for cucumbers. W 2 for cucumber pickers. Since the markets are in general equilibrium, this will persist unless something happens to change it.

5 Disturbing the Equilibrium Assume the government announces that tomatoes cure the common cold, resulting in an increase in demand. Initially, this would shift the demand curve for tomatoes outward to D’. The increase in tomatoes prices brought about by the increase in demand stimulates the demand for more tomato pickers which shifts outward to D’.

6 Disturbing the Equilibrium The higher wages for tomato pickers increases the costs for tomato growers, shifting the tomato supply curve back to S’. If the demand for cucumbers decreased because of the increase in demand for tomatoes. This decreases the price of cucumbers and leads to less produced. The demand for cucumber pickers falls, and their wages also decrease.

7 Price P1P1 S’ D’ D S Tomatoes (a) Market for Tomatoes 0 Wages W1W1 D’ D S Tomato pickers (b) Market for Tomato Pickers 0 Price P2P2 D’ D S Cucumbers (c) Market for Cucumbers 0 Wages W2W2 D’ D S Cucumber pickers (d) Market for Cucumber Pickers 0 FIGURE 12-1: The Market for Tomatoes and Several Related Markets

8 Reestablishing Equilibrium Eventually we would expect each market to eventually reach a new equilibrium. The new equilibrium in Figure 12-1 is shown by the lighter colored demand and supply curves. There is a rise in tomato prices (to P 3 ), an increase in tomato picker wages (to w 3 ), a fall in cucumber prices (to P 4 ), and a fall in cucumber picker wages (to w 4 ).

9 Price P3P3 P1P1 S’ D’ D S Tomatoes (a) Market for Tomatoes 0 Wages W3W3 W1W1 D’ D S Tomato pickers (b) Market for Tomato Pickers 0 Price P2P2 P4P4 D’ D S Cucumbers (c) Market for Cucumbers 0 Wages W4W4 W2W2 D’ D S Cucumber pickers (d) Market for Cucumber Pickers 0 FIGURE 12-1: The Market for Tomatoes and Several Related Markets

10 An Efficient Mix of Outputs A technically efficient allocation of resources in which the output combination also reflects people’s preferences is an economically efficient allocation of resources. Figure 12-2 illustrates the requirements for economic efficiency in the mix of outputs.

11 A Simple General Equilibrium Model The best use of resources is achieved at point E. This point is the utility maximizing choice where the person’s indifference curve is tangent to the production possibility frontier. Point E is defined as an economically efficient allocation of resources.

12 Quantity of Y per week P G U1U1 U2U2 U3U3 E F Quantity of X per week 0 P’ FIGURE 12-2: Efficiency of Output Mix

13 Efficiency in Output Mix Profit maximizing firms will equate the rate at which they can trade X for Y in production to the equilibrium price ratio. Utility maximizing people will equate their MRS to the equilibrium price ratio. Thus, RPT equals MRS, which, when demand equals supply, meets the requirements for economic efficiency.

14 Efficiency of Perfect Competition With an arbitrary initial price ratio, in Figure 12-3, profit maximizing firms will produce the output combination X 1, Y 1. Societies’ budget constraint, CC, must go through this point since the value of income must equal the value of output.

15 Quantity of Y per week Y1Y1 P Y* Y’ 1 C C Initial prices Quantity of X per week X1X1 0 X* U2U2 U3U3 X’ 1 P’ FIGURE 12-3: How Perfectly Competitive Prices Bring about Efficiency

16 A Graphic Demonstration On the budget constraint, CC, individuals will demand X ’ 1, Y ’ There is an excess demand for good X 1 and an excess supply of good Y 1. Firms will produce more X and less Y.

17 Quantity of Y per week Y1Y1 P Y* Y’ 1 C* E C C Efficient prices Initial prices Quantity of X per week X1X1 0 X* U2U2 U3U3 X’ 1 P’ FIGURE 12-3: How Perfectly Competitive Prices Bring about Efficiency

18 A Graphic Demonstration The market will cause prices to move toward their equilibrium levels P* X and P* Y. People will respond to the changes in prices by substituting Y for X in their consumption choices. These action will eliminate the excess demand for X and the excess supply for Y. Equilibrium is reached at X *, Y * with equilibrium prices P * X and P * Y.

19 A Graphic Demonstration At this price ratio, supply and demand are equilibrated for both goods. Profit maximizing firms will produce X * and Y *. With the income generated, individuals will maximize utility by choosing X * and Y *. Competitive market have generated an efficient allocation of resources.

20 Why Markets Fail to Achieve Economic Efficiency Imperfect competition Externalities Public goods Imperfect information

21 Imperfect Competition Imperfect competition is a market situation in which buyers or sellers have some influence on the prices of goods or services. In this case, the firm is not a price taker so marginal revenue does not equal price. Relative prices do not reflect relative marginal costs, and inefficiency can result (for example, monopoly dead-weight loss).

22 Externalities Externalities represent additional costs-- those that arise from the external damage. The firm, however, only responds to private input costs, it disregards the social costs of pollution. This results in a gap between market price and social marginal cost, which leads to a misallocation of resources.

23 Public Goods Price cannot equal marginal cost (which is zero), since the fixed cost of providing the good would not be covered. The incentive is for people to refuse to pay for the good hoping others will purchase, and thus provide the good. This causes society to not allocate enough resources to public goods.

24 Imperfect Information It has been assumed that economic actors are fully informed, especially about equilibrium market prices. Without this information, the “invisible hand” results do not hold. Without perfect information, a consumer would have problems (costs) finding quality and the prices charged by different firms.

25 Efficiency and Equity Equity is the fairness of the distribution of goods or utility. A primary problem with this concept is developing an accepted definition of “fair” or “unfair” allocations of resources. Opinions vary from, an allocation is fair if no laws are broken in obtaining it to a fair allocation requires all people share equally.

26 The Edgeworth Box Diagram The Edgeworth box diagram is a graphic device for illustrating all of the possible allocations of two goods (or two inputs) that are in fixed supply. It can be used to show how the production possibility frontier is constructed. It can also be adapted to illustrate voluntary exchange between two individuals.

27 Total X Total Y OSOS OJOJ FIGURE 12-4: Edgeworth Box Diagram

28 The Edgeworth Box Diagram for Exchange For consumer Smith, quantities of X are measured along the horizontal axis rightward from her axis O S, and quantities of Y are shown along the vertical axis above O S. Consumption for the other consumer, Jones, is shown starting from the origin O J. At point E, for example, Smith gets X E S, Y E S and Jones gets X E J, Y E J.

29 Total X Total Y YSYS E XSXS E YJYJ E XJXJ E OSOS OJOJ E FIGURE 12-4: Edgeworth Box Diagram

30 Mutually Beneficial Trades All possible allocations of the goods between Smith and Jones are shown within the box. To identify those which provide mutually beneficial trades, indifference curves representing the preferences of Smith and Jones are shown in Figure 12-5.

31 Mutually Beneficial Trades Smith’s indifference curve map is drawn with origin O S. Movements in the northeasterly direction represent higher levels of utility for Smith. Jones’s indifference curve map is drawn with origin O J. Movements in a southwesterly direction represent higher levels of utility for Jones.

32 Total Y Smith’s Y Jones’s Y Smith’s X Jones’s X Total X OSOS OJOJ USUS 4 UJUJ 4 USUS M1M1 M2M2 M3M3 M4M4 USUS 2 USUS 1 E F UJUJ UJUJ UJUJ FIGURE 12-5: Edgeworth Box diagram of Pareto Efficiency in Exchange

33 Mutually Beneficial Trades Any point for which the MRS for Smith is unequal to that for Jones represents an allocation where mutually beneficial trades can take place. Such a point, E, is shown where the indifference curves intersect. Any point inside the oval-shaped area represent mutually beneficial trades.

34 Efficiency in Exchange When the marginal rates of substitution are equal, such as points M 1 through M 4, mutually beneficial trades are no longer possible. Movements away from these tangency positions result in at least one person being made worse off. The movement from M 2 to E, for example, makes Smith worse off and Jones no better off.

35 Contract Curve The contract curve is the set of efficient allocations of the existing goods in an exchange situation. Points off that curve are necessarily inefficient, since individuals can be made unambiguously better-off by moving to the curve. In Figure 12-5, this curve is the set of points, such as M 2, on the line connecting O S to O J.

36 Contract Curve A movement to the curve from off the curve represents mutually beneficial trades, but a movement along the curve does not since one of the parties is always worse off. If the contract curve is interior to the Edgeworth box, the individuals’ MRS will be equal along the curve.

37 Efficiency and Equity Suppose, for example, that everyone agreed that the only fair allocation is one of equal utilities. Point E in Figure 12-6 might be such a point. Assume point A is the initial endowments; the initial holdings of good from which trading begins.

38 Smith’s Y Jones’s Y Smith’s X Jones’s X OSOS OJOJ M2M2 M1M1 M3M3 3 M4M4 E A Total X UJUJ 2 1 USUS 2 1 Total Y UJUJ UJUJ UJUJ USUS USUS USUS FIGURE 12-6: Voluntary Transactions May Not Result in Equitable Allocations

39 Efficiency and Equity Point E lies outside of the region on the contract curve, between M 2 and M 3, which is mutually preferable to point A. Smith would not voluntarily agree to point E since she would be made worse off. With unbalanced initial endowment, a equal allocation is not possible through mutually beneficial trade.