1. General Equilibrium Analysis
Partial equilibrium analysis assumes that activity in one market is independent of other markets.
General equilibrium analysis determines the prices and quantity in all markets simultaneously and takes the feedback effect into account.
A feedback effect is a price or quantity adjustment in one market caused by price and quantity adjustments in related markets.
Chapter 16 4

2. Two Interdependent Markets (Movie Tickets and Videocassette Rentals) Moving to General Equilibrium
$6.35
Q’M
S*M
Assume the government
imposes a $1 tax on
each movie ticket.
Q’V
D’V
$3.50
General Equilibrium Analysis:
Increase in movie ticket prices
increases demand for videos.
Price
Price SM SV DV DM
$6.00 QM QV
$3.00
Number of
Movie Tickets
Number
of Videos 19

3. The increase in the price of videos increases the
Two Interdependent Markets (Movie Tickets and Videocassette Rentals) Moving to General Equilibrium
D’M
Q”M
$6.75
The increase in the price
of videos increases the
demand for movies.
The Feedback
effects continue.
$3.58
Q*V
D*V
Price
Price
D*M
$6.82
Q*M SM SV
S*M DV DM
$3.50
$6.35
$6.00 QM QV
$3.00
D’V
Without considering the feedback effect with general equilibrium, the impact of the tax would have been underestimated. What are the policy implications of using a partial equilibrium analysis compared to a general equilibrium in this scenario?
Q’M
Number of
Movie Tickets
Q’V
Number
of Videos 19

4. Efficiency in Exchange
Exchange increases efficiency until no one can be made better off without making someone else worse off (Pareto efficiency).
The Advantages of Trade
Trade between two parties is mutually beneficial.
Chapter 16 25

5. Efficiency in Exchange
Assumptions
Two consumers (countries)
Two goods
Both people know each others preferences
Exchanging goods involves zero transaction costs
James & Karen have a total of 10 units of food and 6 units of clothing.
Chapter 16 26

6. The Advantage of Trade James 7F, 1C -1F, +1C 6F, 2C
Individual Initial Allocation Trade Final Allocation
James 7F, 1C -1F, +1C 6F, 2C
Karen 3F, 5C +1F, -1C 4F, 4C
Karen’s MRS of food for clothing is 3.
James’s MRS of food for clothing is 1/2.
Karen and James are willing to trade: Karen
trades 1C for 1F. When the MRS is not equal,
there is gain from trade. The economically
efficient allocation occurs when the MRS is equal.
Chapter 16 28

7. Exchange in an Edgeworth Box
James’s
Clothing
Karen’s
Karen’s Food
James’s Food
10F 4F 3F 7F 6F 0K 6C A B
The initial allocation
before trade is A: James
has 7F and 1C & Karen
has 3F and 5C.
+1C
-1F
The allocation
after trade is B: James
has 6F and 2C & Karen
has 4F and 4C. 2C 1C 5C 4C
Efficient Allocations: If James’s and Karen’s MRS are the same at B the allocation is efficient. This depends on the shape of their indifference curves. 6C 0J
10F 34

8. Efficiency in Exchange
Karen’s
Clothing
Karen’s Food
UK1
UK2
UK3 0K 6C
Is B efficient?
Hint: is the
MRS equal
at B?
James’s
Clothing
James’s Food
UJ1
UJ2
UJ3 B C D A
A: UJ1 = UK1,
but the MRS
is not equal.
All combinations
in the shaded
area are
preferred to A.
Gains from
trade
Is C efficient?
and D? 6C 0J
10F
Chapter 16 39

9. 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.
The Contract Curve: to find all possible efficient allocations of food and clothing between Karen and James, we look for all points of tangency between each of their indifference curves. A
Karen’s
Clothing
Karen’s Food
UK1
UK2
UK3
James’s
James’s Food
UJ1
UJ2
UJ3 B C D
10F 0K 0J 6C
Chapter 16 39

10. The Contract Curve 0K G F E 0J Contract Curve E, F, & G are
Pareto efficient . If
a change improves
efficiency, everyone
benefits.
Karen’s Food 0K
James’s
Clothing
Karen’s
Clothing 0J
James’s Food
Chapter 16 47

11. Efficiency in Exchange
Application: The policy implication of Pareto efficiency when removing import quotas:
1) Remove quotas
Consumers gain
Some workers lose
2) Subsidies to the workers that cost less than the gain to consumers
Chapter 16 50

12. Efficiency in Exchange
Equilibrium in a Competitive Market
Competitive markets have many actual or potential buyers and sellers, so if people do not like the terms of an exchange, they can look for another seller who offers better terms.
There are many Jameses and Karens.
They are price takers
Price of food and clothing = 1 (relative prices will determine trade)
Chapter 16 51

13. Competitive Equilibrium
Karen’s Food
10F 0K 6C P
Price Line P’
PP’ is the price line
and shows possible
combinations; slope is -1 C A
Begin at A:
Each James buys
2C and sells 2F
Each James would
move from
Uj1 to Uj2, which
is preferred (A to C).
Each Karen buys 2F and sells 2C. Each Karen would move from
UK1 to UK2, which
At the prices chosen: Qd food (K) = Qs food (J) – competitive equilibrium.
UJ1
UJ2
UK1
UK2
James’s
Clothing
Karen’s
Clothing
At the prices chosen: Qd
clothing (James) = Qs
clothing (Karen) –
competitive equilibrium. 6C 0J
10F
James’s Food 60

14. Competitive Equilibrium
Karen’s Food
10F 0K 6C
Price Line P
The MRSCF is equal to the ratio of the prices, or MRSJFC = PC/PF = MRSKFC.
James’s
Clothing
Karen’s
Clothing C
Point C shows that the
allocation in a competitive
equilibrium is economically
efficient. If the ICs were not
tangent, trade would occur.
The competitive equilibrium
Is achieved w/o intervention.
UJ2 A
UJ1 P’
UK2
UK1 6C 0J
10F
James’s Food
Chapter 16 64

15. Equity and Efficiency
In a competitive market, all mutually beneficial trades take place and the resulting equilibrium allocation of resources will be economically efficient (the first theorem of welfare economics)
Is an efficient allocation also an equitable allocation?
Economists and others disagree about how to define and quantify equity.
Chapter 16 69

16. Utility Possibilities Frontier
*Any point inside the
frontier (H) is inefficient.
*Combinations beyond the
frontier (L) are not
obtainable.
Karen’s
Utility
Lets compare H to
E&F. E&F are efficient:
E&F make one person
better off without
making the other worse off. OJ OK E F G H
*Movement from one
combination to another
(E to F) reduces one
person’s utility.
*All points on the frontier
are efficient.
The Utility Possibilities Frontier
indicates the level of satisfaction
that each of two people achieve
when they have traded to an
efficient outcome on the contract curve.
James’s Utility
Chapter 16 74

17. Equity and Efficiency Is H equitable?
Assume the only choices are H & G
Is G more equitable? It depends on one’s perspective.
At G James’ total utility > Karen’s total utility
H may be more equitable because the distribution is more equal, therefore, an inefficient allocation may be more equitable.
James’s Utility
Karen’s
Utility OJ OK E F H G
Chapter 16 77

18. Equity and Efficiency
Equity & Perfect Comp.: A competitive equilibrium leads to a Pareto efficient outcome that may or may not be equitable.
Points on the frontier are Pareto efficient.
OJ & OK are perfect unequal distributions and Pareto efficient.
To achieve equity (more equal distribution) must the allocation be efficient?
James’s Utility
Karen’s
Utility OJ OK
Chapter 16 83

19. Efficiency in Production
Assume
Fixed total supplies of two inputs; labor and capital
Produce two products; food and clothing
Many people own and sell inputs for income
Income is distributed between food and clothing
Chapter 16 85

20. Efficiency in Production
Production in the Edgeworth Box
Each axis measures the quantity of an input
Horizontal: Labor, 50 hours
Vertical: Capital, 30 hours
Origins measure output
OF = Food
OC = Clothing
Chapter 16 88

21. Efficiency in Production
A is inefficient
Shaded area is preferred to A
B and C are efficient
The production contract curve shows
all combinations that are efficient
Labor in clothing production
50L
40L
30L
20L
10L 0C
30K B C D A
10C
80F
30C
25C
20K
10K
60F
50F
Capital
in clothing
production
Capital
in food
production
Each point measures inputs
to the production
A: 35L and 5K--Food
B: 15L and 25K--Clothing
Each isoquant shows input
combinations for a given output
Food: 50, 60, & 80
Clothing: 10, 25, & 30
10K
20K
30K 0F
10L
20L
30L
40L
50L
Labor in Food Production 94

22. Efficiency in Production
Competitive Market Observations
The wage rate (w) and the price of capital (r) will be the same for all industries.
Minimize production cost
MPL/MPK = w/r
w/r = MRTSLK
MRTS = slope of the isoquant
Competitive equilibrium is on the production contract curve.
Competitive equilibrium is efficient.
Chapter 16 99

23. triangle is also inefficient
Efficiency in Production: Production Possibilities Frontier (derived from the contract curve)
Clothing
(units)
OF & OC
are extremes.
Why is the production
possibilities frontier
downward sloping?
Why is it concave? 60
100 OF OC B C D
B, C, & D are
other possible
combinations. A
A is inefficient. ABC
triangle is also inefficient
due to labor market
distortions.
Food
(Units)
Chapter 16
105

24. Output Efficiency Clothing (units) 60 C 100 How do you find the
MRS = MRT combination
with many consumers
who have different
indifference curves?
MRS = MRT C 60
100
Production
Possibilities
Frontier
Indifference
Curve
Goods must be produced at minimum
cost and in combinations that match
people’s WTP. The efficient output
and Pareto efficient allocation occurs
where MRS = MRT
Food
(Units)
Chapter 16
114

25. Efficiency in Production
Efficiency in Output Markets
Consumer’s Budget Allocation
Profit Maximizing Firm
Chapter 16
115

26. Overview: The Efficiency of Competitive Markets
Conditions Required for Economic Efficiency
Efficiency in Exchange (for a competitive market)
Chapter 16
142

27. Overview: The Efficiency of Competitive Markets
Conditions Required for Economic Efficiency
Efficiency in the Use of Inputs in Production (for a competitive market)
Chapter 16
144

28. Overview: The Efficiency of Competitive Markets
Conditions Required for Economic Efficiency
Efficiency in the Output Market (in a competitive market)
Chapter 16
146

29. Overview: The Efficiency of Competitive Markets
Conditions Required for Economic Efficiency
However, consumers maximize their satisfaction in competitive markets only if
Chapter 16
147