1. ©2005, Southwestern Slides by Pamela L. Hall Western Washington University General Competitive Equilibrium Chapter 11

2. 2 Introduction In general, changes in one market will affect demand and supply in other markets General-equilibrium analysis  Study of how demand and supply conditions interact in a number of markets and determine prices of many commodities Economy is viewed as a closed and interrelated system  Where interactions of all markets determine equilibrium market prices and quantities Disturbance in one market generates ripples that spread through many other markets A (general) equilibrium model of all markets will result in necessary conditions for economic efficiency  Achieved by agents (households and firms) trading commodities Agents will engage in trade until all gains from trade are exhausted

3. 3 Introduction This chapter no longer restricts supply of commodities to sum of individual agents’ initial endowments  Allows firms to employ these endowments as inputs into production and produce some outputs that will increase supply of those commodities  With introduction of production, conditions yielding production efficiency are now required for economic efficiency Allocation conditions for production efficiency  Allocation Condition 1 (opportunity cost condition) Obtained by deriving production possibilities frontier  Where production must occur for efficiency  Allocation Condition 2, (marginal product condition) For efficiency inputs should be allocated so that marginal products in production of a particular commodity are equal  Allocation Condition 3 (comparative advantage condition) For efficient production a firm with comparative advantage in producing a commodity should produce that commodity

4. 4 Introduction Conditions for overall economic efficiency  Must link producers’ efficient production decisions with consumers’ preferences An economy may be production efficient  But if it is not producing commodities consumers desire, it is inefficient Aim in this chapter  Demonstrate how a perfectly competitive market will result in an efficient allocation of a society’s resources Based on link between economic efficiency and competitive markets  Applied economists are able to investigate effects that various policies have On directly affected market On related markets  With this general analysis of markets throughout economy, economists can determine complete impact of policies on an economy Failure to consider all effects across all markets may result in erroneous analysis  Wrong prescriptions for curing market imperfections

5. 5 Efficiency in Production Can extend concept of Pareto efficiency and Edgeworth box to production efficiency Efficiency in production deals with allocation of resources (inputs) within a specific firm  As well as how resources and outputs should be allocated among firms Generally, an allocation of resources is production efficient  When no reallocation of resources will yield an increase in one commodity without a sacrifice in output from other commodities Necessary conditions for such an efficiency are stated in three allocation conditions  Opportunity cost condition  Marginal product condition  Comparative advantage condition

6. 6 Allocation Condition 1 (Opportunity Cost Condition) For production efficiency no more of one commodity can be produced without having to cut back on production of other commodities Requires that MRTS for each output be equal Consider optimal choice of inputs for a single firm producing two outputs (fish, F, and bread, B)  With two inputs (capital, K, and labor, L)  Assuming limited resources and holding total quantities of K and L fixed Problem is how to efficiently allocate these fixed resources to production of F and B  Firm will operate efficiently if it is not possible to reallocate its inputs in such a way that output of F can be increased without cutting back on B

7. 7 Allocation Condition 1 (Opportunity Cost Condition) Firm with fixed resources has allocated its resources efficiently if it has them fully employed and  MRTS between inputs is same for every output firm produces Suppose firm has 100 units of L and 100 units of K  Uses half of each input to produce fish and bread If firm employs 50 units of K and 50 units of L to produce fish and MRTS F (K for L) = 2  Same amount of fish could be produced by employing 48 units of K and 51 units of L (See Table 11.1)

8. 8 Table 11.1 Allocation Condition 1 (Opportunity Cost Condition)

9. 9 Allocation Condition 1 (Opportunity Cost Condition) Represented graphically in Figure 11.1  Edgeworth box is analogous to box representing pure-exchange model in Chapter 6 Compares various output levels for fish and bread with isoquants  Illustrates that every point inside box represents a feasible allocation Origin 0 F  Allocation where no resources are allocated to fish production (0, 0) and all resources are devoted to bread production (100, 100) is a feasible allocation represented by the  Output of bread is maximized and no fish is produced At 0 B, allocation is (0, 0) toward production of bread and (100, 100) for fish For a movement toward 0 F, more of K and L are being allocated toward bread production and less toward fish  Every feasible combination of K and L in production of fish and bread is represented inside Edgeworth box  Points outside the box are not feasible

10. 10 Figure 11.1 Allocation Condition 1

11. 11 Allocation Condition 1 (Opportunity Cost Condition) Size of box is determined by amount of fixed resources, K and L  An increase in amount of resources will enlarge box A change in technology for combining resources to produce outputs may also expand output potential but not size of box Production-efficient allocations are characterized by efficiency locus in Figure 11.1  Called production contract curve Represents set of efficient allocations  At every point on production contract curve MRTS F = MRTS B

12. 12 Allocation Condition 1 (Opportunity Cost Condition) In Figure 11.1, point C is not Pareto efficient  Possible to reallocate inputs in such a manner that one product can be increased without reducing other product For example, moving along bread isoquant curve toward point P 3  Bread production remains unchanged but fish production increases Mathematically, efficiency condition MRTS F = MRTS B is determined by maximizing one output while holding other output constant

13. 13 Production Possibilities Frontier In U.S., over 40% of all scientists, engineers, and technical professionals work in military defense sector  Allocation of talent and intellectual resources could be used for other production possibilities Based on efficiency locus in Figure 11.1, these alternative production possibilities for commodities (guns and butter or fish and bread) can be illustrated by production possibilities frontier (See Figure 11.2)  A mapping of efficient output levels, F and B, for each point on production contract curve Corresponding output levels for fish (F 1, F 2, F 3, and F 4 ) and bread (B 1, B 2, B 3, and B 4 ) are plotted on horizontal and vertical axes in Figure 11.2

14. 14 Figure 11.2 Production possibilities frontier

15. 15 Production Possibilities Frontier Points on production possibilities frontier correspond to tangency of isoquants along production contract curve in Figure 11.1  Output combinations (F 1,B 1 ), (F 2,B 2 ), (F 3,B 3 ), and (F 4,B 4 ) associated with (P 1, P 2, P 3, and P 4 ) are same for both figures Every point inside production possibilities frontier is a feasible allocation  Corresponding to points inside Edgeworth box in Figure 11.1 Boundary of production possibilities frontier represents efficiency locus (production contract curve) in Figure 11.1  For given amounts of K and L, production possibilities frontier indicates combinations of F and B that can be produced An increase in amount of K and L or an improvement in technology will result in production possibilities frontier shifting outward

16. 16 Marginal Rate of Product Transformation Slope of production possibilities frontier measures how output F can be substituted for output B  When total level of inputs (resources) is held constant Negative of this slope is called marginal rate of product transformation (MRPT)  MRPT (B for F) = -slope of production possibilities frontier  MRPT (B for F) = -dB/dF| holding input constant Slope of production possibilities frontier is negative Given production efficiency, an increase in one output will require a sacrifice in other output  Taking negative of this negative slope yields a positive MRPT MRPT measures how much one commodity is sacrificed to produce an additional amount of another commodity  At point P 1 in Figure 11.2, MRPT is a relatively small number Sacrifice in B for an additional unit of F is small  At point P 4 MRPT is a relatively large number Sacrifice in B for an additional unit of F is large  Increase in MRPT as F increases is due to concave nature of production possibility frontier

17. 17 Concave Production Possibilities Frontier Concave shape of production possibilities frontier is characteristic of most production situations  Based on technical relationship exhibited by two outputs Can represent total cost of producing F and B by total cost function TC(F, B) Given fixed level of input supply, cost is constant along production possibilities frontier  Total differential of this cost function is dTC = (∂TC/∂F)dF + (∂TC/∂B)dB = 0  dTC is equal to zero because cost is constant along production possibilities frontier Rearranging terms results in  MRPT(B for F) = -dB/dF| dTC=0 = (∂TC/∂F)/( (∂TC/∂B) = MC F /MC B In general MRPT(q 2 for q 1 ) = MC 1 /MC 2

18. 18 Concave Production Possibilities Frontier Can compare relationship of MRPT equaling ratio of marginal costs to allocation of inputs for production of F and B  Recall that for one variable input—say, labor MC F = w/MP L | F MC B = w/MP L | B  MP L | F (MPL|B) is marginal product of labor in production of fish (bread)  Assume it takes 1 unit of L to produce 2 units of F, MP F = 2; if wage rate is 1 MC F = ½  For a concave production possibilities frontier (as illustrated in Figure 11.2) Ratio of MC F to MC B increases as output of F increases and B decreases  In short run, this is result of Law of Diminishing Marginal Returns  An increase in F results in an increase in its SMC Decrease in B results in a decrease in its SMC In long run, a concave production possibilities frontier will also result if decreasing returns to scale exists for both outputs  LMC curves have a positive slope

19. 19 Concave Production Possibilities Frontier Specialized inputs exist when some inputs are relatively more suited for production of a particular output  Have a comparative advantage in production of one output versus another In Figure 11.2, concave nature of production possibilities curve implies that increases in F production requires taking inputs out of B production  Where they are more suitable  Allocating them to F production Where they are progressively less suitable  As production of F increases and that of B declines Marginal cost for F production increases and marginal cost for B production decreases  Yields a relatively larger MRPT Specialized inputs assume heterogeneous inputs  Even if inputs are homogeneous, production possibilities frontier will be concave if production of F and B use inputs in different proportions Different input intensities are represented by nonlinear production contract curves

20. 20 Concave Production Possibilities Frontier In Figure 11.3 production contract curve is bowed above main diagonal  Indicates that production of F is relatively more capital intensive than that of B If curve were bowed below main diagonal  B would be relatively more capital intensive Production possibilities frontier will be concave if production contract curve is not linear through origin of both F and B Consider Figure 11.3, where F is using a high proportion of capital relative to B  Weighted average of points P 1 and P 2 is represented by linear cord connecting points Points on this cord result in a lower level of output for both F and B  Compared to points on production contract curve In terms of corresponding production possibilities frontier, Figure 11.4  Cord lies in interior of mapping that establishes concave nature of frontier

21. 21 Figure 11.3 Production contract curve with weighted average of outputs

22. 22 Figure 11.4 Production possibilities frontier with differing factor intensities

23. 23 Opportunity Costs Production possibilities frontier illustrates a fundamental condition in economic theory Assuming resources are fully employed in most efficient way  Any increase in production of one commodity will require shifting of resources out of other commodity and vice versa Opportunity cost of producing more of the one commodity  MRPT measures degree of opportunity cost  A relatively large MRPT = -dB/dF|dTC=0  Illustrates a large opportunity cost of increasing F Concave production possibilities frontier is associated with increasing opportunity cost  The more concave the frontier The greater the increase in opportunity cost as one commodity is sacrificed for production of another Constant MRPT implies a linear production possibilities frontier and constant opportunity cost Theoretically, if factor intensities are the same and production functions exhibit increasing returns to scale  Production possibilities frontier will be convex Represents decreasing opportunity cost as one commodity is substituted for another

24. 24 Economies of Scope Increasing opportunity cost results in lowest opportunity cost for increasing fish corresponding to point A  At point A, production of fish is zero Lowest opportunity cost for producing bread is at point B  Production of bread is zero Low levels of opportunity cost result from joint production of fish and bread In general, a firm incurs production advantages when it produces two or more products  Can use inputs and technologies common to producing a set of products May be advantages in joint use of inputs, marketing programs, or administration

25. 25 Economies of Scope Unless there are some constraints firms will almost always produce more than one product Technologies resulting in joint production advantages are called economies of scope or increasing returns to scope  Exist when one firm jointly producing a set of products results in a higher level of output than a set of separate firms each uniquely producing one of the products  Results in concave production possibilities curves Without these production advantages associated with joint production  Joint production would generate same output as the two specialized firms Production possibilities frontier would be linear  Representing constant opportunity cost or constant returns to scope

26. 26 Diseconomies of Scope Decreasing opportunity cost associated with convex production possibilities frontiers characterize diseconomies of scope (decreasing returns to scope)  Illustrated in Figure 11.5 Opportunity cost of specialization is lower than cost of joint production Production possibilities frontier is below cord connecting points A and B  At point A in Figure 11.5, increasing fish production Results in MRPT on convex production possibilities frontier being greater than MRPT on cord between points A and B  Opportunity cost of producing fish and bread jointly is greater than opportunity cost of specialized production There is no direct relationship between economies to scale and economies of scope  Economies of scale is concerned with output effect of expanding production through increasing all inputs  Economies of scope is concerned with output effect of expanding production through increasing number of different products produced Both are related to increasing output  But differ in how output is increased Returns to scale increases output through input usage  Returns to scope increases output through product diversification

27. 27 Figure 11.5 Decreasing returns to scope, decreasing opportunity cost, and …

28. 28 Allocation Condition 2 (Marginal Product Condition) If production is to be efficient, resources should be allocated to point where marginal product of any resource in production of a particular commodity is the same  No matter which firm produces the commodity For example, consider two firms (1 and 2) producing the same commodity, Q  An objective of society is to determine efficient allocation of K and L between the two firms that will maximize output, Q

29. 29 Allocation Condition 2 (Marginal Product Condition) Incorporating constraints into objective function yields

30. 30 Allocation Condition 2 (Marginal Product Condition) In general, for N firms, F.O.C.s result in Allocation Condition 2 (marginal product condition)  MPK| firm 1 = MPK| firm 2 = … = MPK| firm n  MPL| firm 1 = MPL| firm 2 = … = MPL| firm n For labor input with two firms this allocation condition is illustrated in Figure 11.6  If MPL| firm 1 > MPL| firm 2 Can increase combined output for both firms by reallocating labor inputs  Area under a marginal product curve is total amount of output produced  Shaded areas represent change in output Shaded area associated with firm 1 is larger than shaded area for firm 2  Net gain in output represents increase in output by reallocating input  Can continue to increase output by shifting input allocation until level of the input used by each firm results in equivalent marginal products

31. 31 Figure 11.6 Allocation Condition 2

32. 32 Allocation Condition 2 (Marginal Product Condition) Alternative illustration of Allocation Condition 2 for production functions of two firms producing the same commodity, Q, with one variable input, L  Shown in Figure 11.7 Can increase total output of Q with given amount of labor, L   By reallocating labor between two firms  Taking labor away from less productive firm 1  Allocate it to relatively more productive firm, firm 2  Will enlarge box vertically Output will continue to increase for given level of labor  Until production functions are tangent At this tangency, marginal products for these two firms will be equal  Results in an efficient allocation of labor for production of Q  Indicated in Figure 11.8  Q* in Figure 11.8 is greater than Q' in Figure 11.7

33. 33 Figure 11.7 Inefficient allocation of labor between two firms

34. 34 Figure 11.8 Allocation Condition 2 with an Edgeworth box

35. 35 Allocation Condition 3 (Comparative Advantage Condition) If two or more firms produce same outputs  They must operate at points on their respective production possibility frontiers At which marginal rates of product transformation are equal Figure 11.9 illustrates this Pareto-efficient condition  At point A MRPT for firm 1 is greater than MRPT for firm 2 By reallocating production of outputs between the two firms  Can reduce total amount of resources employed for producing given amount of fish and bread Only where MRPTs for two firms are equal is it impossible to reallocate production in such a way as to reduce resource requirements for given level of production

36. 36 Figure 11.9 Allocation Condition 3

37. 37 Comparative Advantage Related to Allocation Condition 3 is theory of comparative advantage in international trade  First developed by David Ricardo A country has a comparative advantage in commodities that it is relatively more efficient in producing Efficiency is measured in the sacrifice of other commodities for production of an additional unit of a commodity Comparative advantage is in contrast to absolute advantage  A country’s cost in terms of input usage is used as measure of advantage Countries will specialize in producing products for which they have a comparative advantage until their MRPTs are equilibrated  Will then trade with other countries to satisfy consumer demand

38. 38 Comparative Advantage As countries specialize in production of commodity for which they have a comparative advantage  Gains from improved efficiency are realized Ability to either produce more of both commodities or  Maintain their current production levels and allocate excess resources to other activities  Total world production will increase Improved efficiency through comparative advantage and trade is basis for supporting idea of reducing trade barriers

39. 39 Economic Efficiency If all three allocation conditions for production and equality of MRS exchange condition hold  Provides for a Pareto-efficient production and exchange of commodities However, they are not sufficient for achieving economic efficiency  Also require output efficiency What firms produce is what households want  For example, an economy that concentrates on efficient production of military commodities at expense of household items during relative peace is inefficient  Requires that MRS = MRPT MRS measures how much a household is willing to substitute one commodity for another, holding utility constant MRPT measures opportunity cost (sacrifice of another commodity) of producing one more unit of a commodity  If MRS > MRPT, household’s willingness to substitute one commodity for another is greater than opportunity cost  Efficiency can be improved by a reallocation of resources until a household’s willingness-to-pay is equal to cost of producing any additional unit of a commodity

40. 40 One-household Or Homogeneous Preferences Economy Concept of equating MRS to MRPT is illustrated in Figure 11.10 for case of a one-household economy  Or case where all households have same utility function Assume this household (or set of households acting as one) produces and consumes two commodities with a given level of inputs  Household’s preferences for two commodities are represented by indifference curves superimposed on household’s production possibilities frontier Household attempts to maximize utility subject to production possibilities constraint

41. 41 Figure 11.10 Economic efficiency for a one-household economy

42. 42 One-household or Homogeneous Preferences Economy At commodity bundle A, MRS(x 2 for x 1 ) > MRPT(x 2 for x 1 )  The one household can increase its utility by moving down along production possibilities frontier from A to B At bundle B, household is maximizing its utility for this production possibilities frontier  Corresponds to where MRS(x 2 for x 1 ) = MRPT(x 2 for x 1 )  Economically efficient commodity bundle (Pareto-efficient allocation) for the economy  Point where society maximizes social welfare, local bliss  Because there is only one household in this economy Bundle B is only point on production possibilities frontier where there is no other commodity bundle preferred to it  For example, bundle A is Pareto efficient in terms of production But there are commodity bundles, such as C, within production possibilities frontier that are preferred to A  Bundle C is inefficient in terms of production  Because it is in interior of production possibilities frontier

43. 43 Pareto Efficiency With More Than One Type Of Household Preferences In Chapter 6, general-equilibrium condition for a pure-exchange economy with n households equated MRS across all households By combining this pure-exchange condition with equilibrium solution when considering a one-household production economy, MRS = MRPT  Get necessary conditions for a Pareto-efficient allocation When there are more than one type of household preferences, a Pareto- efficient allocation requires that  MRS 1 = MRS 2 = … = MRS n = MRPT If all n households have the same preferences for the commodities  Their MRSs will be the same and a Pareto-efficient allocation for more than one type of household preferences reduces to one-household production economy solution MRS = MRPT

44. 44 Two-Household Economy with Heterogeneous Preferences Assuming Friday and Robinson have different preferences, we must examine economic efficiency associated with more than one type of household preferences Pareto-efficient allocation is where MRS for Robinson equals MRS for Friday and both are equal to MRPT  Illustrated in Figure 11.11 Production-efficient commodities, Q 1 * and Q 2 *, from production possibilities frontier, forms an Edgeworth box  Robinson’s indifference map originates from production possibilities frontier point of origin, 0 R  Friday’s indifference map is rotated 180  with its origin placed on production possibilities frontier associated with Q 1 * and Q 2 * At point where Robinson’s and Friday’s MRSs are equal and MRPT is also equal to their MRSs  Pareto-efficient allocation exists

45. 45 Figure 11.11 Economic efficiency for a two-household economy

46. 46 Figure 11.12 Economic efficiency for alternative utility levels

47. 47 Two-Household Economy with Heterogeneous Preferences Mathematically, we derive the condition MRS R = MRS F = MRPT by maximizing Robinson’s utility subject to  Friday’s utility  Production possibilities constraint  And condition that what is being produced (supply) must equal demand If all commodities are desirable, then an efficient allocation would have no excess demand  Supply would equal demand This Pareto-efficiency allocation, illustrated in Figure 11.11, is based on a given level of utility for Friday  Changing this level of utility for Friday will result in alternative combinations of Q 1 and Q 2 produced and allocated between Robinson and Friday Maximizing Robinson’s utility results in Pareto-efficient allocation  Illustrated in Figure 11.12

48. 48 Two-Household Economy with Heterogeneous Preferences In general, considering all possible Pareto-efficient allocations, MRS R = MRS F = MRPT  By varying Friday’s utility from consuming zero units of Q 1 and Q 2 to Friday consuming all of Q 1 and Q 2 Obtain a collection of all economically efficient utility levels (contract curve) for both Robinson and Friday Initial endowment of resources held by Robinson and Friday will determine which of these economically efficient allocations are feasible  For example, if Friday initially has a relatively large share of resources An economically efficient allocation resulting in Robinson consuming most of the commodities would not be feasible Competitive-price system will yield an economically efficient allocation  However, initial allocation of endowments or access to these endowments (equal opportunity) has social-welfare implications Redistribution of initial endowments may enhance social welfare and thus be socially desirable

49. 49 General Equilibrium in a Competitive Economy A perfectly competitive economy assumes agents (households and producers) take all prices as given No agent has control over some of the markets and, thus, no agent can influence market prices  In this economy, a general competitive equilibrium is a set of prices for both inputs and outputs Where quantity demanded equals quantity supplied in all input and output markets, simultaneously  At this set of prices, households maximize utility subject to their initial endowments and firms maximize profit

50. 50 Efficiency In Production Can establish a relationship between this competitive-equilibrium set of prices and efficiency in production by examining three allocation conditions Perfectly competitive pricing provides necessary conditions for these allocation conditions to hold Recall Allocation Condition 1  MRTS 1 = MRTS 2 = … = MRTS k = w*/v*, for all k commodities Where the two inputs are labor and capital with a wage rate of w and a rental rate of v  Given perfect competition in input markets, firms producing these k commodities will equate their MRTS(K for L) to common input price ratio, w*/v*, which results in Allocation Condition 1 Thus, in a decentralized tâtonnement process, without any market intervention, firms will adopt least-cost combination of inputs for a given level of output

51. 51 Efficiency In Production Allocation Condition 2 (Figure 11.8)  MPs of an input are equal for all firms producing same output, Q MP L | firm 1 = MP L | firm 2 = MP L | firm 3 = … = MP L | firm n = w*/p*  Where p is price per unit for output Q Multiplying both sides by p* yields VMP L = p 1 *MP L = w*  Where VMP L is value of marginal product for labor  Profit-maximizing condition for a perfectly competitive market  Where marginal revenue from hiring an additional worker (VMP L ) is equal to wage rate w*  Fixed prices (w*, p*) ensure MP L will be same across all firms producing Q Free market results in a Pareto-efficient allocation of all inputs among firms producing same product  A decentralized decision process yields an efficient resource allocation

52. 52 Efficiency In Production Allocation Condition 3  MRPT(q 2 for q 1 ) firm 1 = MRPT(q 2 for q 1 ) firm 2 = … = MRPT(q 2 for q 1 ) firm n = MC 1 /MC 2 = p* 1 /p* 2 Where p 1 and p 2 denote per-unit price of outputs q 1 and q 2, respectively  Given perfect competition, all firms face same set of output prices Which for maximizing profits are set equal to each respective marginal cost of production  Thus, ratio of marginal cost, MRPT, will be same for all firms in a perfectly competitive market Indicates that no firm has a lower sacrifice in additional production of a commodity than any other firm  Market intervention could not alter production mix among firms and increase efficiency Production is Pareto efficient under perfect competition without any central decision making

53. 53 Output Efficiency If price ratios associated with households are same as price ratios for producers, then  MRS 1 = MRS 2 = … = MRS n = MRPT = p* 1 /p* 2 Will be true for any pair of commodities Tâtonnement process assures supply and demand will be equalized for all commodities  Results in market-clearing price, where no excess supply or demand exists (Walrasian equilibrium) First Fundamental Theorem of Welfare Economics  When assumptions of perfectly competitive equilibrium hold, every general perfectly competitive equilibrium is efficient in production  Results in a Pareto-efficient allocation (output efficiency)  Second Fundamental Theorem of Welfare Economics also holds, given assumptions of a perfectly competitive equilibrium Every allocation that is efficient in production and could potentially be a Pareto- efficient allocation can be obtained with a general perfectly competitive equilibrium  By reallocating initial endowments

54. 54 Output Efficiency Figure 11.12 illustrates duality of these welfare theorems in a two- household, two-product productive economy  Perfectly competitive prices p 1 * and p 2 * correspond to a Pareto-efficient allocation  Given a change in initial endowments, a new Pareto-efficient allocation is obtainable with perfectly competitive prices p' 1 and p' 2 These dual results provide support for laissez-faire position taken by many economists  Adam Smith’s invisible hand will provide production efficiency and output efficiency Society’s problem of achieving an economically efficient allocation of resources is decentralized and solved at individual agent level  Each household and firm only has to be concerned with its own maximization problem Only information communicated among agents is market prices  Market prices act as signals in determining relative scarcity of commodities  Tâtonnement process results in efficient resource allocation

55. 55 Optimal Reallocation Of Endowments Free markets take distribution of initial endowments as given  Unless some optimal initial distribution of endowments is mated with competitive markets, social welfare may not be maximized To achieve an optimal initial distribution of endowments, some government authority must be able to identify individual household preferences and endowments  This government authority is some policymaker, social planner, or decision maker with objective of maximizing social welfare  Decision maker will not undertake actions counter to households’ preferences So that decision makers can properly identify individual preferences and endowments and thus reallocate endowments to improve social welfare  Many government agencies will require some type of needs evaluation For example, welfare, college financial aid, and many other public-assistance programs require a completed application  Designed to reveal an applicant’s preferences and endowments

56. 56 Imperfect Markets Free markets will fail to achieve efficiency due to  Imperfect competition  Externalities  Supply of public goods  Asymmetric information Inability of free markets alone to maximize social welfare opens way for government programs  A sound understanding of economic theory can guide development and implementation of effective government programs

57. 57 Imperfect Markets Opposite of a free market is a centrally planned economy  All aspects of production, distribution, and consumption are based on a government plan Efficient outcome requires knowledge of individual household preferences and production possibilities  Such knowledge is difficult and costly to obtain  Unless individual preferences and production plans are dictated by some party  Such dictation is at the expense of individual freedom of expression Thus, even in centrally planned economies there still exists a free market, either legally or illegally The question is  What degree of government intervention into the free activities of markets is required for improving social welfare?

58. 58 Imperfect Markets General failure of centrally planned socialism in determining efficient resource allocation led to a system of decentralized socialism Prior to World War II, O. Lange and F. Taylor demonstrated how decentralized socialism can result in a Pareto-efficient allocation of resources  State would own all capital and rent it out to state-owned, bureaucratically managed firms These firms would then be free to maximize profits in a competitively determined labor market  State would receive all profits and distribute them to households—in the form of public goods and subsidies—in some equitable form  As in perfect competition, prices would be determined in free markets  A problem with decentralized socialism is determining optimal supply of capital State would have to make this determination  There is no invisible hand to reflect households’ preferences

59. 59 Imperfect Markets Decentralized socialism was adopted in a limited form after World War II in Eastern Europe  System was abandoned in late 1980s due to Major problems of allocating capital among firms Political appointment of firm managers Limited individual incentives to work Socialist societies generally attempt to replace individual incentives to work and invest with social responsibility  Put great weight on common welfare of whole society  Such a system can work well during national emergencies (for example, during wars) Becomes a social responsibility for all households to work toward ensuring their joint preservation However, without some common menace, social responsibility wanes as a motivation to work  Thus, some socialist states will manufacture threats  Such as Cultural Revolution in China

60. 60 Imperfect Markets A general problem with relying on centralized control  Complete system failure occurs when control unit fails In an economic system, free market, with its emphasis on decentralized control, mimics decentralization found in nature  Human agents are all basically identical Each take on specialized tasks  Failure or exit of any one household or firm will not result in complete failure of economic system Those agents exiting will be replaced by other agents  Without a perceptible disruption in economy