1. Chapter 16 General Equilibrium Cut Down Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2. Main Topics The nature of general equilibrium Positive analysis of general equilibrium 16-2

3. The Nature of General Equilibrium Already studied competitive equilibrium in a single isolated market: partial equilibrium analysis Useful when supply and demand for a good are largely independent of activities in other markets However, markets are often interdependent (e.g., if complements or substitutes) General equilibrium analysis is the study of competitive equilibrium in many markets at the same time Allows us to understand the consequences of interdependence among markets Factors that affect supply and demand in one market can have ripple effects in other markets Accounts for feedback between markets Markets can be linked because the price or production of one good affects the demand or cost of another….think substitutes or complements. 16-3

4. Figure 16.1: General Equilibrium 16-4 Above is the general equilibrium in the markets for Pie and Ice cream. Both equilibriums take the other product (and product price) into account in identifying its own product clearing price and quantity.

5. Positive Analysis of General Equilibrium General equilibrium analysis can provide more accurate answers than partial equilibrium analysis does to positive questions Examine the effects of a sales tax on ice cream Assume pie and ice cream are complements Assume no supply linkages General equilibrium effects of the tax include: Demand curve for pie shifts downward, so price of pie falls This produces a feedback effect on the ice cream market Effects of the tax ripple back and forth between the markets Need a new tool to determine the prices that will prevail in both markets in a general equilibrium 16-5

6. Market-Clearing Curves First step in identifying a general equilibrium is to find the market-clearing curve for each good Shows the combinations of prices for that good and related goods that bring supply and demand for the good into balance Prices of the goods are on the axes For two goods that are complements, the market-clearing curves will be downward sloping Example: an increase in the price of pie reduces the demand for ice cream, which lowers the partial equilibrium price of ice cream For substitutes, the curves will be upward sloping 16-6

7. Figure 16.2: A Market-Clearing Curve 16-7 Slide A shows the ice cream curve with 3 different demand curves that correspond to different prices for pie. Slide B is the general equil. market-clearing curve for both products.

8. Figure 16.2: A Market-Clearing Curve 16-8 Slide A shows the pie curve with 3 different demand curves that correspond to different prices for ice cream. Slide B is the general equil. market-clearing curve for both products.

9. General Equilibrium in Two Markets If a price combination lies on both market- clearing curves, then both markets are in equilibrium This is a general equilibrium Find a general equilibrium by plotting both market-clearing curves on the same graph Horizontal axis shows the price of one good; vertical axis shows the price of the other good Intersection of the two market-clearing curves reveals the general equilibrium prices The two goods markets clear at these prices 16-9

10. Figure 16.4: General Equilibrium Price Combination General equilibrium prices are $12 per pie and $6 per gallon of ice cream Pie and ice cream markets both clear at these prices 16-10

11. Effects of a Sales Tax: Partial Equilibrium Continue the ice cream example Examine effects of $3 per gallon sales tax on ice cream Begin from initial equilibrium price of $6 per gallon, 25 million gallons Tax shifts supply curve upward by $3 New partial equilibrium is at intersection of the new supply curve and initial demand curve Price of pie held constant at $12 per pie (Consumer) Price of ice cream rises by $1.67 per gallon, less than the amount of the tax 16-11

12. Effect of a Sales Tax: Gen. Equilibrium Need new market-clearing curve for ice cream, to find general equilibrium effects of tax Tax shifts market-clearing curve for ice cream upward New curve lies exactly $1.67 above the old one Magnitude of the shift equals partial equilibrium effect of the tax Look for intersection of new market-clearing curve for ice cream and old market-clearing curve for pie Shows new general equilibrium Pie price is $11 per pie, ice cream price is $8 per gallon These prices clear both markets 16-12

13. Effect of a Sales Tax: Gen. Equilibrium 16-13

14. Sales Tax Effect : General Equilibrium As a result of the tax, demand curves for both goods shift Sales tax on ice cream reduces the price of a pie by $1 Because pie and ice cream are complements Partial equilibrium analysis understates the effect of the tax on the price of ice cream Based on partial anal., ice cream prices rise only by $1.67, but based on general equil, prices rise by $2. Lower pie price leads to greater demand for ice cream Reinforces pressure for ice cream price to rise General equilibrium analysis accounts for this feedback; partial equilibrium analysis does not 16-14

15. Figure 16.6: Effects of a Tax, part 2 16-15