Walter Nicholson Christopher Snyder Amherst College Christopher Snyder Dartmouth College PowerPoint Slide Presentation | Philip Heap, James Madison University ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

General Equilibrium and Welfare CHAPTER 10 General Equilibrium and Welfare ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter Preview Rather than look at one market in isolation we now want to look at multiple markets: both output and input markets. Partial equilibrium vs. general equilibrium models. How would a change in the demand for orange juice effect the price and quantity of orange juice? How would that change in the demand for orange juice effect the price and quantity of apple juice? the wages of orange and apple pickers?...

Chapter Preview We want to use a general equilibrium model to show how a perfectly competitive price system will lead to an economically efficient allocation of resources: First Welfare Theorem. We’ll also extend out discussion of efficiency and look at reasons why markets may fail to be efficient.

A Perfectly Competitive Price System Assumptions of the model: All individuals and firms take prices as given: price takers. All individuals maximize their utility. All firms maximize profits. All individuals and firms are fully informed.

General Equilibrium: The Tomato Market Suppose new evidence shows that eating tomatoes is good for your health. Use demand/supply analysis to explain what happens to the price and quantity of tomatoes exchanged. Then explain how this in turn effects the market for tomato workers, the market for cucumbers and the market for cucumber workers.

General Equilibrium: The Tomato Market Step 1: The demand for tomatoes will increase (preferences) causing the price and quantity of tomatoes to increase. Price S D’ D Tomatoes

General Equilibrium: The Tomato Market Step 2: The demand for tomato workers will increase causing the wage and quantity of tomato workers to rise. Wage S D’ D Tomato workers

General Equilibrium: The Tomato Market Step 3: The demand for cucumbers will fall causing the price and quantity of cucumbers to fall. Price S D’ D Cucumbers

General Equilibrium: The Tomato Market Step 4: The demand for cucumber workers will fall causing the wage and quantity of cucumber workers to fall. Wage S D’ D Cucumber workers

General Equilibrium: The Tomato Market Could carry this on even further. Since cucumber workers now have lower wages they may decide to be tomato workers. So now there are more tomato workers with lower wages. And less cucumber workers with higher wages. . . .

A Simple General Equilibrium Model Quantity of Y PPF: shows the combinations of X and Y that can be produced if resources are used efficiently It also shows the relative opportunity cost of good X in terms of Y: “supply curve” Quantity of X

A Simple General Equilibrium Model The indifference curves represent consumer preferences: “demand curve”. Quantity of Y F Point E is economically efficient: it both is productively efficient (on the PPF) and it maximizes utility. E U3 U2 What’s wrong at point F? U1 Quantity of X

A Simple General Equilibrium Model The slope of the PPF shows the opportunity cost of X in terms of Y. As more X is produced, the opportunity cost rises. The slope is the rate of product transformation (RPT). The slope of the indifference curve shows the rate at which consumers are willing to trade one good for another in consumption. The slope is the marginal rate of substitution (MRS). At the efficient point the RPT = MRS

The Efficiency of Perfect Competition We now have an idea of where we want to be: point E. How do we get there? First Welfare Theorem: A perfectly competitive price system will bring about an economically efficient allocation of resources.

The Efficiency of Perfect Competition Consumers will want to consume at this point Quantity of Y Excess supply of Y U3 Firms will maximize profits by producing here. Economy’s initial budget constraint given by the initial prices of X and Y U2 Excess demand for X Quantity of X

The Efficiency of Perfect Competition What’s the problem? At the initial set of prices the decisions of firms and consumers don’t match up. There is an excess demand for X and an excess supply of Y. What will happen to the prices of X an Y. The price of X will increase and the price of Y will decrease. The budget line will pivot and become steeper.

The Efficiency of Perfect Competition Quantity of Y Consumers will now maximize utility here. Firms now maximize profits here. U3 U2 But we still have excess demand for X and excess supply of Y. Quantity of X

The Efficiency of Perfect Competition Quantity of Y U3 Firms maximize profits and consumers maximize utility at the same point. U2 Quantity of X

The Efficiency of Perfect Competition At equilibrium: Firms maximize profits. Given their income consumers earn from that level of production, consumers maximize utility. The amount of X and Y producers supply is equal to the amount of X and Y that consumers demand.

Prices, Efficiency and Laissez Faire The natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security, is so powerful a principle that it is alone, and without any assistance, not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often encumbers its operations. What was Adam Smith saying?

Why Markets Fail to Achieve Efficiency What do we mean by “market failure”? Imperfect Competition A market in which some buyers and/or sellers have some influence on the prices of goods and services Externalities The effect of one party’s economic activities on another party that is not taken into account by the price system (pollution) Public Goods Goods that are both non-exclusive and non-rival Imperfect Information

Efficiency and Equity Even if an outcome is efficient it may not be equitable: goods and services are not fairly distributed. What is a potential problem with this argument? How do you define equity? How can you achieve it?

The Edgeworth Box Diagram: Exchange Suppose we have two people, Smith and Jones, and two goods, X and Y. Smith begins with XSE and YSE, and Jones begins with XJE and YJE XSE + XJE = Total X, and YSE + YJE = Total Y We want to show how voluntary exchange will lead to an efficient allocation of X and Y.

The Edgeworth Box Diagram: Exchange Any point inside the box represents an allocation of available goods between Smith and Jones. 0J 0S To find the allocations that offer mutually beneficial trades we need to add Smith’s and Jones’ utility curves.

The Edgeworth Box Diagram: Exchange 0J UJ1 UJ2 US3 UJ3 US2 US1 0S

The Edgeworth Box Diagram: Exchange Pick some point in the box and see if there is a potential for mutually beneficial exchange. If not it is a pareto efficient allocation. We want to find the set of pareto efficient allocations or the contract curve.

The Edgeworth Box Diagram: Exchange 0J UJ1 No. Smith could trade some X to Jones for some Y. Both of their utility rises. UJ2 US3 UJ3 US2 US1 0S Is the point efficient?

The Edgeworth Box Diagram: Exchange Is the point efficient? 0J UJ1 UJ2 US3 UJ3 US2 US1 0S

The Edgeworth Box Diagram: Exchange 0J This point is efficient. UJ1 UJ2 US3 UJ3 US2 US1 0S

The Edgeworth Box Diagram: Exchange 0J UJ1 Contract Curve UJ2 US3 UJ3 US2 US1 0S

The Edgeworth Box Diagram: Exchange For any initial allocation we can see where trade may lead. 0J UJ1 Contract Curve UJ2 US3 UJ3 US2 US1 0S

The Edgeworth Box Diagram: Exchange Suppose F is the “fair” allocation and E is the initial allocation. What’s the problem? 0J UJ1 UJ2 F US3 UJ3 US2 E US1 0S It is not possible with voluntary exchange. Coercion would make Smith better off but Jones worse off.

Money in General Equilibrium Models The competitive model shows how relative prices are determined. Money used to determine the absolute price level. Money serves two primary functions: Medium of exchange. Store of value. Money also serves as an accounting standard: a measure in which all prices can be quoted if one apple trades for two oranges or four bananas if Papple = $1.00 then, Porange = $0.50 and Pbanana = $0.25

Money in General Equilibrium Models With commodity money the relative price of money is determined by the forces of supply and demand. An increase in the supply of gold will cause the relative price of gold to fall, but the price of all goods in terms of gold to rise (inflation). With fiat money an increase in the money supply will in general also lower the relative price of money and lead to inflation. Money, however, acts as a ‘veil’ for real economic activity.

Summary Since profit maximizing firms use resources efficiently they will operate on the production possibility frontier. Under competitive conditions the RPT = MRS. Economic efficiency is prevented by factors such as imperfect markets, externalities, public goods, and imperfect information. Under perfect competition, voluntary transactions will not necessarily lead to fair outcomes. Attempts to achieve fair allocations may require a loss of efficiency. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Summary If money is introduced into the competitive model we can show how nominal prices are determined as well as relative prices. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.