chapter 16 General Equilibrium, Efficiency, and Equity Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-2 Learning Objectives Explain how general equilibrium analysis helps economists to understand interdependence among markets. Use a simple general equilibrium model to answer positive economic questions. Identify criteria for answering normative economic questions. Describe how competitive markets achieve efficient exchange and efficient production in general equilibrium. Discuss how the goals of equity and efficiency can come into conflict. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-3 Overview The analysis of a single market considered in isolation is often incomplete. General equilibrium analysis is the study of competitive equilibrium in two or more markets at the same time, allowing us to understand the consequences of interdependence between markets. Competitive markets allocate consumption goods efficiently among consumers and also assure efficient production. Good economic institutions avoid waste while treating all members of society fairly, two goals that can come into conflict. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-4 The Nature of General Equilibrium Partial equilibrium analysis focuses on a single competitive market, considered in isolation General equilibrium analysis is the study of competitive equilibrium in many markets at the same time – Factors that affect supply and demand in one market can have significant ripple effects in other markets, creating unintended consequences – The interdependence of markets can produce feedback on the original market Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-5 General Equilibrium in Two Markets (a) Pie market Pie price ($/pie) Pies (millions) C2C Ice Cream: $6 (a) Ice cream market Ice cream price ($/gal.) Ice cream (million gallons) Pie: $ Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-6 Market-Clearing Curves The market-clearing curve for a good shows the combinations of prices (both for that good and for other related goods) that bring supply and demand for the good into balance. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-7 Market-Clearing Curve for Ice Cream (a) Ice cream market Ice cream price ($/gal.) Ice cream (million gallons) S1S1 (b) Market-clearing curve Ice cream price ($/gal.) Pie price ($/gal.) Market- clearing curve for ice cream Pie: $18 A3A Pie: $12 A2A Pie: $6 A1A B1B1 6 6 B2B B3B3 18 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-8 A General Equilibrium in Two Markets General equilibrium price combination Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-9 Effects of a Sales Tax $3 tax on ice cream shifts the market- clearing curve for ice cream upward The vertical distance is the partial equilibrium effect of the tax Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-10 Tax on Ice Cream (a) Pie market Pie price ($/pie) Pies (millions) C2C Ice Cream: $ C4C4 Ice Cream: $8 Pie: $ A4A4 (a) Ice cream market Ice cream price ($/gal.) Ice cream (million gallons) Pie: $12 A2A Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-11 Normative Criteria for Evaluating Economic Performance Efficiency Equity Social welfare functions Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-12 Efficiency An economy is wasteful (or inefficient) if we can reallocate resources in a way that will make at least one consumer better off without hurting anyone else Utility possibility frontier: shows utility levels associated with all efficient allocations of resources Efficient Inefficient Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-13 Equity Equity is a subjective concept Process-oriented notions of equity focus on the procedures used to arrive at an allocation of resources rather on the allocation itself Example: principle of equal opportunity Some people believe that the free market system is a fair process Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-14 Equity Outcome-oriented notions of equity focus on whether the process used to allocate resources yields fair results According to utilitarianism, society should place equal weight on the well-being of every individual According to Rawlsianism, society should place all weight on the well-being of its worst-off member According to egalitarianism, equal division of society’s resources among all members of the population is the most equitable outcome Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-15 Social Welfare Functions A social welfare function summarizes judgments about resource allocations. For each possible allocation, the function assigns a number that indicates the overall level of social welfare. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-16 Applying Social Welfare Functions For the social welfare function corresponding to the red social indifference curves, point A is the best possible outcome. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-17 General Equilibrium in an Exchange Economy In an exchange economy, people own and trade goods, but no production takes place An endowment is the bundle of goods an individual starts out with before trading Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-18 General Equilibrium in an Exchange Economy (b) Lauren Water (gal.) Food (lb.) (a) Humphrey Water (gal.) Food (lb.) 3 8 AHAH Endowment P W =1, P F =1 P W =1, P F =2 CHCH BHBH Consumption P W =1, P F =2 P W =1, P F =1 4 CLCL 3 6 BLBL Consumption 7 2 ALAL Endowment Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-19 Equilibrium in an Edgeworth Box 6 C P W =1, P F = BLBL BHBH P W =1, P F =1 Lauren’s food (lb.) Lauren’s water (gal.) Humphrey’s water (gal.) Humphrey’s food (lb.) A Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-20 First Welfare Theorem First welfare theorem: in a general equilibrium with perfect competition, the allocation of resources is Pareto efficient Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-21 First Welfare Theorem in an Exchange Economy Point C is a competitive equilibrium allocation Humphrey must like point C better than all points to the left of the budget line, like D Lauren must like point C better than all points to the right of the budget line, like D Both must like point C at least as well as all other points on the budget line Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-22 Efficiency in Exchange Point G is inefficient (Lauren and Humphrey both like H better) Point J makes Humphrey better off without hurting Lauren Point J is Pareto efficient Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-23 Exchange Efficiency Condition Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-24 Contract Curve The contract curve shows every efficient allocation of consumption goods in an Edgeworth box Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-25 Contract Curve and Utility Possibility Frontier Every allocation on the contract curve corresponds to a point on the utility possibility frontier Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-26 Efficiency in Production Exchange efficiency is not enough; production must also be efficient Requirements for efficient production 1.Input efficiency 2.Output efficiency Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-27 Input Efficiency Input efficiency: holding constant the total amount of each input used in the economy, there is no way to increase any firm’s output without decreasing the output of another firm Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-28 Input Efficiency The production contract curve shows every efficient allocation of inputs between two firms in an Edgeworth box The input efficiency condition holds if, for every pair of inputs, every pair of firms share the same marginal rate of technical substitution Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-29 Production Possibilities The production possibility frontier shows the combinations of outputs that firms can produce when inputs are allocated efficiently among them, given their technologies and the total inputs available Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-30 Marginal Rate of Transformation Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-31 Output Efficiency Output efficiency means that, among allocations satisfying exchange efficiency and input efficiency, there is no way to make one consumer better off without harming anyone else by shifting production from one good to another Output efficiency Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-32 Efficiency as a Justification for Free Markets The doctrine of laissez faire holds that the government should adopt a hands-off approach to private commerce The first welfare theorem provides some support for this position Reservations – When market failures occur, the government may be able to promote economic well-being by intervening in markets (chapters 17-20) – Free markets can produce inequitable outcomes Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-33 Second Welfare Theorem Second welfare theorem: every Pareto efficient allocation is a competitive equilibrium for some initial allocation of resources With a lump-sum transfer, the amount of resources received or surrendered by each consumer is fixed; it does not depend on the consumer’s choices Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-34 Equity vs. Efficiency The second welfare theorem suggests that societies can use competitive markets in combination with lump-sum transfers to achieve both efficiency and equity Since wealth is observable, we could try to achieve an equitable outcome by redistributing resources from the rich to the poor But wealth is not an endowment; it depends on a variety of choices (education, employment, saving) Thus, transfers based on wealth are not lump-sum transfers Equity and efficiency are in direct conflict Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-35 Equity vs. Efficiency Endowment A heavily favors Humphrey Equilibrium B is efficient but arguably unfair to Lauren Government can tax Humphrey’s food purchases and give the food to Lauren Point D is more equitable, but inefficient Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-36 Review Economists evaluate economic performance on the basis of efficiency and equity The first welfare theorem tells us that competitive general equilibria are Pareto efficient Market failures may prevent free markets from operating efficiently The second welfare theorem implies that, in principle, societies can use competitive markets to achieve efficiency without sacrificing equity, though in practice governments cannot achieve their distributional goals through lump-sum transfers Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16-37 Looking Forward Next, we will study different cases when markets may not allocate resources efficiently, the so called market failures Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.