1 Chapters 6 & 19.1 & 19.2: Exchange Efficiency, and Prices

2 General and Partial Equilibrium Analysis Partial equilibrium analysis - the study of how individual markets function in isolation –Ceteris paribus –What we’ve been doing! Partial equilibrium analysis ignores: –Spillover effects - a change in equilibrium in one market may affect other markets too –Feedback effects - a change in equilibrium in a market that is caused by events in other markets that, in turn, are the result of an initial change in equilibrium in the market under consideration General equilibrium analysis - study of economic outcomes when one simultaneously considers the the interconnected system of markets –Here we are not making ceteris paribus assumptions

3 A Simply Exchange Economy An Edgeworth box is a useful tool to help understand general equilibrium in a simply exchange economy with two consumers –Provides an understanding of the value of exchange –Defines points of optimality for the economy Edgeworth box allows us to judge different allocations between individuals in an economy –An allocation “A” is superior to an allocation “B” if at least one individual prefers “A” to “B” and all others are at least as happy with “A” as “B” “A” is said to be Pareto superior to “B” Pareto optimality (efficiency) - set of allocations (between individuals) where it is impossible to make one person better off without making at least some others worse off –Contract curve defines the set of Pareto optimal points - all voluntary contracts must lie on the contract curve Inefficient - the condition under which, though a reallocation of resources at lease one person could be made better off w/o making anyone else worse off

4 Edgeworth Box Adam’s quantity of food Adam’s quantity of clothes Beth’s quantity of food Beth’s quantity of clothes Contract Curve Adam’s indifference curves Beth’s indifference curves

5 An Example of a Disequilibrium Relative Price Ratio Adam Beth Food Clothes P f = P c

6 The Invisible Hand & Welfare Theorems The first theorem of welfare economics also known as the Invisible Hand Theorem states that “An equilibrium produced by competitive markets will exhaust all possible gains from exchange” –Adam Smith –Every competitive equilibrium allocation is efficient The second theorem of welfare economics says that, under relatively unrestricted conditions, any allocation on the contract curve can be sustained as a competitive equilibrium –May require reallocation of initial endowments Cautions: –These theorems apply, but only under certain conditions We will discuss later whether/when they exist –These theorems do not imply that individuals would not prefer different equilibrium points, in general they would, but they are the best that individuals can do given their initial endowments

7 The Inefficiency of Taxes/Subsidies in General Equilibrium Taxes or subsidies in an economy change the relative price ratio between goods, which leads to In equilibrium consumers will still have a common value of MRS, and producers will still have a common value of MRTS, but inefficiency arises from the fact that producers and consumers see different price ratios –Consumption decisions are based on gross prices (prices inclusive of taxes and subsidies) –Production decisions are based on net prices (prices received by producer after tax is paid or subsidy received)

8 Would the World Be Better Without Taxes? Not necessarily because: 1.The optimums produced from a competitive economy only apply under certain conditions –We will discuss some of the exceptions to these conditions shortly 2.As a society we might care about other things in addition to efficiency, such as equity, human rights, etc. Still, in general, we limit the inefficiency caused by taxation if we impose taxes that keep price distortions to a minimum –E.g. same tax rate applied to all products, or a head tax

9 Chapters 7: Production

10 Production Any activity that creates present or future activity We assume an input output relationship defined by the production function defining a relationship by which inputs are combined to produce output –Q = F(K, L, E) K = capital, L = labor, E= Entrepreneurship

11 Fixed and Variable Inputs Two types of inputs, variable and fixed –Variable inputs are those whose quantity can be relatively easily altered –Fixed inputs are those whose quantity cannot be altered within a given time period Short-run - the longest period of time during which at least one of the inputs used in production cannot be varied Long-run - shortest period of time required to alter the amounts of every input –Note that all inputs are variable in the long run Note that neither the short or long run is defined by specific time periods, and that the short and long runs may be different for different production processes

12 Law of Diminishing Marginal Returns Total product - Q = F(K,L), omit E for simplicity Marginal product - change in total product with a change of one of the inputs, holding constant all others –MP = MP L Note production function implies diminishing marginal returns –Law of Diminishing Marginal Returns - increase in output from an increase in a variable input, ceteris paribus, must eventually decline Average product - average product produced with a given level of input –AP L = Q/L

13 Numerical Example of Production (in the Short Run) LaborTotal Product Average Product Marginal Product

14 Graphical Representation of Production (in the Short Run) Total Product Slope = Marginal Product at L * Slope = Average Product at L * L* Q L

15 Relationship Between Production Curves AP L MP L Q L L Q

16 Relationship Between Production Curves AP L MP L Q L L Q Q 10 - Q 9

17 Production in the Long run In the long run all factors of production can be varied Isoquant represents the set of all input combinations that yield a given level of output –The production equivalent of an indifference curve Marginal rate of technical substitution (MRTS) is the rate at which one input can be exchanged for another without altering the total level of output –MRTS around a point A

18 Graphical Representation of Marginal Rate of Technical Substitution K L

19 Returns to Scale The proportional change in production that occurs with a given change in all inputs defines the returns to scale –Constant returns to scale if Q = F(  K,  L) =  F(K, L) –Increasing returns to scale if Q = F(  K,  L) >  F(K, L) –Decreasing returns to scale if Q = F(  K,  L) <  F(K, L) In theory we should never observe decreasing returns to scale Note that decreasing returns to scale has nothing to do with diminishing marginal returns

20 Returns to Scale on the Isoquant Map Q=30 Q=240 Q=180 Q=400 Q=360 Q=300 Q= Q=90 L K