MICROECONOMICS: Theory & Applications By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11 th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College Chapter 19: General Equilibrium Analysis and Economic Efficiency

Copyright 2012John Wiley & Sons, Inc. 2 Learning Objectives Delineate the difference between partial and general equilibrium analysis. Explain the concept of economic efficiency. Outline the three conditions necessary for the attainment of economic efficiency. Examine efficiency in production and what this implies about input usage across difference industries. (continued)

Copyright 2012John Wiley & Sons, Inc. 3 Learning Objectives (continued) Show how efficiency in output is related to the production possibility frontier. Demonstrate how perfect competition satisfies all three conditions for economic efficiency. Spell out the reasons why economic efficiency may not be achieved.

Copyright 2012John Wiley & Sons, Inc. 4 Partial and General Equilibrium Analysis Compared General equilibrium analysis – the study of how equilibrium is determined in all markets simultaneously Partial equilibrium analysis – the study of the determination of an equilibrium price and quantity in a given product or input market viewed as self-contained and independent of other markets; assumes that some things that conceivably could, but do not, change (“other things equal”)

Copyright 2012John Wiley & Sons, Inc. 5 The Mutual Interdependence of Markets Illustrated Spillover effect – a change in equilibrium in one market that affect other markets Feedback effect – 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

Copyright 2012John Wiley & Sons, Inc. 6 Figure Interdependence Between Markets: Butter and Margarine

Copyright 2012John Wiley & Sons, Inc. 7 When Should General Equilibrium Analysis Be Used? Guideline: Partial analysis is usually accurate in cases involving a change in conditions primarily affecting one market among many, with repercussions on other markets dissipated throughout the economy General equilibrium analysis tends to be more appropriate when a change in conditions affects many, or all, markets are the same time and to the same degree Pareto optimal – the condition in which it is not possible, through any feasible change in resource allocation, to benefit one person without making some other person or persons worse off

Copyright 2012John Wiley & Sons, Inc. 8 Economic Efficiency Efficient – Pareto optimal; an allocation of resources when it is not possible, through any feasible change in resource allocation, to benefit one person without making any other person worse off Inefficient – the condition in which it is possible, through some feasible reallocation of resources, to benefit at least one person without making any other person worse off

Copyright 2012John Wiley & Sons, Inc. 9 Figure Welfare Frontier A curve that separates welfare levels that are attainable from those that cannot be reached given the available resources Every point lying on the curve satisfies the definition of economic efficiency Every point lying inside the curve represents an inefficient allocation of resources

Copyright 2012John Wiley & Sons, Inc. 10 Efficiency as a Goal for Economic Performance The notions of efficient and inefficient resource allocations emphasize the factors that affect the level and distribution of well-being. BUT, given the premise that each person is the best judge of their own welfare, we cannot conclude that any efficient position is better than any inefficient position.

Copyright 2012John Wiley & Sons, Inc. 11 Conditions for Economic Efficiency Any economy must solve 3 fundamental economic problems: how much of each good to produce how much of each input to use in the production of each good how to distribute goods among consumers Condition for efficiency in the distribution of goods:

Copyright 2012John Wiley & Sons, Inc. 12 Figure Efficiency in Production Edgeworth Production Box – a diagram that identifies all the ways two inputs such as labor and land can be allocated between industries in a simplified economy

The Production Contract Curve and Efficiency in Production Efficient resource allocations in input markets lies on the contract curve which connects points of tangency between isoquants. Where the equilibrium lies on the contract curve depends on the input prices. A general equilibrium in competitive input markets will occur at the point in which the slopes of the isoquants are equal to one another, as well as the input price ratio. Copyright 2012John Wiley & Sons, Inc. 13

Copyright 2012John Wiley & Sons, Inc. 14 Figure 19.4 – General Equilibrium in Input Markets

Copyright 2012John Wiley & Sons, Inc. 15 General Equilibrium in Competitive Input Markets The condition for cost minimization: The slopes of the two input isoquants must equal one another since both are equal to the same input price ratio.

The Production Possibility Frontier and Efficiency in Output The PPF shows the alternative combinations of two goods that can be produced with fixed supplies of inputs; it can be derived from the contract curve by plotting various possible output combinations directly Marginal rate of transformation (MRT) – the rate at which one product can be “transformed” into another At any point on the frontier, the slope, or MRT, equals MC c /MC F Copyright 2012John Wiley & Sons, Inc. 16

Copyright 2012John Wiley & Sons, Inc. 17 Figure The Production Possibility Frontier Revisited

Efficiency in Output Efficiency in output is attained when the rate at which consumers are willing to exchange one good for another (MRS) equals the rate at which one good can be transformed into another (MRT): It is always possible to change the output mix and leave consumers better off whenever their common marginal rates of substitution are not equal to the marginal rate of transformation Copyright 2012John Wiley & Sons, Inc. 18

Copyright 2012John Wiley & Sons, Inc. 19 Figure Efficiency in Output

Copyright 2012John Wiley & Sons, Inc. 20 Figure 19.7 – The PPF and the Gains from International Trade

Copyright 2012John Wiley & Sons, Inc. 21 Competitive Markets and Economic Efficiency Perfectly competitive markets satisfy the 3 conditions for economic efficiency: an efficient distribution of products among consumers efficiency in production efficiency in output

Condition 1 and Condition 2 Condition 1: Efficient Distribution of Products Among Consumers Condition 2: Efficiency in Production Copyright 2012John Wiley & Sons, Inc. 22

Condition 3 Condition 3: Efficiency in Output Copyright 2012John Wiley & Sons, Inc. 23

“Invisible Hand” Theorem Adam Smith If perfect competition prevails, then all three conditions for economic efficiency are satisfied. People pursuing their own ends in competitive markets promote economic efficiency. Copyright 2012John Wiley & Sons, Inc. 24

Copyright 2012John Wiley & Sons, Inc. 25 The Role of Information When resources are efficiently allocated, it is assumed that all the relevant information is known. Consumers or producers adjust their behavior based on prices. Efficient responses occur in a market system without anyone knowing why prices change.

Copyright 2012John Wiley & Sons, Inc. 26 The Causes of Economic Inefficiency Market power Monopoly (output market) Monopsony (input market) Imperfect information Externalities/Public goods Side effects borne by people not directly involved in the market activities May be harmful or beneficial

Copyright 2012John Wiley & Sons, Inc. 27 Copyright © 2012 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back- up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein.