1. Lecture 18 Towards general equilibrium
Microeconomics 1000
Lecture 18 Towards general equilibrium

2. General equilibrium
Partial equilibrium analysis focuses on a single market
It is based on the ceteris paribus (i.e. all else equal) assumption
But changes in one market may also affect several other markets
A change in the price of a product affects the demand for complements and substitutes
A change in the price of a factor of production affects the income of the owners of that factor, and hence their demand for goods
Hence the need for general equilibrium analysis 6

3. Main problems
Can a general equilibrium (i.e. a state where all markets are simultaneously in equilibrium) be reached?
Is the general equilibrium efficient?

4. Figure 1 The Circular Flow
Firms sell
Households buy
MARKETS
FOR
GOODS AND SERVICES
Revenue
Spending
Goods
and services
sold
Goods and
services
bought
FIRMS
Produce and sell
goods and services
Hire and use factors
of production
Buy and consume
goods and services
Own and sell factors
of production
HOUSEHOLDS
Households sell
Firms buy
MARKETS
FOR
FACTORS OF PRODUCTION
Factors of
production
Labor, land,
and capital
Wages, rent,
and profit
Income
= Flow of inputs
and outputs
= Flow of dollars
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5. The Circular-Flow Diagram: agents
Firms
Produce and sell goods and services
Hire and use factors of production
Households
Buy and consume goods and services
Own and sell factors of production 7

6. The Circular-Flow Diagram: markets
Markets for Goods and Services
Firms sell
Households buy
Markets for Factors of Production (inputs, such as land, labor and capital, used to produce goods and services)
Households sell
Firms buy 7

7. Our First Model: One Good, One Input, One (Representative) Household
Suppose there is only one good (corn) and only one input (labour)
Hence, two markets
Many identical households
Many identical firms
Perfect competition in both markets 7

8. Figure 2 The Production Function
Quantity of
Corn
3000
1000
Quantity of
Labour
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9. Firm’s equilibrium
We know that a perfectly competitive firm maximises its profit at a point where p = MC, or, equivalently, w = VMPL
We can depict the profit-maximising choice of a point on the production function using iso-profit lines, i.e., lines where profit is constant

10. Iso-profit lines Dividing by p and re-arranging we get
The slope of the iso-profit line is the real wage rate, i.e., the wage rate measured in units of corn

11. Figure 3 Equilibrium of the (representative) firm
Quantity of
Corn
3000
Supply of corn E
Demand for labour
1000
Quantity of
Labour
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12. Firm’s equilibrium
The firm maximises its profit when it reaches the highest iso-profit line, given the production function.
The slopes of the production function and the iso-profit line are equal at the optimum, i.e.
This is the standard condition p = MC or w = VMPL

13. Household’s equilibrlium
We have already analysed the household’s optimal choice of labour supply

14. Figure 4 Equilibrium of the (representative) household
Quantity of
Corn
Demand for corn E
Non-labour income
Labour supply
leisure
1000
Quantity of
Leisure
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15. Important properties: relative prices
Only relative prices matter (the real wage rate, i.e. the wage rate measured in units of corn)
The real wage rate determines both the slope of the iso-profit lines (and hence the firm equilibrium) and the slope of the budget constraint (and hence the household equilibrium)
Thus, with two goods we have in fact only one price to determine

16. The Production Possibilities Frontier
The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology. 14

17. Figure 5 The Production Possibilities Frontier
Quantity of
Corn
3,000 D C
2,200
600 A
700
2,000
Production
possibilities
frontier
1,000
300 B
1,000
Quantity of
Leisure
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18. Important properties: Walras’ law
The two markets are interdependent
When one market is in equilibrium, the other is necessarily in equilibrium
Hence, with two goods we have in fact only one independent equilibrium condition
And, indeed, we have only one (relative) price to determine

19. Figure 6 Disequilibrium: excess supply of labour
Quantity of
Corn H
3,000
Excess demand for corn K
Excess supply of labour
1,000
Quantity of
Leisure
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20. Figure 7 Disequilibrium: excess demand for labour
Quantity of
Corn
3,000 K
Excess supply of corn H
Excess demand for labour
1,000
Quantity of
Leisure
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21. Figure 8 The General equilibrium
Quantity of
Corn
3,000 E
2,200
600
1,000
Quantity of
Leisure
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22. Important properties: efficiency
The general equilibrium of a perfectly competitive economy is efficient
With homogeneous agents, efficiency is equivalent to the maximisation of the welfare (utility) of the representative agent

23. Figure 9 Efficiency of the General equilibrium
Quantity of
Corn
3,000 E
2,200
600
1,000
Quantity of
Leisure
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24. Feedback Answers to Exercises are posted on the course web page
Answers to Questions Sheets and mock exams will be posted
TAs should mark the essays you hand in

25. Our Second Model: Two Goods, One Input, Constant Returns
Suppose there are two goods (corn and bicycles) and again only one input (labour)
Now, however, the marginal productivity of labour is constant
Suppose that the supply of labour is fixed at 100 workers, and the productivity of labour is 10 bicycles or 20 tons of corn per worker 7

26. Constant marginal cost
When marginal products and marginal costs are constant, prices are determined only by the supply side of the market
Market demand affects only equilibrium quantities
This simplified framework was used by classical economists (Adam Smith, David Ricardo)

27. Adam Smith ( )

28. David Ricardo ( )

29. Figure 10 The Ricardian Model
Price of
Corn
Equilibrium price
450
1,000
Quantity of
Corn
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30. Figure 11 The Production Possibilities Frontier in the Ricardian Model
Quantity of
Corn
2,000 C B
Production
possibilities
frontier A
1,000
Quantity of
Bicycles
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31. Equilibrium prices
In terms of (tons of) corn, the wage rate is 20 and the price of a bicycle is 2
In terms of bicycles, the wage rate is 10 and the price of a ton of corn is ½

32. Figure 12 Equilibrium quantities
Quantity of
Corn
2,000 E
1,000
Quantity of
Bicycles
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