1. Chapter 16

2. GENERAL EQUILIBRIUM AND MARKET EFFICIENCY McGraw-Hill/IrwinCopyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 16

3. 16-3 Chapter Outline A Simple Exchange Economy Efficiency In Production Efficiency In Product Mix Gains From International Trade Taxes In General Equilibrium Other Sources Of Inefficiency

4. 16-4 A Simple Exchange Economy General equilibrium analysis: the study of how conditions in each market in a set of related markets affect equilibrium outcomes in other markets in that set.

5. 16-5 Figure 16.1: Two interdependent markets: Movie Tickets and DVDs 0 0 30 28 24 20 Price (R) Price (R) Number of Movie tickets Number of DVDs 16 15 12 D MOV D DVD

6. 16-6 A Simple Exchange Economy Simple economy in which there are only two consumers—Jacob and Thabo— and two goods, food and clothing. – Allocation: an assignment of these total amounts between Jacob and Thabo. – Initial endowments: the amounts of the two goods with which Jacob and Thabo begin each time period.

7. 16-7 Figure 16.2: An Edgeworth Exchange Box Thabo’s quantity of clothing Thabo’s quantity of food Jacob’s quantity of food Jacob’s quantity of clothing OJOJ OTOT

8. 16-8 Edgeworth Exchange Box Edgeworth exchange box: a diagram used to analyze the general equilibrium of an exchange economy.

9. 16-9 Figure 16.3: Gains from Exchange Thabo’s quantity of clothing Thabo’s quantity of food Jacob’s quantity of clothing Jacob’s quantity of food OJOJ OTOT I T1 I J3 I J2 I J1 I T2 I T3

10. 16-10 Figure 16.4: Further Gains from Exchange OJOJ OTOT Jacob’s quantity of food Thabo’s quantity of clothing Jacob’s quantity of clothing Thabo’s quantity of food

11. 16-11 Figure 16.5: A Pareto-Optimal Allocation Thabo’s quantity of clothing OTOT Thabo’s quantity of food Jacob’s quantity of clothing OJOJ Jacob’s quantity of food

12. 16-12 The Pareto Criterion Pareto superior allocation: an allocation that at least one individual prefers and others like at least as well. Pareto optimal: the term used to describe situations in which it is impossible to make one person better off without making at least some others worse off.

13. 16-13 The Contract Curve Contract curve: a curve along which all final, voluntary contracts must lie. – Identifies all the efficient ways of dividing the two goods between the two consumers.

14. 16-14 Figure 16.6: The Contract Curve OJOJ OTOT I T1 I T2 I T3 I J3 I J2 I J1

15. 16-15 Figure 16.7: Initial Endowments Constrain Final Outcomes OJOJ OTOT

16. 16-16 Figure 16.8: A Disequilibrium Relative Price Ratio Thabo’s quantity of clothing Thabo’s quantity of food OTOT Jacob’s quantity of food Jacob’s quantity of clothing OJOJ Food supplied by Thabo Food supplied by Jacob Clothing demanded by Jacob Clothing demanded by Thabo I J0 I T0

17. 16-17 Figure 16.9: General Equilibrium Thabo’s quantity of clothing Jacob’s quantity of food Jacob’s quantity of clothing Thabo’s quantity of food OJOJ OTOT Food supplied by Thabo Clothing demanded by Thabo Clothing supplied by Jacob Food demanded by Jacob J* T* ITIT IJIJ

18. 16-18 The Invisible Hand Theorem Theorem of the invisible hand: an equilibrium produced by competitive markets will exhaust all possible gains from exchange. – Equilibrium in competitive markets is Pareto optimal.

19. 16-19 Figure 16.10: Sustaining Efficient Allocations Thabo’s quantity of clothing OTOT Thabo’s quantity of food Jacob’s quantity of food Jacob’s quantity of clothing I T1 I T2 I T3 I J1 I J2 I J3 OJOJ

20. 16-20 Second Theorem The second theorem of welfare economics says that, under relatively unrestrictive conditions: – Any allocation on the contract curve can be sustained as a competitive equilibrium. The significance of the second welfare theorem is that the issue of equity in distribution is logically separable from the issue of efficiency in allocation.

21. 16-21 Efficiency In Production Suppose we now add a productive sector to our exchange economy, one with two firms, each of which employs two inputs—capital (K) and labour (L)—to produce either of two products, food (F) or clothing (C). – Suppose firm C produces clothing and firm F produces food. – The marginal rates of technical substitution for the two firms will be equal in competitive equilibrium.

22. 16-22 Figure 16.11: An Edgeworth Production Box

23. 16-23 Efficiency In Production The marginal rates of technical substitution for the two firms will be equal in competitive equilibrium. Competitive general equilibrium is efficient not only in the allocation of a given endowment of consumption goods, but also in the allocation of the factors used to produce those goods.

24. 16-24 Efficiency In Product Mix Production possibilities frontier: the set of all possible output combinations that can be produced with a given endowment of factor inputs. Marginal rate of transformation (MRT): the rate at which one output can be exchanged for another at a point along the production possibilities frontier.

25. 16-25 Figure 16.12: Generating the Production Possibilities Frontier 0 Firm F’s Labour Firm C’s Labour

26. 16-26 Efficiency in the Product Mix For an economy to be efficient in terms of its product mix, it is necessary that the marginal rate of substitution for every consumer be equal to the marginal rate of transformation.

27. 16-27 Figure 16.13: An Inefficient Product Mix 0 0 Jacob’s food Jacob’s clothing

28. 16-28 Figure 16.14: MRT Equals the Ratio of Marginal Costs 0

29. 16-29 Figure 16.15: Competition and output efficiency 0 Food (units) Clothing (units) F* F 2 F 1 C 1 C 2 C* I 2 I 1 A B C / / /

30. 16-30 Gains From International Trade The fact that the international budget constraint contains the original competitive equilibrium point means that it is possible to make everyone better off than before. – But the impersonal workings of international trading markets provide no guarantee that every single person will in fact be made better off by trade.

31. 16-31 Figure 16.16: Gains from International Trade 0

32. 16-32 Figure 16.17: Taxes Affect Product Mix 0

33. 16-33 Taxes In General Equilibrium A tax on food does not alter the fact that consumers will all have a common value of MRS in equilibrium. – Nor does it alter the fact that producers will all have a common value of MRTS. The real problem created by the tax is that it causes producers to see a different price ratio from the one seen by consumers.

34. 16-34 Other Sources Of Inefficiency Monopoly – Market power Externalities – Positive – Negative Public Goods – Non-rival & non-excludable – Free riders