Chapter 16 General Equilibrium and Economic Efficiency.

Chapter 16 General Equilibrium and Economic Efficiency

©2005 Pearson Education, Inc. Chapter 164 General Equilibrium Analysis Up to this point, we have been focused on partial equilibrium analysis  Activity in one market has little or no effect on other markets Market interrelationships can be important  Complements and substitutes  Increase in firms’ input demand can cause market price of the input and product to rise

©2005 Pearson Education, Inc. Chapter 165 General Equilibrium Analysis To study how markets interrelate, we can use general equilibrium analysis  Simultaneous determination of the prices and quantities in all relevant markets, taking into account feedback effects The feedback effect is the price or quantity adjustment in one market caused by price and quantity adjustments in related markets

©2005 Pearson Education, Inc. Chapter 166 Two Interdependent Markets – Moving to General Equilibrium Scenario  The competitive markets of: DVD rentals Movie theater tickets  These goods are substitutes  Changing prices in one market are likely to affect the other market

©2005 Pearson Education, Inc. Chapter 167 Two Interdependent Markets – Moving to General Equilibrium Scenario  Equilibrium price of movies is $6.00  Equilibrium price of DVD rentals is $3.00  Government places a $1.00 tax on each movie ticket  Need to look at effect of tax on Market for DVDs Feedback effects in movie market

©2005 Pearson Education, Inc. 8 Two Interdependent Markets – Movies and DVDs DVDV DMDM Price Number of Videos Price Number of Movie Tickets SMSM SVSV $6.00 QMQM QVQV $3.00 $6.35 Q’ M S* M $1 tax on each movie ticket causes supply to fall D’ V Q’ V $3.50 General Equilibrium Analysis: Increase in movie ticket prices increases demand for videos.

©2005 Pearson Education, Inc. Chapter 169 Two Interdependent Markets – Movies and DVDs Price Number of Videos Price Number of Movie Tickets DMDM SMSM $6.00 QMQM $6.35 Q’ M S* M The increase in the price of videos increases the demand for movies. D’ V DVDV SVSV QVQV $3.00 Q’ V $3.50 General Equilibrium Analysis: The Feedback effects continue. D* M $6.82 Q* M Q” M $6.75 D’ M $3.58 Q* V D* V

©2005 Pearson Education, Inc. Chapter 1610 Two Interdependent Markets – Movies and DVDs Observation  Without considering the feedback effect with general equilibrium, the impact of the tax would have been underestimated  This is an important consideration for policy makers You can check for yourself that in the market for complements, the tax would be overestimated

©2005 Pearson Education, Inc. Chapter 1611 Reaching General Equilibrium Must be able to determine the equilibrium price of both movies and DVDs simultaneously  We must simultaneously find two prices that equate quantity demanded and quantity supplied in all related markets  The requires finding the solution to four equations: demand and supply for DVDs and movies

©2005 Pearson Education, Inc. Chapter 1612 The Interdependence of International Markets Brazil and the United States compete in the world soybean market, so one market can affect the other Brazil limited exports of soybeans in the late 1960’s and early 1970’s, causing price in Brazil to fall Eventually the export controls were to be removed, and Brazilian exports were expected to increase

©2005 Pearson Education, Inc. Chapter 1613 The Interdependence of International Markets Expectation was based on partial equilibrium analysis  Program actually increased the price and production of soybeans in US as well as US exports  This caused Brazil to have difficulties exporting even after control was removed  Can show how each market was affected and compare to general equilibrium analysis

©2005 Pearson Education, Inc. Chapter 1615 Efficiency in Exchange We showed before that competitive markets are efficient because consumer and producer surpluses are maximized We can study this in more detail by examining an exchange economy  Market in which two or more consumers trade two goods among themselves  Same for two countries

©2005 Pearson Education, Inc. Chapter 1616 Efficiency in Exchange An efficient allocation of goods is one where no one can be made better off without making someone else worse off  Pareto efficiency Voluntary trade between two parties is mutually beneficial and increases economic efficiency

©2005 Pearson Education, Inc. Chapter 1617 The Advantages of Trade Assumptions  Two consumers (countries)  Two goods  Both people know each other’s preferences  Exchanging goods involves zero transaction costs  James and Karen have a total of 10 units of food and 6 units of clothing

©2005 Pearson Education, Inc. Chapter 1618 The Advantage of Trade IndividualInitial Allocation TradeFinal Allocation James7F, 1C-1F, +1C6F, 2C Karen3F, 5C+1F, -1C4F, 4C To determine if they are better off, we need to know the preferences for food and clothing

©2005 Pearson Education, Inc. Chapter 1619 The Advantage of Trade Karen has a lot of clothing and little food  MRS of food for clothing is 3  To get 1 unit of food, she will give up 3 units of clothing James’ MRS of food for clothing is only ½  He will give up ½ unit if clothing for 1 unit of food

©2005 Pearson Education, Inc. Chapter 1620 The Advantage of Trade There is room for trade  James values clothing more than Karen  Karen values food more than James  Karen is willing to give up 3 units of clothing to get 1 unit of food, but James is willing to take only ½ unit of clothing for 1 unit of food Actual terms of trade are determined through bargaining  Trade for 1 unit of food will fall between ½ and 3 units of clothing

©2005 Pearson Education, Inc. Chapter 1621 The Advantage of Trade Suppose Karen offers James 1 unit of clothing for 1 unit of food  James will have more clothing, which he values more than food  Karen will have more food, which she values more Whenever two consumers’ MRSs are different, there is room for mutually beneficial trade  Allocation of resources is inefficient

©2005 Pearson Education, Inc. Chapter 1622 The Advantage of Trade From this analysis we obtain an important result: An allocation of goods is efficient only if the goods are distributed so that the marginal rate of substitution between any pair of goods is the same for all consumers

©2005 Pearson Education, Inc. Chapter 1623 The Edgeworth Box Diagram A diagram showing all possible allocations of either two goods between two people or of two inputs between two production processes is called an Edgeworth Box

©2005 Pearson Education, Inc. Chapter 1624 The Edgeworth Box Diagram Food is measured across the horizontal axis Clothing is measured on the vertical axis Length of box is the total amount of food – 10 units Height of box is the total amount of clothing – 6 units

©2005 Pearson Education, Inc. Chapter 1625 The Edgeworth Box Diagram Each point describes the market baskets of both consumers  James’ basket is read from origin O J  Karen’s basket is read from origin O K, in the reverse direction  James has 7 units of food and 1 unit of clothing – point A  Karen has 3 units of food and 5 units of clothing – point A from different axis

©2005 Pearson Education, Inc. 26 Exchange in an Edgeworth Box 10F 0K0K 0J0J 6C 10F 6C James’ Clothing Karen’s Clothing James’ Food Karen’s Food 1C 5C 3F 7F A The initial allocation before trade is A: James has 7F and 1C & Karen has 3F and 5C.

©2005 Pearson Education, Inc. Chapter 1627 Exchange in an Edgeworth Box James’ Food Karen’s Food 10F 0K0K 0J0J 6C 10F 6C James’ Clothing Karen’s Clothing 1C 5C 3F 7F A The allocation after trade is B: James has 6F and 2C & Karen has 4F and 4C. 4F 6F +1C -1F 2C4C B

©2005 Pearson Education, Inc. Chapter 1628 Efficient Allocations A trade from A to B makes both Karen and James better off  Is it efficient? If James’ and Karen’s MRS are the same at B, the allocation is efficient  This depends on the shape of their indifference curves

©2005 Pearson Education, Inc. Chapter 1629 Efficient Allocations James’ indifference curves are drawn as we usually see them Karen’s indifference curves are rotated 180 o convex to her axis The indifference curves that go through point A have different slopes and therefore different MRSs  The allocation is not efficient

©2005 Pearson Education, Inc. Chapter 1630 Efficient Allocations The shaded area between these two indifference curves represents all the possible allocations of food and clothing that would make both James and Karen better off than A  Describes all mutually beneficial trades

©2005 Pearson Education, Inc. Chapter 1631 Efficient Allocations We can see both parties are better off at point B since they both end up on a higher indifference curve  Not efficient since MRSs are different – indifference curves have different slopes Although a trade might make both parties better off, the new allocation is not necessarily efficient

©2005 Pearson Education, Inc. Chapter 1632 Efficient Allocations How do these parties reach an efficient allocation?  When there is no more room for trade  When their MRSs are equal  They will keep trading, reaching higher indifference curves, until they can no longer do so and still make each better off  This is when indifference curves are tangent – they have the same slope and same MRS

©2005 Pearson Education, Inc. Chapter 1633 A: U J 1 = U K 1, but the MRS is not equal. All combinations in the shaded area are preferred to A. Karen’s Clothing Karen’s Food UK1UK1 James’s Clothing James’s Food UJ1UJ1 Efficiency in Exchange 10F 0K0K 0J0J 6C 10F 6C Gains from trade A

©2005 Pearson Education, Inc. Chapter 1634 Efficiency in Exchange Karen’s Clothing Karen’s Food James’s Clothing James’s Food 10F 0K0K 0J0J 6C 10F 6C UK1UK1 UJ1UJ1 A Point B is on higher IC but is not efficient UJ2UJ2 UK2UK2 B At point C, MRSs are equal and allocation is efficient UK3UK3 C D is also a possible efficient allocation depending on bargaining UJ3UJ3 D

©2005 Pearson Education, Inc. Chapter 1635 Efficiency in Exchange Any move outside the shaded area will make one person worse off (closer to their origin) B is a mutually beneficial trade--higher indifference curve for each person Trade may be beneficial but not efficient MRS is equal when indifference curves are tangent and the allocation is efficient A Karen’s Clothing Karen’s Food UK1UK1 UK2UK2 UK3UK3 James’ Clothing James’ Food UJ1UJ1 UJ2UJ2 UJ3UJ3 B C D 10F 0K0K 0J0J 6C 10F 6C

©2005 Pearson Education, Inc. Chapter 1636 Efficiency in Exchange The Contract Curve  To find all possible efficient allocations of food and clothing between Karen and James, we would look for all points of tangency between each of their indifference curves  The contract curve shows all the efficient allocations of goods between two consumers, or of two inputs between two production functions

©2005 Pearson Education, Inc. Chapter 1638 Contract Curve All points of tangency between the indifference curves are efficient  MRS of individuals is the same  No more room for trade The contract curve shows all allocations that are Pareto efficient  Pareto efficient allocation occurs when further trade will make someone worse off

©2005 Pearson Education, Inc. Chapter 1639 Efficiency in Exchange Application: The policy implication of Pareto efficiency when removing import quotas: 1.Remove quotas US consumers gain Some US workers lose 2.Removal of quotas and subsidies to the workers

©2005 Pearson Education, Inc. Chapter 1640 Efficiency in Exchange US consumers would be better off and after a time, the US workers are no worse off and might be better off  Package will increase efficiency Efficiency, therefore, can be reached when the combined set of changes leaves someone better off and no one worse off

©2005 Pearson Education, Inc. Chapter 1641 Efficiency in Exchange Consumer Equilibrium in a Competitive Market  Competitive markets have many actual or potential buyers and sellers, so if people do not like the terms of an exchange, they can look for another seller who offers better terms

©2005 Pearson Education, Inc. Chapter 1642 Consumer Equilibrium in a Competitive Market There are many Jameses and Karens They are price takers Relative price of food and clothing = 1  Trade depends on relative prices, not actual prices

©2005 Pearson Education, Inc. Chapter 1643 Consumer Equilibrium in a Competitive Market We can show opportunities for trade for many consumers  When prices of food and clothing are equal, we can show the price line, PP’ with a slope of –1 Shows all possible allocations that exchange can achieve  James buys 2 clothing for 2 food: A to C  Karen buys 2 food for 2 clothing: A to C  Both increase satisfaction

©2005 Pearson Education, Inc. Chapter 1644 Consumer Equilibrium in a Competitive Market Price Line 10F 0K0K 0J0J 6C 10F 6C James’ Clothing Karen’s Clothing Karen’s Food James’ Food C A Begin at A: Each James buys 2C and sells 2F moving from U J 1 to U J 2, which is preferred (A to C). Begin at A: Each Karen buys 2F and sells 2C moving from U K 1 to U K 2, which is preferred (A to C). P P’ UJ2UJ2 UJ1UJ1 UK1UK1 UK2UK2

©2005 Pearson Education, Inc. Chapter 1645 Consumer Equilibrium in a Competitive Market The amount of clothing that Karen wanted to sell is equal to the amount of clothing that James wanted to buy An equilibrium is a set of prices at which the quantity demanded equals the quantity supplied in every market  Also called competitive equilibrium

©2005 Pearson Education, Inc. Chapter 1646 Consumer Equilibrium in a Competitive Market Not all prices lead to equilibrium If the MRSs of the players are not equal, then we are not in equilibrium If the price of food is 1 and price of clothing is 3:  James is unwilling to trade, MRS = ½  Karen is happy to sell clothing at that price but has no one to sell to  Market is in disequilibrium

©2005 Pearson Education, Inc. Chapter 1647 Consumer Equilibrium in a Competitive Market Disequilibrium is only temporary in a competitive market  Excess demand will cause price to rise  Excess supply will cause price to fall In our example, we have excess supply of clothing and excess demand of food  Should expect the price of food to increase relative to price of clothing  Prices adjust until equilibrium is reached

©2005 Pearson Education, Inc. Chapter 1648 Economic Efficiency of Competitive Markets As shown before, we can see that the allocation in a competitive equilibrium is economically efficient  The efficient point must occur where the two indifference curves are tangent  If not, one of the consumers can increase their utility and be better off

©2005 Pearson Education, Inc. Chapter 1649 Consumer Equilibrium in a Competitive Market In a general equilibrium setting where all markets are perfectly competitive, we can show the same result  Best example of Adam Smith’s invisible hand  Economy will automatically allocate all resources efficiently without need for regulatory control Supports argument for less government intervention and more highly competitive markets

©2005 Pearson Education, Inc. Chapter 1650 Consumer Equilibrium in a Competitive Market First Theorem of Welfare Economics  If everyone trades in a competitive marketplace, all mutually beneficial trades will be completed and the resulting equilibrium allocation of resources will be economically efficient  Welfare economics involves the normative evaluation of markets and economic policy

©2005 Pearson Education, Inc. Chapter 1651 Consumer Equilibrium in a Competitive Market Competitive equilibrium 1.Because the indifference curves are tangent, all MRSs are equal between consumers 2.Because each indifference curve is tangent to the price line, each person’s MRS is equal to the price ratio of the two goods

©2005 Pearson Education, Inc. Chapter 1652 Consumer Equilibrium in a Competitive Market Difficult for efficient allocation with many consumers and producers unless all markets are perfectly competitive Efficient outcomes can also be achieved by centralized system Competitive outcome preferred since consumers and producers can better assess their preferences and supplies

©2005 Pearson Education, Inc. Chapter 1653 Equity and Efficiency Although there are many efficient allocations, some may be more fair than others The difficult question is, what is the most equitable allocation? We can show that there is no reason to believe that efficient allocation from competitive markets will give an equitable allocation

©2005 Pearson Education, Inc. Chapter 1654 The Utility Possibilities Frontier From the Edgeworth Box, we showed a two person exchange The utility possibilities frontier represents all allocations that are efficient in terms of the utility levels of the two individuals  Shows the levels of satisfaction that are achieved when the two individuals have reached the contract curve

©2005 Pearson Education, Inc. Chapter 1655 The Utility Possibilities Frontier James’ Utility Karen’s Utility E F G OKOK L OJOJ H O J – James has zero utility O K – Karen has zero utility E, F, G – points on contract curve H – inefficient – can do better in shaded area L - unobtainable

©2005 Pearson Education, Inc. Chapter 1656 The Utility Possibilities Frontier James’ Utility Karen’s Utility E F G OKOK OJOJ H Are all efficient points equitable? Efficient points E or F make both persons better off without making one worse off from H If only possible points are H and G, can argue that one is more equitable to James and one to Karen

©2005 Pearson Education, Inc. Chapter 1657 The Utility Possibilities Frontier From previous example, can see that an inefficient allocation might be more equitable than an efficient one But how do we define an equitable allocation?  It depends on what we believe equity to entail  Requires interpersonal comparisons of utility

©2005 Pearson Education, Inc. Chapter 1658 Social Welfare Functions Weights are often applied to individual’s utility to determine what is socially desirable  How these weights are applied comes from the social welfare functions The utilitarian function weights everyone’s utility to maximize utility for the whole society

©2005 Pearson Education, Inc. Chapter 1659 Social Welfare Functions Each social welfare function is associated with a particular view of equity Some views of equity do not assign weights and cannot be represented by a welfare function  Competitive market process is equitable because it rewards those who are most able and work hardest  Believes competitive equilibrium would be most equitable

©2005 Pearson Education, Inc. Chapter 1660 Social Welfare Functions The Rawlsian view is that individuals don’t know what their endowment will be Rawls argues that if you don’t know your own fate, you will opt for the system in which the least well-off person is treated reasonably well The most equitable allocation maximizes the utility of the least well-off person in society

©2005 Pearson Education, Inc. Chapter 1661 Social Welfare Functions An egalitarian view believes that goods should be equally shared by all individuals in society Could have situation where more productive people are rewarded, thereby producing more goods and then having more to reallocate to all of society

©2005 Pearson Education, Inc. Chapter 1662 Four Views of Equity Egalitarian All members of society receive equal amount of goods Rawlsian Maximize the utility of the least-well- off person Utilitarian Maximize the total utility of all members of society Market - Oriented The market outcome is the most equitable

©2005 Pearson Education, Inc. Chapter 1663 Equity and Perfect Competition A competitive equilibrium can occur at any point on the contract curve depending on the initial allocation Since not all competitive equilibriums are equitable, we rely on the government to help reach equity by redistributing income  Taxes  Public services

©2005 Pearson Education, Inc. Chapter 1664 Equity and Perfect Competition Must a society that wants to be more equitable necessarily operate in an inefficient world? Second Theorem of Welfare Economics If individual preferences are convex, then every efficient allocation (every point on the contract curve) is a competitive equilibrium for some initial allocation of goods

©2005 Pearson Education, Inc. Chapter 1665 Equity and Perfect Competition Any equilibrium that is equitable can be achieved by redistributing resources and may be efficient Typical ways to redistribute goods, however, are costly  Taxes lead to bad incentives Firms devote fewer resources to production in order to avoid taxes Encourage individuals to work less

©2005 Pearson Education, Inc. Chapter 1666 Efficiency in Production From the discussion of exchange of two goods, we can extend to the efficient use of inputs used for production Assume:  Two fixed inputs: capital and labor  Produce same two goods: food and clothing  Many consumers own inputs to production and earn income from selling them  Income allocated between goods

©2005 Pearson Education, Inc. Chapter 1667 Efficiency in Production Using the Edgeworth Box diagram, we can show efficient use of inputs in production  Labor on horizontal axis  Capital on vertical axis  50 hours of labor and 30 hours of capital available  Each origin is an output

©2005 Pearson Education, Inc. 68 Production in an Edgeworth Box 50L 0C0C 0F0F 30K 50L 30K Capital in Food Production Capital in Clothing Production Labor in Food Production Labor in Clothing Production 5K 25K 15L 35L A The initial allocation is A. Every combination of labor and capital used to produce two goods is represented as a point in the box.

©2005 Pearson Education, Inc. Chapter 1669 Production in an Edgeworth Box Each point in the box represents the labor and capital inputs in the production of food and clothing Can use production isoquants to show levels of output produced with each combination of inputs  3 isoquants representing 50, 60 and 80 units of food  3 isoquants representing 10, 25 and 30 units of clothing

©2005 Pearson Education, Inc. 70 Production in an Edgeworth Box 50L 0C0C 0F0F 30K 50L 30K Capital in Food Production Capital in Clothing Production Labor in Food Production Labor in Clothing Production 5K 25K 15L 35L 3 isoquants representing food production 3 isoquants representing food and clothing production 10C 60F 50F 25C B 30C 80F A

©2005 Pearson Education, Inc. Chapter 1671 Production in an Edgeworth Box To find efficient production, must find different combinations of inputs used to produce the two outputs An allocation of inputs is technically efficient if the output of one good cannot be increased without decreasing the output of another good

©2005 Pearson Education, Inc. Chapter 1672 Production in an Edgeworth Box Production at point A is inefficient since we can increase production of both goods  Shaded area indicates increases in production of both goods if begin at A  Allocation A could exist if a labor union market has enforced inefficient work rules

©2005 Pearson Education, Inc. 73 Production in an Edgeworth Box 50L 0C0C 0F0F 30K 50L 30K Capital in Food Production Capital in Clothing Production Labor in Food Production Labor in Clothing Production 5K 25K 15L 35L Can move from A to B or C which increases efficiency. 10C 60F 50F 25C 30C C 80F D A B Any place in shaded area will increase efficiency from allocation A.

©2005 Pearson Education, Inc. Chapter 1674 Production in an Edgeworth Box Points B and C are efficient allocations and therefore lie on the production contract curve  Curve showing all technically efficient combinations of inputs  Curve connects the origins O F and O C  All points on curve are tangencies between two isoquants

©2005 Pearson Education, Inc. 75 Production in an Edgeworth Box 50L 0C0C 0F0F 30K 50L 30K Capital in Food Production Capital in Clothing Production Labor in Food Production Labor in Clothing Production 5K 25K 15L 35L 10C 60F 50F 25C 30C C 80F D A B Production Contract Curve

©2005 Pearson Education, Inc. Chapter 1676 Producer Equilibrium – Competitive Input Markets If input markets are competitive, an efficient point will be achieved In competitive input markets  Wage rate, w, will be equal in all industries  Rental rate of capital, r, will be equal in all industries

©2005 Pearson Education, Inc. Chapter 1677 Producer Equilibrium – Competitive Input Markets We saw before that if producers minimize costs, they will choose inputs to the point where the ratio of the marginal products of the two inputs is equal to the ratio of input prices:

©2005 Pearson Education, Inc. Chapter 1679 Producer Equilibrium – Competitive Input Markets The MRTS is the slope of the isoquant, so competitive equilibrium exists only if:  Slopes of the isoquants are equal to one another  These also equal the ratio of the prices of two inputs Competitive equilibrium lies on the production contract curve, and the competitive equilibrium is efficient in production

©2005 Pearson Education, Inc. Chapter 1680 Production Possibilities Frontier PPF shows the various combinations of two goods that can be produced with fixed quantities of inputs Frontier is derived from the production contract curve Points on PPF show efficiently produced levels of both goods

©2005 Pearson Education, Inc. Chapter 1681 Production Possibilities Frontier Clothing (units) Food (units) Point A is inefficient Points B, C and D are efficient All points in triangle ABC completely utilize capital and labor, but distortion in labor market leads to inefficient use OFOF OCOC D C B A

©2005 Pearson Education, Inc. Chapter 1682 Production Possibilities Frontier PPF is downward sloping  In order to produce more of one good, must give up producing some of the other good PPF is concave  Slope is the MRTS which increases as the level of production of food increases

©2005 Pearson Education, Inc. Chapter 1683 Production Possibilities Frontier Marginal rate of transformation (MRT) of food for clothing is the magnitude of the slope of the frontier at each point  Amount of one good that must be given up to produce one additional unit of a second good  How much clothing must be given up to produce one additional unit of food  As we increase the production of food by moving along the PPF, the MRT increases

©2005 Pearson Education, Inc. Chapter 1684 Marginal Rate of Transformation The productivity of labor and capital differs depending on whether the inputs are used to produce more food or clothing  Starting where only clothing is produced, MP of labor and capital are relatively low  Transferring some to food production where MP is relatively high  As we do this, MP in food decreases and MP in clothing increases

©2005 Pearson Education, Inc. Chapter 1686 Marginal Rate of Transformation Can also describe in terms of costs  When producing at O F, the MC of food is very low and the MC of clothing is very high  When MRT is low, so is the ratio of the MC of producing food to clothing  Slope of PPF measures the MC of producing one good relative to the MC of producing the other

©2005 Pearson Education, Inc. Chapter 1687 Output Efficiency For efficiency,  Good produced at minimum cost  Must be produced in combinations that match people’s willingness to pay  MRS = consumer’s WTP for additional food by consuming less clothing  MRT = cost of additional unit of food in terms of producing less clothing Efficiency means MRS = MRT

©2005 Pearson Education, Inc. Chapter 1688 Output Efficiency What if MRT  MRS?  Suppose MRT = 1 and MRS = 2  Consumer willing to give up 2 units of clothing to get 1 unit of food  Cost of getting additional food is only 1 unit of lost clothing  Too little food is being produced  Food production must increase, MRS falls and MRT increases until two are equal again

©2005 Pearson Education, Inc. Chapter 1690 Efficiency in Output Markets For perfectly competitive markets, all consumers allocate their budgets so their MRS between two goods are equal to the ratio of prices Profit maximizing firms produce output to the point where price is equal to MC MRT is equal to the MRS

©2005 Pearson Education, Inc. Chapter 1691 Efficiency in Output Markets Efficiency in competitive markets is achieved when there is separate production and consumption Market price ratio of P 1 F /P 1 C Food and clothing are produced at A where price ratio equals MRT This price causes consumer to maximize utility and consume at B

©2005 Pearson Education, Inc. Chapter 1692 Efficiency in Output Markets Clothing (units) Food (units) U1U1 P F */P C * U2U2 P F 1 /P C 1 C1C1 A F1F1 C C* F* F2F2 B C2C2 Produce at A Consume at B Inefficient at P F 1 /P C 1 Need to move to C

©2005 Pearson Education, Inc. Chapter 1693 The Gains from Free Trade We have showed gains from trade in an Edgeworth Box, but what about gains from trade in two countries where one has the comparative advantage?  A country has a comparative advantage over another country in the production of a good if the first country can produce the good at a lower opportunity cost than the other country

©2005 Pearson Education, Inc. Chapter 1694 The Gains from Free Trade Ex: Two countries producing two goods  Holland and Italy  Cheese and Wine  Holland has comparative advantage in cheese production  Italy has comparative advantage in wine production  Trade is good for both countries

©2005 Pearson Education, Inc. Chapter 1696 The Gains from Free Trade When there is comparative advantage, free trade allows the country to consume outside its PPF Before trade  Produces at A on indifference curve U 1 where MRT and pre-trade price ratio is 2  Holland would want to export 2 pounds of cheese for 1 gallon of wine

©2005 Pearson Education, Inc. Chapter 1697 The Gains from Free Trade After trade  Suppose they choose to trade 1 gallon of wine for 1 pound of cheese  Holland will produce at the point of tangency on the 1/1 price line and PPF – point B  Consumption will occur at D, on a higher indifference curve U 2 tangent to the trade price line

©2005 Pearson Education, Inc. Chapter 1698 The Gains from Trade Cheese (lbs) Wine (gal) U1U1 Pre-Trade Prices U2U2 World Prices CBCB B WBWB A WDWD D CDCD Trade allows Holland to consume outside PPF Exports Imports

©2005 Pearson Education, Inc. Chapter 1699 Overview – Efficiency of Competitive Markets 1.Efficiency in Exchange  MRS J FC = MRS K FC  MRS J FC = P F /P C = MRS K FC 2.Efficiency in the use of inputs in production  MRTS F LK = MRTS C LK  MRTS F LK = w/r = MRTS C LK

©2005 Pearson Education, Inc. Chapter 16100 Overview – Efficiency of Competitive Markets 3.Efficiency in the output market  MRT FC = MRS FC (for all consumers)  P F = MC F, P C = MC C resulting in  MRT FC = MC F /MC C = P F /P C ; therefore  MRS FC = MRT FC

©2005 Pearson Education, Inc. Chapter 16101 Why Markets Fail Market Power  Those with market power choose the price and quantity  Less output is sold than in competitive markets  Inefficiency  Can have market power as producers or as inputs

©2005 Pearson Education, Inc. Chapter 16102 Why Markets Fail Incomplete Information  Consumers must have accurate information about market prices or production quality for markets to operate efficiently  Lack of information can change supply Buy products with no value Don’t buy enough of products with value  Some markets may never develop

©2005 Pearson Education, Inc. Chapter 16103 Why Markets Fail Externalities  Market prices do not always reflect the activities of either producers or consumers  Consumption or production has indirect effect on other consumption or production not reflected in market prices  May be impossible to get insurance because suppliers of insurance lack information

©2005 Pearson Education, Inc. Chapter 16104 Why Markets Fail Public Goods  Nonexclusive, nonrival goods that can be made available cheaply but which, once available, are difficult to prevent others from consuming  Company thinking about researching a new technology if can’t get patent Once it’s made pubic, others can duplicate it

Chapter 16 General Equilibrium and Economic Efficiency.

Similar presentations

Presentation on theme: "Chapter 16 General Equilibrium and Economic Efficiency."— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

Chapter 16 General Equilibrium and Economic Efficiency.

Similar presentations

Presentation on theme: "Chapter 16 General Equilibrium and Economic Efficiency."— Presentation transcript:

Similar presentations

About project

Feedback