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ECON0301/ECON2252

Sept 2013
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General equilibrium
multiple agents (firms and consumers) all optimizing
The aggregation problem: no inconsistency between
aggregate and individual level decisions
One shot environment
a static model
income=expenditure => balance of trade
Market structure
Constant returns to scale, perfect competition
Variable returns to scale, market power (new trade
theory in 80s; new new trade theory in this past
decade)

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Preference: Consumer Theory
Technology: Producer Theory
Market Structure: Perfectly Competitive Market
General Equilibrium
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4
Consumption choice problem

max
,
, subject to

.

Equalization of marginal utility per dollar



Marginal rate of substitution = relative price


y
x x x
x y y y
MU
MU MU P
P P MU P
= =
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A
At point A, the budget line
BL and some IC are
tangential to each other

Omitting the negative signs,

Slope of the IC =


Slope of the BL =



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y
x
Budget line
Indifference
curve
U=10
U=20
U=30
V=100
V=200
V=2001
An order-preserving re-labeling of ICs does not alter the
preference ordering.
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x
y
1 1
2 2
6 6
2 2 2 ' ' ' '
' ' '
' '
2 2 2 '
+ = + =
= =
+ = + =
= =
=
y x U U
xy U U
xy U U
y x U U
xy U
They are called positive monotonic transformation








They all refer to the same preferences, leading to
the same choice
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CD utility function:



Marginal utilities:

( ) ( )
( )
1
, ,
,
x
U x y U x y
x y
MU x y
x x x
U x y
MUy
y
o |
o |
o o o
|

c
= = = =
c
=
( )
, U x y x y
o |
=
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MRS = relative price


Expenditure shares constant


Very nice demand functions

x x x
y y y
MU P P x y
MU x P P y
o o
| |
= = =
and
y
x
P y
P x
I I
o |
o | o |
= =
+ +
( ) ( )
, , and , ,
x x y y x y
x y
I I
D p p I D p p I
P P
o |
o | o |
= =
+ +
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Without loss of generality, we assume



If not, we can always represent the old CD utility
function by a new CD function




The preference ordering is still preserved
after such positive monotonic transformation.
The demand functions found out are just the
same as before
1 o | + =
( )
, where and
a b
U x y x y a b
o |
o | o |
= = =
+ +
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Unit income elasticity
1% increase in income => 1% increase in
consumption
The aggregation problem
Given total income, income distribution does not
affect market demand
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Suppose there are N agents, each with the same CD utility
function
Suppose their incomes are I
1
,I
2
, , I
N
, summing up to I.
The total market demand for x equals






Given the total income, the income distribution itself does
not affect the market demand.
A property need not generally hold for other utility
functions
1
1
N
x x
N
x x
I I
P P
I I I
P P
o o
o | o |
o o
o | o |
+ +
+ +
| |
+
= =
|
+ +
\ .
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Two goods: necessity (x) and luxury (y): p
x
=1, p
y
=1.

Two agents, where I
1
+I
2
= I = 10
Suppose each will consume luxury only after x
0
< 5 units of
necessity is consumed.

Equal income: the market quantity demanded for x is 2x
0
;
the market quantity demanded for y is 10 - 2x
0

Unequal income: suppose I
1
< I
2
and I
1
< x
0
. Then market
quantity demanded for x is I
1
+ x
0
< 2x
0
; market quantity
demanded for y is 10-(x
0
+ I
1
).

Unequal income diverts resource to luxuries while basic
necessities are not fully provided => income distribution
matters
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The CD utility function is in the family of
utility functions, for which the ratios of goods
demanded depend only on relative prices, not
on income
can define the relative demand for x by an
individual
For example, with CD utility function,



the relative demand is independent of the individuals
income
/
y
x
y x y x
p
D I I
D P P p
o | o
o | o | |
| |
| |
= =
|
|
|
+ +
\ .
\ .
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The relative demand for x in the whole economy is
just the same as the relative demand for x by any
individual




Take out: With CD utility function, we can talk about
The demand for x by the economy without
knowing income distribution, and
Relative demand for x by the economy without
knowing the total income
1 2 1 2
/
y
x N N
y x y x
p
D I I I I I I
D P P p
o | o
o | o | |
| |
| |
+ + + +
= =
|
|
|
+ +
\ .
\ .
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total product ( , )
average product of labor
marginal product of labor
average product of capital
marginal product of capital
L
L
K
K
Q f K L
Q
AP
L
Q
MP
L
Q
AP
K
Q
MP
K
= =
= =
c
= =
c
= =
c
= =
c
Definitions:







Assumptions:
Diminishing marginal productivity
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Output elasticity and returns to scale
Suppose



>1 Increasing return to scale (IRTS)
=1 Constant return to scale (CRTS)
<1 Decreasing return to scale (DRTS)


=
/
/
=
% change in output
% change in all input

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When returns to scale do not change with
scale, for any t >1, the technology exhibits



( ) ( )
( ) ( )
( ) ( )
IRTS if , ,
CRTS if , ,
DRTS if , ,
f tK tL tf K L
f tK tL tf K L
f tK tL tf K L
>
=
<
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For CRTS technology, there are two nice
properties:
MP
K
and MP
L
depend on capital-labor ratio only,
but not on the absolute scale
e.g., MP
K
the same when you hire K=3 and L=5,
compared with when you hire K=6 and L=10.
Eulers equation:

= ,

When factors are hired up to =


and =

, the profit is just zero!





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( ) ( )
( ) ( )
( ) ( )
( )
( ) ( )
( )
, , ( CRTS)
Differentiating it w.r.t , we obtain
, ,
, ,
, (chain rule)
, ,
,
Now imposing
f tK tL tf K L
t
d
f tK tL f K L
dt
f tK tL f tK tL
tK tL
f K L
tK t tL t
f tK tL f tK tL
K L f K L
tK tL
=
=
c c
c c
+ =
c c c c
c c
+ =
c c
( ) ( )
( )
the condition that 1, it becomes
, ,
,
t
f K L f K L
K L f K L
K L
=
c c
+ =
c c
We show the second property:
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Firms problem:


Assume each firm is too small to affect input
prices (w, r ) and output price (p). If an
optimum exists, will hire K and L such that
( )
,
max , - -
K L
pf K L rK wL
( )
( )
,
,
K
L
f K L
pMP p r
K
f K L
pMP p w
L
c
= =
c
c
= =
c
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Treat the firms problem into a two-stage problem: cost
minimization, following by output choice.
First, given output quantity, the firm chooses the input
quantities to minimize costs,


Then, chooses quantity
Perfect Competition: uses p = MC.
Monopoly Competition: uses MR = MC.
Imperfect Competition: strategic consideration
( )
,
min subject to ,
K L
rK wL f K L Q + =
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Doubling input prices simply doubles the total cost:



When RTS does not change with scale, for any
t > 1, the technology exhibits



( ) ( )
( ) ( )
( ) ( )
, , , ,
IRTS if
, , , ,
CRTS if
, , , ,
DRTS if
C r w tQ C r w Q
tQ Q
C r w tQ C r w Q
tQ Q
C r w tQ C r w Q
tQ Q
<
=
>
( )
( ) ( )
, , , satisfying
, , , , for all 0
C r w Q
C tr tw Q tC r w Q t = >
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Isoquant the locus
of K and L such that
the output level is
constant
Bending toward the
origin
L
K
Q =10
Q =20
Iso-cost line
rK+wL = constant
Optimal input
mix to produce
Q =10
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For CRTS technology and in LR equilibrium,
we cannot tell the output level of a particular
firm, because every output level will lead to
the same profit (which is zero) given fixed
input and output prices
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( )
1
1
(1 ) 1
1 1
( , )
When + =1,
and
Marginal products depend on the / ratio, not on the absolute scale
K
L
K
L
Q f K L K L
Q
MP K L
K
Q
MP K L
L
L
MP K L
K
K
MP K L
L
K L
o |
o |
o |
|
| |
o
o o
o
|
o | o o
| |



= =
c
= =
c
c
= =
c
| |
= =
|
\ .
| |
= =
|
\ .
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( ) ( ) ( )
The technology exhibits CRTS iff + =1.
2 , 2 2 2 2 2 ( , ) f K L K L K L f K L
o |
o | o | o |
o |
+ +
= = =
What does + =1 mean?
+>1; IRTS
+=1; CRTS
+<1; DRTS




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Consider an industry with all firms having the
same CRTS technology: Q = f (K , L ); output &
input markets perfectly competitive; and firms
maximizing profits. As a whole, the industry
employs K * and L *.
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Q1: What is the industrial output?
f (K *,L *)
Let K
1
, K
2
, , K
N
be the amount employed in
the N firms; L
1
, L
2
, , L
N
be the amount employed.
Cost minimization requires that K
1
/L
1
=K
2
/L
2
= =
K
N
/L
N
=K*/L*=a.

( ) ( ) ( )
( ) ( ) ( )
( ) ( ) ( )
( )
( )
( )
1 1 2 2
1 1 2 2
1 2
* * *
* *
, , ,
, , ,
,1 ,1 ,1 ( CRTS)
,1 , ( CRTS)
,
N N
N N
N
f K L f K L f K L
f aL L f aL L f aL L
L f a L f a L f a
L f a f aL L
f K L
+ +
= + +
= + +
= =
=
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Q2: What is the marginal product of capital (labor)
in each firm?
Despite possibly different scales, each firms
marginal product of capital is simply equal to
f (K *,L *)/K.
Similarly, all firms have the same marginal product
of labor = f (K *,L *)/L .
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Q3: What is the rental rate of capital paid by
each firm? the wage rate of labor paid by
each firm?
Let p be the price of the good produced in
the industry.
The rental rate of capital is just

.
the wage rate of labor is just

.

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What do we know about industrial output?
simply work out the problem by assuming all
inputs (K * and L *) are hired by a single firm
(which we assume is price taking in both input
and output markets).
we can understand f (K , L ) as an industry
production function.
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Takeout: given same CRTS technology & LR
competitive equilibrium, total K * and L * in
the sector fully describe the output level,
as well as the real rental rate and real wage
rate.
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