Lecture 16

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 16
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
Chapter 16
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
Chapter 16
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
Chapter 16
Two Interdependent Markets Movies and

DVDs
Price
$1 tax on each movie

ticket causes supply to fall
S*M
Price
General Equilibrium Analysis:

Increase in movie ticket prices
increases demand for videos.
SV
SM
$3.50
$6.35
$3.00
DV
$6.00
DM
QM
QM
Number of
Movie Tickets
DV
QV QV
Number
of Videos
8

DVDs
Price
The increase in the price

of videos increases the
demand for movies.
S*M
$6.82
$6.75
Price
General Equilibrium Analysis:

The Feedback effects continue.
SV
SM
$3.58
$3.50
$6.35
D*V
$3.00
D*M
$6.00
DV
DM
DM
QM QM Q*M QM
Number of
Movie Tickets
Chapter 16
DV
QV QV Q*V
Number
of Videos
9

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
Chapter 16
10
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
It requires finding the solution to four equations: demand and supply for
DVDs and movies
Chapter 16
11
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
Chapter 16
15
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
Chapter 16
16
The Advantages of Trade

Assumptions
Two consumers (countries)

Two goods
Both people know each others preferences
Exchanging goods involves zero transaction costs
James and Karen have a total of 10 units of food and 6 units of clothing
Chapter 16
17
The Advantage of Trade

Individual
James
Karen
Initial
Trade
Allocation
7F, 1C
-1F, +1C
3F, 5C
+1F, -1C
Final
Allocation
6F, 2C
4F, 4C
To determine if they are better off, we need to know the

preferences for food and clothing
Chapter 16
18

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

He will give up unit if clothing for 1 unit of food
Chapter 16
19

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 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 and 3 units of clothing
Chapter 16
20

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
Chapter 16
21

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
Chapter 16
22
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
Chapter 16
23

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
Chapter 16
24

Each point describes the market baskets of both consumers
James basket is read from origin OJ

Karens basket is read from origin OK, 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
Chapter 16
25
Exchange in an Edgeworth Box

Karens Food
10F
3F
0K
6C
James
Clothing
The initial allocation

before trade is A: James
has 7F and 1C & Karen
has 3F and 5C.
Karens
Clothing
1C
5C
6C
0J
7F
James Food
10F
26
Exchange in an Edgeworth Box

Karens Food
10F
6C
4F
3F
0K
The allocation
after trade is B: James
has 6F and 2C & Karen
has 4F and 4C.
James
Clothing
Karens
Clothing
B
2C
4C
+1C
1C
5C
-1F
6C
0J
6F
Chapter
James
Food16
7F
10F
27
Efficient Allocations
A trade from A to B makes both Karen and James better off
Is it efficient?
If James and Karens MRS are the same at B, the allocation is efficient
This depends on the shape of their indifference curves
Chapter 16
28
James indifference curves are drawn as we usually see them
Karens indifference curves are rotated 180o convex to her axis
The indifference curves that go through point A have different slopes
and therefore different MRSs
The allocation is not efficient
Chapter 16
29
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
Chapter 16
30
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
Chapter 16
31
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
Chapter 16
32
Karens Food
10F
0K
6C
Jamess
Clothing
A: UJ1 = UK1,
but the MRS
is not equal.
All combinations
in the shaded
area are
preferred to A.
Karens
Clothing
Gains from
trade
0J
UJ1
UK1
10F
Jamess Food
6C
Chapter 16
33
Karens Food
10F
0K
6C
D is also a
At
point
C,
Point
B is on
possible
MRSs
higher
ICare
but
efficient
equal
and
is allocation
not efficient
allocationon
is
depending
bargaining
efficient
Jamess
Clothing
D
Karens
Clothing
UJ3
UK3
UK
2
0J
UK1
6C
10F
Jamess Food
UJ2
UJ1
Chapter 16
34
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
Karens Food
10F
0K
6C
James
Clothing
Chapter 16
Karens
Clothing
UJ3
B
A
0J
UJ2
UJ1
6C
UK3 UK2 UK1

James Food
10F
35
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
Chapter 16
36
The Contract Curve

Karens Food
E, F, & G are
Pareto efficient.
0K
Contract
Curve
G
James
Clothing
Karens
Clothing
0J
James Food
Chapter 16
37
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
Chapter 16
38
Application: The policy implication of Pareto efficiency when

removing import quotas:
1.
Remove quotas
2.
US consumers gain
Some US workers lose
Removal of quotas and subsidies to the workers
Chapter 16
39
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
Chapter 16
40
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
Chapter 16
41
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
Chapter 16
42

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
Chapter 16
43

Market
10F
6C
Begin at A:
Each Karen buys 2F and
sells 2C moving from
UK1 to UK2, which
is preferred (A to C).
0K
Karens Food
Begin at A:
Each James buys 2C and sells 2F
moving from UJ1 to UJ2, which
is preferred (A to C).
Price Line
P
Karens
Clothing
C
James
Clothing
UJ2
A
U K2
0J
6C
10F
James Food
U K1
UJ1
Chapter 16
44

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
Chapter 16
45

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 =
Karen is happy to sell clothing at that price but has no one to sell to
Market is in disequilibrium
Chapter 16
46

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
Chapter 16
47
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
Chapter 16
48

Market
In a general equilibrium setting where all markets are perfectly
competitive, we can show the same result
Best example of Adam Smiths 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
Chapter 16
49

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
Chapter 16
50

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 persons MRS is equal to the price ratio of the
two goods
J
FC
MRS
PC
PF
Chapter 16
MRS
K
FC
51

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
Chapter 16
52
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
Chapter 16
53
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
Chapter 16
54

Karens
Utility
OJ James has zero utility

OK Karen has zero utility
E, F, G points on contract
curve
H inefficient can do better
in shaded area
L - unobtainable
OJ
L
E
F
H
OK
James Utility
Chapter 16
55

Karens
Utility
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
OJ
E
F
H
G
OK
James Utility
Chapter 16
56

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
Chapter 16
57
Social Welfare Functions

Weights are often applied to individuals utility to determine what is
socially desirable
How these weights are applied comes from the social welfare functions
The utilitarian function weights everyones utility to maximize utility

for the whole society
Chapter 16
58

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
Chapter 16
59

The Rawlsian view is that individuals dont know what their
endowment will be
Rawls argues that if you dont 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 welloff person in society
Chapter 16
60

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
Chapter 16
61
Four Views of Equity
Egalitarian
All members of society receive equal

amount of goods
Rawlsian
Maximize the utility of the least-welloff person
Utilitarian
Maximize the total utility of all

members of society
Market Oriented
The market outcome is the most

equitable
Chapter 16
62
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
Chapter 16
63

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
Chapter 16
64

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
Chapter 16
65

Lecture 16

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General Equilibrium Analysis

Up to this point, we have been focused on partial equilibrium

Market interrelationships can be important

2005 Pearson Education, Inc.

General Equilibrium Analysis

The feedback effect is the price or quantity adjustment in one

2005 Pearson Education, Inc.

Two Interdependent Markets Moving to

These goods are substitutes

2005 Pearson Education, Inc.

Two Interdependent Markets Moving to

Equilibrium price of movies is $6.00

2005 Pearson Education, Inc.

Two Interdependent Markets Movies and

$1 tax on each movie

General Equilibrium Analysis:

Two Interdependent Markets Movies and

The increase in the price

General Equilibrium Analysis:

2005 Pearson Education, Inc.

Two Interdependent Markets Movies and

2005 Pearson Education, Inc.

Reaching General Equilibrium

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Voluntary trade between two parties is mutually beneficial and

2005 Pearson Education, Inc.

The Advantages of Trade

Two consumers (countries)

2005 Pearson Education, Inc.

The Advantage of Trade

To determine if they are better off, we need to know the

2005 Pearson Education, Inc.

The Advantage of Trade

James MRS of food for clothing is only

2005 Pearson Education, Inc.

The Advantage of Trade

Actual terms of trade are determined through bargaining

2005 Pearson Education, Inc.

The Advantage of Trade

Whenever two consumers MRSs are different, there is room for

2005 Pearson Education, Inc.

The Advantage of Trade

An allocation of goods is efficient only if the goods are distributed so

2005 Pearson Education, Inc.

The Edgeworth Box Diagram

2005 Pearson Education, Inc.

The Edgeworth Box Diagram

2005 Pearson Education, Inc.

The Edgeworth Box Diagram

James basket is read from origin OJ

2005 Pearson Education, Inc.

Exchange in an Edgeworth Box

The initial allocation

Exchange in an Edgeworth Box

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

UK3 UK2 UK1