Advanced Microeconomics Chapter 1 - Equilibrium Analysis PDF

ADVANCED MICROECONOMICS CHAPTER 1 UNIT III: EQUILIBRIUM ANALYSIS INTRODUCTION The objective of equilibrium analysis is to utilize microeconomic tools to examine the allocation of resources and output within a market economy. The central focus is to determine whether the individual actions of consum...

ADVANCED MICROECONOMICS CHAPTER 1 UNIT III: EQUILIBRIUM ANALYSIS INTRODUCTION The objective of equilibrium analysis is to utilize microeconomic tools to examine the allocation of resources and output within a market economy. The central focus is to determine whether the individual actions of consumers and firms in a competitive market can establish a system-wide equilibrium, where product and factor prices are consistent with the balance between quantity demanded and quantity supplied in each market. Equilibrium Analysis PARTIAL EQUILIBRIUM Partial equilibrium focuses on a single market to reach equilibrium, assuming other factors remain constant (ceteris paribus). It analyzes the price of one product while keeping the prices of others fixed. This method studies how policy actions affect a specific market, ignoring impacts on other sectors. Partial equilibrium is an economic model that looks at individual markets or sectors in isolation, often in microeconomics. It examines the balance in a market by considering changes in one or two variables while holding others constant. The assumption of ceteris paribus is key in partial equilibrium analysis. Equilibrium Analysis PARTIAL EQUILIBRIUM FOR EXAMPLE: 1. Consumer’s Equilibrium: A consumer reaches equilibrium when they get the most satisfaction from their spending based on the prices and availability of goods. This happens when: The satisfaction from each good equals its price. The consumer spends their entire income. This assumes that preferences, income, and prices stay the same. 2. Producer’s Equilibrium: A producer is in equilibrium when they maximize their net profit under current economic conditions. 3. Firm’s Equilibrium: A firm is in long-run equilibrium when it has reached the best size for maximizing profit and efficiently using its resources. 4. Industry’s Equilibrium: An industry is in equilibrium when no new firms want to enter, and no existing firms want to leave. This occurs when the marginal firm is making only normal profits. In this situation, there is no incentive for change. Equilibrium Analysis ASSUMPTIONS IN PARTIAL EQUILIBRIUM 1. Commodity prices are fixed for consumers. 2. Consumer preferences, habits, and incomes are constant. 3. The prices of resources needed for production and related goods (substitutes or complements) are known and constant. 4. Industries can access factors of production at known and constant prices, with consistent production methods. 5. The prices and quantities of products and factors of production are known and constant. 6. Factors of production can move freely between different jobs and locations. Equilibrium Analysis PARTIAL EQUILIBRIUM CONDITIONS 1. Consumption: A consumer is in equilibrium when they are maximizing satisfaction with two goods, x and y. This happens when the rate at which the consumer is willing to trade one good for the other (the slope of the indifference curve) equals the ratio of the prices of the goods. The consumer will reach an optimal consumption point when their willingness to trade between goods matches the price ratio. 2. Production: In production, the equilibrium is reached when the business uses labor and capital in the most efficient way. This is when the slope of the isoquant curve (showing different combinations of labor and capital) equals the slope of the isocost curve (showing the cost of using labor and capital at given prices). Equilibrium in production happens when the cost of using labor and capital is balanced with how efficiently they are used in producing goods. Equilibrium Analysis GENERAL EQUILIBRIUM General equilibrium analysis looks at how all decision-makers and markets in an economy interact at the same time. Unlike partial equilibrium, which studies just a few variables, general equilibrium considers how changes in one market affect the rest of the economy. Partial equilibrium focuses on the price of a single good while assuming other prices stay the same, however, general equilibrium occurs when 1. All consumers are maximizing their satisfaction and all producers are maximizing their profits. 2. All markets are balanced, meaning the demand equals supply for both products and factors at positive prices. Equilibrium Analysis GENERAL EQUILIBRIUM FOR EXAMPLE: General equilibrium looks at the entire economy, where consumers, producers, resource owners, firms, and industries must be in balance. Unlike partial equilibrium, which focuses on one market, general equilibrium sees all markets as interrelated, with prices determined together by solving multiple equations for prices and quantities. Equilibrium Analysis ASSUMPTIONS IN GENERAL EQUILIBRIUM 1. Perfect Competition: Both product and factor markets are perfectly competitive, so consumers and producers face the same prices (Px, Py, w, r). 2. Factors of Production: There are two factors of production: labor (L) and capital (K), both in fixed quantities, homogeneous, and divisible. 3. Two Commodities: Only two goods, x and y, are produced. Technology is fixed, and the production of each good follows a smooth and convex production function, implying diminishing returns to scale. 4. Consumers: There are two consumers (A and B), with preferences shown by convex indifference curves, reflecting diminishing marginal rate of substitution. Consumer choices are independent and unaffected by advertising. 5. Maximization: Each consumer aims to maximize satisfaction within their income limits, while each producer seeks to maximize profit based on their production technology. Equilibrium Analysis ASSUMPTIONS IN GENERAL EQUILIBRIUM 6. Ownership of Factors: Consumers own the factors of production. 7. Full Employment: All factors of production are fully employed, and the income from these factors is fully spent by the consumers. Equilibrium Analysis STATIC PROPERTIES OF A GENERAL EQUILIBRIUM STATE In a general equilibrium, three static properties are observed: 1. Efficient Allocation of Resources: Resources are efficiently allocated among firms (production equilibrium). 2. Efficient Distribution of Commodities: Commodities are efficiently distributed between consumers (consumption equilibrium). 3. Efficient Combination of Products: Both production and consumption are in simultaneous equilibrium. These conditions are called the marginal conditions of Pareto optimality. Equilibrium Analysis MICRO-DYNAMIC (COBWEB) EQUILIBRIUM Micro-Dynamic (Cobweb) Equilibrium explains how demand, supply, and prices change over time. The cobweb model shows how prices and quantities produced move in cycles. These cycles happen because the supply of a product is based on prices from the previous period. For example, prices of perishable goods like vegetables can fluctuate in cycles. Equilibrium Analysis MICRO-DYNAMIC (COBWEB) EQUILIBRIUM TYPES OF MICRO-DYNAMIC (COBWEB) MODEL 1. Convergent Cobweb: In this model, the supply depends on last year's production, and demand is based on the price. The market moves toward equilibrium over several periods through adjustments. For example, if there's a crop failure this year, supply decreases, causing prices to rise. In the next period, producers respond to the higher price by increasing supply. As supply exceeds demand, prices fall, and the process continues until the market reaches equilibrium. 2. Divergent Cobweb: In this model, prices and quantities move further away from equilibrium. If a disturbance causes output to fall, the price will rise. Higher prices encourage more supply, but the increased supply causes prices to drop again. This cycle continues, and the market becomes unstable, with prices and quantities diverging from equilibrium. Equilibrium Analysis MICRO-DYNAMIC (COBWEB) EQUILIBRIUM TYPES OF MICRO-DYNAMIC (COBWEB) MODEL 3. Continuous Cobweb: In this model, prices and quantities continually fluctuate around the equilibrium point. A high price leads to more supply, but as the supply exceeds demand, prices fall. Lower prices increase demand, and the cycle repeats, with prices and quantities oscillating around the equilibrium. Equilibrium Analysis ASSUMPTIONS IN MICRO-DYNAMIC (COBWEB) EQUILIBRIUM 1. The supply in the current year depends on last year’s decisions about output. 2. Current output is influenced by last year’s price (P(t-1)). 3. The year is divided into smaller time periods like weeks or fortnights. 4. The factors affecting the supply function stay constant over time. 5. The demand for the commodity this year depends on the current price (P(t)). 6. The expected price for the current year is the actual price from last year. 7. The commodity is perishable and can only be stored for one year. 8. Both supply and demand functions are linear (straight-line curves that increase or decrease at a constant rate). Equilibrium Analysis MACRO-DYNAMIC (COBWEB) EQUILIBRIUM Macro-Dynamics examines how significant economic changes, such as income and investment, evolve over time. It reflects the interconnectedness of these changes, where one alteration can trigger a series of effects throughout the economy. Equilibrium Analysis MACRO-DYNAMIC (COBWEB) EQUILIBRIUM TYPES OF MACRO-DYNAMIC (COBWEB) EQUILIBRIUM 1. Stable Equilibrium: In stable equilibrium, if there is a disturbance (like a price change), the system naturally adjusts and returns to its original state. For example, if the price goes too high, supply exceeds demand, causing a price drop back to equilibrium. If the price goes too low, demand exceeds supply, pushing the price back up to equilibrium. 2. Unstable Equilibrium: In unstable equilibrium, any disturbance moves the system further away from the original equilibrium, and it doesn't return to its previous state. If the supply curve slopes down and the demand curve slopes up (a rare situation), any price change moves the system further away from equilibrium, not back to it. For goods like Giffen goods (e.g. some basic necessities), higher prices can cause more demand, and lower prices cause less demand, so the market moves away from equilibrium. Equilibrium Analysis MACRO-DYNAMIC (COBWEB) EQUILIBRIUM TYPES OF MACRO-DYNAMIC (COBWEB) EQUILIBRIUM 3. Neutral Equilibrium: Neutral equilibrium occurs when the system doesn’t go back to its original equilibrium, nor does it move away from it. Instead, the system settles at a new point where it stays. For example, if the price increases and the quantity remains the same, the market reaches a new equilibrium point without moving further. Equilibrium Analysis REFERENCES Emery, E.D. (1984). Intermediate Microeconomics, Harcourt Brace Jovanovich, Publishers, Orlando, USA Jhingan, M.L. (2009). Microeconomics Theory, Vrinda Publications (P) Limited, Delhi Pindyck, R.S & Daniel, L. R. (2009). Microeconomics, (7ed), Pearson Education, Inc. New Jersey, USA. Salvatore, D. (2003). Microeconomics, Harper Publishers Inc. New York, USA Salvatore, D. (2006). Microeconomics. Schuams Series. McGraw-Hill Companies, Inc. USA Equilibrium Analysis