Lecture 11 - General Equilibrium & Economics Efficiency PDF

Welcome to Intermediate Economics Semester 1, 2024 1  Lecture 11 General equilibrium and economic efficiency 5ECON010C-n Intermediate Microeconomics LECTURE OUTLINE 1. General Equilibrium Analysis 2. Efficiency...

Welcome to Intermediate Economics Semester 1, 2024 1  Lecture 11 General equilibrium and economic efficiency 5ECON010C-n Intermediate Microeconomics LECTURE OUTLINE 1. General Equilibrium Analysis 2. Efficiency in Exchange 3. Equity and Efficiency 4. Efficiency in Production 5. The Gains from Free Trade Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved  Equilibrium as an efficient point Equilibrium – is the market-determined point, where producer and consumer surpluses are maximized. Feedback effect – the tendency observed in interdependent markets, when a change in one market triggers a change in the other market, which in turn triggers further change in the first market. 5ECON010C-n Intermediate Microeconomics Equilibrium as an efficient point Partial equilibrium – the equilibrium in single market without taking into account of feedback effects from other relevant markets Change in wage rate brings labor market to new equilibrium – but that new equilibrium ignores changes in other markets and the effect of those changes on labor market. General equilibrium – simultaneous determination of equilibrium price and quantities in several markets taking into account feedback effects. 5ECON010C-n Intermediate Microeconomics Efficiency in Consumption General Equilibrium Analysis Two Interdependent Markets—Moving to General Equilibrium FIGURE 16.1 TWO INTERDEPENDENT MARKETS: (A) MOVIE TICKETS AND (B) DVD RENTALS When markets are interdependent, the prices of all products must be simultaneously determined. Here a tax on movie tickets shifts the supply of movies upward from SM to S*M, as shown in (a). The higher price of movie tickets ($6.35 rather than $6.00) initially shifts the demand for DVDs upward (from DV to D’V ), causing the price of DVDs to rise (from $3.00 to $3.50), as shown in (b). General Equilibrium Analysis Two Interdependent Markets—Moving to General Equilibrium FIGURE 16.1 TWO INTERDEPENDENT MARKETS: (A) MOVIE TICKETS AND (B) DVD RENTALS The higher video price feeds back into the movie ticket market, causing demand to shift from DM to D’M and the price of movies to increase from $6.35 to $6.75. This continues until a general equilibrium is reached, as shown at the intersection of D*M and S*M in (a), with a movie ticket of $6.82, and the intersection of D*V and SV in (b), with a DVD price of $3.58. Efficiency in Exchange Exchange economy: Market in which two or more consumers trade two goods among themselves. Pareto efficient allocation: Simultaneous determination of the prices and quantities in all relevant markets, taking feedback effects into account. In a Pareto efficient allocation of goods, no one can be made better off without making someone else worse off. Note that there is an equity implication of Pareto efficiency. It may be possible to reallocate the goods in a way that increases the total well-being of the two individuals, but leaves one individual worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engineer and economist, who used the concept in his studies of economic efficiency and income distribution Efficiency in Exchange The Advantages of Trade TABLE 16.1: THE ADVANTAGE OF TRADE INDIVIDUAL INITIAL ALLOCATION TRADE FINAL ALLOCATION James 7F, 1C – 1F, + 1C 6F, 2C Karen 3F, 5C + 1F, – 1C 4F, 4C Take two individuals – James and Karen – each owning some endowment of clothing and food. The combination of two goods give them certain level of utility. However, with trading some of the excess goods, they can even further increase their utility level. Efficiency in Exchange The Advantages of Trade TABLE 16.1: THE ADVANTAGE OF TRADE INDIVIDUAL INITIAL ALLOCATION TRADE FINAL ALLOCATION James 7F, 1C – 1F, + 1C 6F, 2C Karen 3F, 5C + 1F, – 1C 4F, 4C Karen has a lot of clothing and little food, her marginal rate of substitution (MRS) of food for clothing is 3: To get 1 unit of food, she will give up 3 units of clothing. James will give up 1 unit of food for 1/2 unit of clothing. The actual terms of the trade depend on the bargaining process. Whenever two consumers’ MRSs are different, there is room for mutually beneficial trade. Conversely, 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. Efficiency in Exchange The Edgeworth Box Diagram If trade is beneficial, which trades can occur? Which of those trades will allocate goods efficiently among customers? How much better off will consumers then be? We can answer these questions for any two-person, two-good example by using a diagram called an Edgeworth Box. Edgeworth box Diagram showing all possible allocations of either two goods between two people or of two inputs between two production processes. In the Edgeworth box, each point describes the market baskets of both consumers. The Edgeworth Box is named after the Irish Economist Francis Edgeworth (1881). Efficiency in Exchange: The Edgeworth Box FIGURE 16.4 EXCHANGE IN AN EDGEWORTH BOX Each point in the Edgeworth box simultaneously represents James’s and Karen’s market baskets of food and clothing. Point A Food Clothing James 7 1 Karen 3 5 Total 10 6 James gives up 1F in exchange for 1C, moving from A to B. Karen gives up 1C and obtains 1F, also moving from A to B. Point B thus represents the market baskets of both James and Karen after the mutually beneficial trade. The Edgeworth Box Efficient Allocations FIGURE 16.5 EFFICIENCY IN EXCHANGE The Edgeworth box illustrates the possibilities for both consumers to increase their satisfaction by trading goods. If A gives the initial allocation of resources, the shaded area describes all mutually beneficial trades. Even if a trade from an inefficient allocation makes both people better off, the new allocation is not necessarily efficient. When the indifference curves are tangent, one person cannot be made better off without making the other person worse off. Points C and D are both efficient allocations, although James prefers D to C and Karen C to D. In general, the allocation that will be reached in a bargain depends on the bargaining abilities of the people involved. James Karen Clothing Clothing Food Food  Karen James Food Clothing Clothing Food  Karen’s Food James’s Karen’s Clothing Clothing James’s Food Efficiency in Exchange: The Edgeworth Box FIGURE 16.4 EXCHANGE IN AN EDGEWORTH BOX Each point in the Edgeworth box simultaneously represents James’s and Karen’s market baskets of food and clothing. Point A Food Clothing James 7 1 Karen 3 5 Total 10 6 James gives up 1F in exchange for 1C, moving from A to B. Karen gives up 1C and obtains 1F, also moving from A to B. Point B thus represents the market baskets of both James and Karen after the mutually beneficial trade. The Edgeworth Box Efficient Allocations FIGURE 16.5 EFFICIENCY IN EXCHANGE The Edgeworth box illustrates the possibilities for both consumers to increase their satisfaction by trading goods. If A gives the initial allocation of resources, the shaded area describes all mutually beneficial trades. Even if a trade from an inefficient allocation makes both people better off, the new allocation is not necessarily efficient. When the indifference curves are tangent, one person cannot be made better off without making the other person worse off. Points C and D are both efficient allocations, although James prefers D to C and Karen C to D. In general, the allocation that will be reached in a bargain depends on the bargaining abilities of the people involved. Efficiency in Exchange The Contract Curve Contract curve is a collection of all Pareto efficient points. Curve showing all efficient allocations of goods between two consumers, or of two inputs between two production functions. FIGURE 16.6 THE CONTRACT CURVE The contract curve contains all allocations for which consumers’ indifference curves are tangent. Every point on the curve is efficient because one person cannot be made better off without making the other person worse off. Efficiency in Exchange FIGURE 16.7 COMPETITIVE EQUILIBRIUM In a competitive market the prices of the two goods determine the terms of exchange among consumers. If A is the initial allocation of goods and the price line PP′ represents the ratio of prices, the competitive market will lead to an equilibrium at C, the point of tangency of both indifference curves. As a result, the competitive equilibrium is efficient where: 𝑱 𝑴𝑹𝑺𝑭𝑪 = 𝑷𝑭 /𝑷𝑪 = 𝑴𝑹𝑺𝑲 𝑭𝑪 An equilibrium is a set of prices at which the quantity demanded equals the quantity supplied in every market. This is also a competitive equilibrium because all suppliers and demanders are price takers. Efficiency in Exchange Let’s summarize what we know about a competitive equilibrium from the consumer’s perspective: 1. Because the indifference curves are tangent, all marginal rates of substitution between consumers are equal. 2. Because each indifference curve is tangent to the price line, each person’s MRS of clothing for food is equal to the ratio of the prices of the two goods. MRS J = P F = MRS K FC PC FC The market is in disequilibrium when the quantities of food and clothing demanded are not equal to the quantities supplied. This disequilibrium should be only temporary. Efficiency in Exchange Let’s go back to contract curve. It shows different Pareto efficient allocations. Some are likely to be more fair than others. How do we decide what is the most equitable allocation? Equity and Efficiency The Utility Possibilities Frontier Utility possibilities frontier: Curve showing all efficient allocations of resources measured in terms of the utility levels of two individuals. FIGURE 16.8 UTILITY POSSIBILITIES FRONTIER The utility possibilities frontier shows the levels of satisfaction that each of two people achieve when they have traded to an efficient outcome on the contract curve. Points E, F, and G correspond to points on the contract curve and are efficient. Point H is inefficient because any trade within the shaded area will make one or both people better off. Equity and Efficiency Social welfare function: Measure describing the well-being of society as a whole in terms of the utilities of individual members. TABLE 16.2: FOUR VIEWS OF EQUITY 1. Egalitarian — all members of society receive equal amounts of goods 2. Rawlsian — maximize the utility of the least-well-off person 3. Utilitarian — maximize the total utility of all members of society 4. Market-oriented — the market outcome is the most equitable The four views of equity in Table 16.2 move roughly from most to least egalitarian. While the egalitarian view explicitly requires equal allocations, the Rawlsian puts a heavy weight on equality (otherwise, some people would be much worse off than others). The utilitarian is likely to require some difference between the best- and worst-off members of society. Finally, the market-oriented view may lead to substantial inequality in the allocations of goods and services. Efficiency in Production Efficiency in Production Input Efficiency Technical efficiency: Condition under which firms combine inputs to produce a given output as inexpensively as possible. We know that to minimize production costs, producers will use combinations of labor and capital so that: MPL =w r MPK and, MRTS LK = w r Because the MRTS is the slope of the firm’s isoquant, the competitive equilibrium is efficient in production Efficiency in Production: The PPF The Production Possibilities Frontier Production possibilities frontier: Curve showing the combinations of two goods that can be produced with fixed quantities of inputs. FIGURE 16.9 PRODUCTION POSSIBILITIES FRONTIER The production possibilities frontier shows all efficient combinations of outputs. The production possibilities frontier is concave because its slope (the marginal rate of transformation) increases as the level of production of food increases. Efficiency in Production: The PPF Slope MARGINAL RATE OF TRANSFORMATION Marginal rate of transformation (MRT): amount of one good that must be given up to produce one additional unit of a second good. When the MRT is low, so is the ratio of the marginal cost of producing food MCF to the marginal cost of producing clothing MCC. In fact, the slope of the production possibilities frontier measures the marginal cost of producing one good relative to the marginal cost of producing the other. At every point along the frontier, the following condition holds: MRT = MCF MCC Efficiency in Production Efficiency in Output Markets When output markets are perfectly competitive, all consumers allocate their budgets so that their marginal rates of substitution between two goods are equal to the price ratio. For our two goods, food and clothing, MRS = PF PC At the same time, each profit-maximizing firm will produce its output up to the point at which price is equal to marginal cost. Again, for our two goods, PF = MCF and PC = MCC When output and input markets are competitive, production will be output efficient in that the MRT is equal to the MRS, and it follows that MRT = MCF = PF = MRS MCC PC Efficiency in Production FIGURE 16.11 COMPETITION AND OUTPUT EFFICIENCY In a competitive output market, people consume to the point where their MRS is equal to the price ratio. Producers choose outputs so that the MRT is equal to the price ratio. Because the MRS equals the MRT, the competitive output market is efficient. Any other price ratio will lead to an excess demand for one good and an excess supply of the other. The Gains from Free Trade Comparative Advantage Comparative advantage: Situation in which Country 1 has an advantage over Country 2 in producing a good because the cost of producing the good in 1, relative to the cost of producing other goods in 1, is lower than the cost of producing the good in 2, relative to the cost of producing other goods in 2. Absolute advantage: Situation in which Country 1 has an advantage over Country 2 in producing a good because the cost of producing the good in 1 is lower than the cost of producing it in 2. TABLE 16.3: HOURS OF LABOR REQUIRED TO PRODUCE CHEESE AND WINE CHEESE (1 LB) WINE (1 GAL) Holland 1 2 Italy 6 3 The Gains from Free Trade An Expanded Production Possibilities Frontier FIGURE 16.12 THE GAINS FROM TRADE Without trade, production and consumption are at point A, where the price of wine is twice the price of cheese. With trade at a relative price of 1 cheese to 1 wine, domestic production is now at B, while domestic consumption is at D. Free trade has allowed utility to increase from U1 to U2. Reading Mandatory reading Pindyck & Rubinfeld (2015). “Microeconomics”, 8th edition. Chapter 16 Optional reading Varian (2010). “Intermediate Microeconomics: a Modern Approach”, 8th edition. Chapters 31 and 33 Workshop reading What Wealth Inequality in America Looks Like: Key Facts & Figures (2,700 words) https://www.stlouisfed.org/open-vault/2019/august/wealth-inequality-in- america-facts-figures 5ECON010C-n Intermediate Microeconomics