Prepared by Dr Della Lee Sue, Marist College MICROECONOMICS: Theory & Applications Chapter 19: General Equilibrium Analysis and Economic Efficiency By Edgar K Browning & Mark A Zupan John Wiley & Sons, Inc 12th Edition, Copyright 2015 Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives     Delineate the difference between partial and general equilibrium analysis Explain the concept of economic efficiency Outline the three conditions necessary for the attainment of economic efficiency Examine efficiency in production and what this implies about input usage across different industries (continued) Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives    (continued) Show how efficiency in output is related to the production possibility frontier Demonstrate how perfect competition satisfies all three conditions for economic efficiency Spell out the reasons why economic efficiency may not be achieved Copyright © 2015 John Wiley & Sons, Inc All rights reserved Delineate the difference between partial and general equilibrium analysis 19.1 PARTIAL AND GENERAL EQUILIBRIUM ANALYSIS COMPARED Copyright © 2015 John Wiley & Sons, Inc All rights reserved Partial and General Equilibrium Analysis Compared  General equilibrium analysis – the study of how equilibrium is determined in all markets simultaneously  Partial equilibrium analysis – the study of the determination of an equilibrium price and quantity in a given product or input market viewed as self-contained and independent of other markets  assumes that some things that conceivably could, but not, change (“other things equal”) Copyright © 2015 John Wiley & Sons, Inc All rights reserved The Mutual Interdependence of Markets Illustrated  Spillover effect – a change in equilibrium in one market that affect other markets  Feedback effect – a change in equilibrium in a market that is caused by events in other markets that, in turn, are the result of an initial change in equilibrium in the market under consideration Copyright © 2015 John Wiley & Sons, Inc All rights reserved Figure 19.1 - Interdependence Between Markets: Butter and Margarine Copyright © 2015 John Wiley & Sons, Inc All rights reserved When Should General Equilibrium Analysis Be Used?  Guideline:  Partial analysis is usually accurate in cases involving a change in conditions primarily affecting one market among many, with repercussions on other markets dissipated throughout the economy   General equilibrium analysis tends to be more appropriate when a change in conditions affects many, or all, markets are the same time and to the same degree Pareto optimal  the condition in which it is not possible, through any feasible change in resource allocation, to benefit one person without making some other person or persons worse off Copyright © 2015 John Wiley & Sons, Inc All rights reserved Explain the concept of economic efficiency 19.2 ECONOMIC EFFICIENCY Copyright © 2015 John Wiley & Sons, Inc All rights reserved Economic Efficiency  Efficient – Pareto optimal; an allocation of resources when it is not possible, through any feasible change in resource allocation, to benefit one person without making any other person worse off  Inefficient – the condition in which it is possible, through some feasible reallocation of resources, to benefit at least one person without making any other person worse off Copyright © 2015 John Wiley & Sons, Inc All rights reserved 10 General Equilibrium in Competitive Input Markets The condition for cost minimization:  The slopes of the two input isoquants must equal one another since both are equal to the same input price ratio Copyright © 2015 John Wiley & Sons, Inc All rights reserved 19 Show how efficiency in output is related to the production possibility frontier 19.5 THE PRODUCTION POSSIBILITY FRONTIER AND EFFICIENCY IN OUTPUT Copyright © 2015 John Wiley & Sons, Inc All rights reserved 20 The Production Possibility Frontier and Efficiency in Output  The PPF shows the alternative combinations of two goods that can be produced with fixed supplies of inputs; it can be derived from the contract curve by plotting various possible output combinations directly  Marginal rate of transformation (MRT) – the rate at which one product can be “transformed” into another  At any point on the frontier, the slope, or MRT, equals MCc/MCF Copyright © 2015 John Wiley & Sons, Inc All rights reserved 21 Figure 19.5 - The Production Possibility Frontier Revisited Copyright © 2015 John Wiley & Sons, Inc All rights reserved 22 Efficiency in Output  Efficiency in output is attained when the rate at which consumers are willing to exchange one good for another (MRS) equals the rate at which one good can be transformed into another (MRT):  It is always possible to change the output mix and leave consumers better off whenever their common marginal rates of substitution are not equal to the marginal rate of transformation Copyright © 2015 John Wiley & Sons, Inc All rights reserved 23 Figure 19.6 - Efficiency in Output Copyright © 2015 John Wiley & Sons, Inc All rights reserved 24 Figure 19.7 – The PPF and the Gains from International Trade Copyright © 2015 John Wiley & Sons, Inc All rights reserved 25 Demonstrate how perfect competition satisfies all three conditions for economic efficiency 19.6 COMPETITIVE MARKETS AND ECONOMIC EFFICIENCY Copyright © 2015 John Wiley & Sons, Inc All rights reserved 26 Competitive Markets and Economic Efficiency Perfectly competitive markets satisfy the conditions for economic efficiency:  an efficient distribution of products among consumers  efficiency in production  efficiency in output Copyright © 2015 John Wiley & Sons, Inc All rights reserved 27 Condition and Condition  Condition 1: Efficient Distribution of Products Among Consumers  Condition 2: Efficiency in Production Copyright © 2015 John Wiley & Sons, Inc All rights reserved 28 Condition  Condition 3: Efficiency in Output Copyright © 2015 John Wiley & Sons, Inc All rights reserved 29 “Invisible Hand” Theorem  Adam Smith  If perfect competition prevails, then all three conditions for economic efficiency are satisfied  People pursuing their own ends in competitive markets promote economic efficiency Copyright © 2015 John Wiley & Sons, Inc All rights reserved 30 The Role of Information  When resources are efficiently allocated, it is assumed that all the relevant information is known  Consumers or producers adjust their behavior based on prices  Efficient responses occur in a market system without anyone knowing why prices change Copyright © 2015 John Wiley & Sons, Inc All rights reserved 31 Spell out the reasons why economic efficiency may not be achieved 19.7 THE CAUSES OF ECONOMIC INEFFICIENCY Copyright © 2015 John Wiley & Sons, Inc All rights reserved 32 The Causes of Economic Inefficiency  Market power  Monopoly (output market)    Monopsony (input market) Imperfect information Externalities/Public goods  Side effects borne by people not directly involved in the market activities  May be harmful or beneficial Copyright © 2015 John Wiley & Sons, Inc All rights reserved 33 ... partial and general equilibrium analysis 19. 1 PARTIAL AND GENERAL EQUILIBRIUM ANALYSIS COMPARED Copyright © 2015 John Wiley & Sons, Inc All rights reserved Partial and General Equilibrium Analysis... are willing to exchange one good for another (MRS) equals the rate at which one good can be transformed into another (MRT):  It is always possible to change the output mix and leave consumers... such as labor and land can be allocated between industries in a simplified economy Copyright © 2015 John Wiley & Sons, Inc All rights reserved 16 The Production Contract Curve and Efficiency