general equilibrium

Definition
Market situation where demand and supply requirements of all decision makers (buyers and sellers) have been satisfied without creating surpluses or shortages

odern concept of general equilibrium in economics

The modern conception of general equilibrium is provided by a model developed jointly by Kenneth Arrow, Gerard Debreu and Lionel W. McKenzie in the 1950s. Gerard Debreu presents this model in Theory of Value (1959) as an axiomatic model, following the style of mathematics promoted by Bourbaki. In such an approach, the interpretation of the terms in the theory (e.g., goods, prices) are not fixed by the axioms. Three important interpretations of the terms of the theory have been often cited. First, suppose commodities are distinguished by the location where they are delivered. Then the Arrow-Debreu model is a spatial model of, for example, international trade. Second, suppose commodities are distinguished by when they are delivered. That is, suppose all markets equilibrate at some initial instant of time. Agents in the model purchase and sell contracts, where a contract specifies, for example, a good to be delivered and the date at which it is to be delivered. The Arrow-Debreu model of intertemporal equilibrium contains forward markets for all goods at all dates. No markets exist at any future dates. Third, suppose contracts specify states of nature which affect whether a commodity is to be delivered: "A contract for the transfer of a commodity now specifies, in addition to its physical properties, its location and its date, an event on the occurrence of which the transfer is conditional. This new definition of a commodity allows one to obtain a theory of [risk] free from any probability concept..." (Debreu, 1959) These interpretations can be combined. So the complete Arrow-Debreu model can be said to apply when goods are identified by when they are to be delivered, where they are to be delivered and under what circumstances they are to be delivered, as well as their intrinsic nature. So there would be a complete set of prices for contracts such as "1 ton of Winter red wheat, delivered on 3rd of January in Minneapolis, if there is a hurricane in Florida during December". A general equilibrium model with complete markets of this sort seems to be a long way from describing the workings of real economies, however its proponents argue that it is still useful as a simplified guide as to how a real economies function. Some of the recent work in general equilibrium has in fact explored the implications of incomplete markets, which is to say an intertemporal economy with uncertainty, where there do

not exist sufficiently detailed contracts that would allow agents to fully allocate their consumption and resources through time. While it has been shown that such economies will generally still have an equilibrium, the outcome may no longer be Pareto optimal. The basic intuition for this result is that if consumers lack adequate means to transfer their wealth from one time period to another and the future is risky, there is nothing to necessarily tie any price ratio down to the relevant marginal rate of substitution, which is the standard requirement for Pareto optimality. Under some conditions the economy may still be constrained Pareto optimal, meaning that a central authority limited to the same type and number of contracts as the individual agents may not be able to improve upon the outcome, what is needed is the introduction of a full set of possible contracts. Hence, one implication of the theory of incomplete markets is that inefficiency may be a result of underdeveloped financial institutions or credit constraints faced by some members of the public. Research still continues in this area.
Social Prices in a General Equilibrium Model The two-good, two-factor model of international trade provides the simplest framework in which to establish a basis for social price determination. Figure 6.1 illustrates an economy capable of producing two goods, Q1 and Q2, with fixed supplies of two domestic-factor inputs, labor and capital. Both inputs are necessary in the production of either good, and both may be shifted from one industry to the other. The production of both goods takes place with constant returns to scale; for example, doubling the amount of each input in an industry results in doubling the amount of output. These two assumptions ensure that the production possibilities curve is at least as far from the origin as the straight line EZF. Putting all labor and capital in industry Q1 results in an output of E, whereas placing all inputs in industry Q2 results in an output of F. Using half of each

input in each industry results in the output combination at point Z, which represents half the maximum outputs of Q1 and Q2

World Prices and Maximum Consumption

The economy is likely to be capable of better performance than that indicated by line EZF. If inputs have different productivities in the two industries, total output can be increased by allowing different input allocations between the commodities. When inputs are reallocated between the two industries, the output of Q1 can be maintained and the output of Q2 can be increased, resulting in an output combination represented by Y. The assumption of diminishing marginal returns to each input means that this set of maximum production points will have a shape that is concave with respect to the origin. When the economy is completely specialized in production of the first commodity (point E), labor and capital resources can be withdrawn with relatively little impact on the output of good 1 and a relatively large impact on the output of good 2. But with diminishing marginal productivities, the incremental tradeoffs become progressively less attractive. Successively larger amounts of good 1 must be sacrificed to attain a one-unit increase in the output of good 2. The maximum production possibilities frontier is represented by the curve EBYF. Movements along the production possibilities curve express the opportunity cost of one good's production in terms of the other good. The curve can be interpreted also as the consumption possibilities for an economy that is entirely self-sufficient. But the introduction of international trading opportunities expands the consumption possibilities set beyond EBYF. If the country is too small to influence commodity prices, the trading opportunities of the economy can be represented by straight lines that intersect the relevant production point. One such line is ABGC. All points along this line represent combinations of goods 1 and 2 that have an equal value in international markets. Therefore, ( Q1 x P1) = - ( Q2 x P2). Rearranging the terms gives ( Q1/ Q2This result shows that the slope of the trading opportunities line, Q1/ Q2can be expressed also as the negative ratio of world prices, -P2/P1. The choice of which good to import and which to export then depends on domestic consumer preferences. Consumption at point G implies exports of Q1equal to HI and imports of Q2 equal to JK. The choice of a point along segment AB would imply imports of Q1and exports of Q2. The line ABGC is the maximum consumption possibilities frontier for the economy. No other trade opportunity line (of slope -P2/P1) would include a point on the production possibilities curve and still allow such large amounts of the two commodities to be consumed. Because production income equals expenditure on consumption, this maximum can be measured by evaluation of either consumption choices at world prices or production choices at world prices. The evaluation of production involves a unique point (B). But the economy can choose to consume at any point on ABGC because these points are all of equal value.

Factor Prices
World prices are the social prices for tradable commodities because their use allows the economy to reach the maximum consumption possibilities frontier. The remaining social prices needed for the simple model are the rental rate (interest plus depreciation) for capital, r, and the wage rate for labor, w. Under the assumption that factor supplies are fixed, these input prices are determined by the prices for outputs and production technology. The assumption of constant returns to scale means that so long as both outputs are produced, knowledge of the particular amounts of Q1 and Q2 is not necessary for the estimation of social input prices. Only world prices and technology matter. If competition for the services of domestic factors eliminates excess prcfits, total costs and total revenues can be expressed as an equality, as in equation 1:

Generating economic impact is the primary rationale for public investment in arenas, convention centers, conference facilities, convention center headquarters hotels and other tourism infrastructure projects. Annual new spending associated with the project is the typical measure used to quantify that impact, with direct spending multiplied by the indirect and induced spending. However, new spending is not the full measure of economic impact. The purpose of this paper is to define economic impact in micro-economic terms and using this definition, provide a theoretical framework for analyzing the economic consequences of public facility development. Economic impact can be broadly defined as a change in wealth or utility of producers and consumers that results from investment in a project. In the language of micro-economics, this is called a change in consumer and producer surplus. Producer and consumer surplus occurs in efficient markets as illustrated in Figure 1 below. Figure 1

The intersection of an upward sloping supply curve and a downward sloping demand curve jointly determine the market equilibrium (a) where a specific quantity (Q) is produced with a market price of (P). The amounts by which price exceeds the cost of production is the producer surplus (the area aPb). The amount of which the willingness of consumers to pay for the product exceeds the equilibrium price is called consumer surplus (the area aPc). The sum of producer and consumer surpluses is the amount of wealth created in the economy as a result of investment in a project. Since properly functioning private markets generate economic impact, creating economic impact is hardly the purview of governments. In the context of the hospitality and tourism industries, the demand curve may represent the desirability of a destination and the willingness of consumers to pay to visit that destination. The supply curve may represent the cost of production of the goods and services that serve visitors to the destination.

If the private sector can produce economic impact, then what rationale does the public sector have for investment in hospitality and tourism infrastructure? The primary reason is market failure economic circumstances in which there exists an opportunity to create economic impact but no incentive for the private sector to produce the goods and services that would create a more efficient market equilibriumi. Public goods are one such cause of market failure that is particularly relevant to investment in tourism infrastructure. Public goods are those in which the marginal cost of production is near zero. Transportation infrastructure, public parks, and street improvements, are examples. As illustrated in Figure 2, public goods may require some level of initial investment and periodic reinvestment, but the consumption of that good by any one individual does not have a measurable cost. Figure 2

Since the supply curve is not upward sloping, the producer surplus is near zero and private investors have no incentive to produce these goods. Public art, streetscapes, waterfront development, and destination marketing are typical publicly-financed tourism products that contribute to destination appeal and create economic impact by creating consumer surplus. A second type of market failure that is particularly relevant to public facilities development is externality. That is, the producer of the good cannot internalize or capture the benefits of investment. Air pollution is the classic example of a negative externality. Polluters invest in industrial equipment or automobiles, but do not bear the cost of the pollution they produce. Convention centers and other tourism amenities have potential to create positive externalities, where only a small portion of the benefits of investment is captured by the owner. A comparison of private and public development of conference and convention space illustrates this form of market failure. The development of convention and conference space in hotels is generally thought of as a loss leader. The capital investment and operating expense associated with conference and convention space does not in itself provide an adequate return on

investment. Hoteliers develop the space because they realize an increase in room revenue, thereby increasing the overall return on hotel investment. Consequently, hotel conference and convention space is usually sized to match the room count. In this way most of the benefits of the investment is internalized or captured by the investor. In contrast, convention centers are designed to attract groups that use multiple hotel properties, and provide external benefits to area producers of tourism goods and services. This may include lodging, transportations services, restaurants, retail and other attractions. Figure 3 below illustrates the increase in economic impact that may result from convention center development if it causes an increase in demand for the destination. Figure 3

Suppose a local area market does not have a convention center. The equilibrium in the market without the convention center is shown in Figure 3 as the intersection (a) of the supply curve and the demand curve (D1) producing certain producer and consumer surpluses (area abc). The addition of a convention center may increase the demand for hotel room nights and other tourism products (D2). A new equilibrium is established (d) with the production of more tourism products (Q2) at increased prices (P2). As a result of the investment in the convention center, the market may generate a greater overall economic impact (area bde) with a net increase in economic impact (area adce). Where private investment in convention centers occurs, an attempt is made to capture the external benefits. The Opryland Hotel and Convention Center in Nashville, Tennessee is one such example. This convention center is surrounded by several hotels, retail and entertainment amenities, all with a single ownership entity, so as to create a self-contained destination and thereby capture the majority of convention delegate spending.

Public investment is also likely to increase the supply of tourism amenities in the market. Public financing of hotels, for example, increases the supply of hotel rooms and meeting space. It is commonly thought that such projects only increase economic impact if they result in an increase in number of hotel room nights generated. Figure 4 illustrates the counterintuitive notion that an increase in the supply alone may generate greater economic impact. Figure 4

Assume the equilibrium in the hotel market without a headquarters hotel is represented by the intersection (a) of demand and supply (S1). The addition of the headquarters hotel causes an increase in supply at every price level (S2) producing a new equilibrium (d). Although price has declined (P2) as may be observed in the market by decreases in average daily room rates, the number of room nights sold increases (Q2). The combination of changes in price and quantity results in a net increase in economic impact (area acbd). Investment in public facilities is most likely to produce a combination of changes in supply and demand as is illustrated in Figure 5. FigGenerating economic impact is the primary rationale for public investment in arenas, convention centers, conference facilities, convention center headquarters hotels and other tourism infrastructure projects. Annual new spending associated with the project is the typical measure used to quantify that impact, with direct spending multiplied by the indirect and induced spending. However, new spending is not the full measure of economic impact. The purpose of this paper is to define economic impact in micro-economic terms and using this definition, provide a theoretical framework for analyzing the economic consequences of public facility development. Economic impact can be broadly defined as a change in wealth or utility of producers and consumers that results from investment in a project. In the language of micro-economics, this is

called a change in consumer and producer surplus. Producer and consumer surplus occurs in efficient markets as illustrated in Figure 1 below. Figure 1

The intersection of an upward sloping supply curve and a downward sloping demand curve jointly determine the market equilibrium (a) where a specific quantity (Q) is produced with a market price of (P). The amounts by which price exceeds the cost of production is the producer surplus (the area aPb). The amount of which the willingness of consumers to pay for the product exceeds the equilibrium price is called consumer surplus (the area aPc). The sum of producer and consumer surpluses is the amount of wealth created in the economy as a result of investment in a project. Since properly functioning private markets generate economic impact, creating economic impact is hardly the purview of governments. In the context of the hospitality and tourism industries, the demand curve may represent the desirability of a destination and the willingness of consumers to pay to visit that destination. The supply curve may represent the cost of production of the goods and services that serve visitors to the destination. If the private sector can produce economic impact, then what rationale does the public sector have for investment in hospitality and tourism infrastructure? The primary reason is market failure economic circumstances in which there exists an opportunity to create economic impact but no incentive for the private sector to produce the goods and services that would create a more efficient market equilibriumi. Public goods are one such cause of market failure that is particularly relevant to investment in tourism infrastructure. Public goods are those in which the marginal cost of production is near zero. Transportation infrastructure, public parks, and street improvements, are examples. As illustrated in Figure 2, public goods may require some level of initial investment and periodic

reinvestment, but the consumption of that good by any one individual does not have a measurable cost. Figure 2

Since the supply curve is not upward sloping, the producer surplus is near zero and private investors have no incentive to produce these goods. Public art, streetscapes, waterfront development, and destination marketing are typical publicly-financed tourism products that contribute to destination appeal and create economic impact by creating consumer surplus. A second type of market failure that is particularly relevant to public facilities development is externality. That is, the producer of the good cannot internalize or capture the benefits of investment. Air pollution is the classic example of a negative externality. Polluters invest in industrial equipment or automobiles, but do not bear the cost of the pollution they produce. Convention centers and other tourism amenities have potential to create positive externalities, where only a small portion of the benefits of investment is captured by the owner. A comparison of private and public development of conference and convention space illustrates this form of market failure. The development of convention and conference space in hotels is generally thought of as a loss leader. The capital investment and operating expense associated with conference and convention space does not in itself provide an adequate return on investment. Hoteliers develop the space because they realize an increase in room revenue, thereby increasing the overall return on hotel investment. Consequently, hotel conference and convention space is usually sized to match the room count. In this way most of the benefits of the investment is internalized or captured by the investor. In contrast, convention centers are designed to attract groups that use multiple hotel properties, and provide external benefits to area producers of tourism goods and services. This may include lodging, transportations services, restaurants, retail and other attractions. Figure 3 below illustrates the increase in economic impact that may result from convention center development if it causes an increase in demand for the destination.

Figure 3

Suppose a local area market does not have a convention center. The equilibrium in the market without the convention center is shown in Figure 3 as the intersection (a) of the supply curve and the demand curve (D1) producing certain producer and consumer surpluses (area abc). The addition of a convention center may increase the demand for hotel room nights and other tourism products (D2). A new equilibrium is established (d) with the production of more tourism products (Q2) at increased prices (P2). As a result of the investment in the convention center, the market may generate a greater overall economic impact (area bde) with a net increase in economic impact (area adce). Where private investment in convention centers occurs, an attempt is made to capture the external benefits. The Opryland Hotel and Convention Center in Nashville, Tennessee is one such example. This convention center is surrounded by several hotels, retail and entertainment amenities, all with a single ownership entity, so as to create a self-contained destination and thereby capture the majority of convention delegate spending. Public investment is also likely to increase the supply of tourism amenities in the market. Public financing of hotels, for example, increases the supply of hotel rooms and meeting space. It is commonly thought that such projects only increase economic impact if they result in an increase in number of hotel room nights generated. Figure 4 illustrates the counterintuitive notion that an increase in the supply alone may generate greater economic impact. Figure 4

Assume the equilibrium in the hotel market without a headquarters hotel is represented by the intersection (a) of demand and supply (S1). The addition of the headquarters hotel causes an increase in supply at every price level (S2) producing a new equilibrium (d). Although price has declined (P2) as may be observed in the market by decreases in average daily room rates, the number of room nights sold increases (Q2). The combination of changes in price and quantity results in a net increase in economic impact (area acbd). Investment in public facilities is most likely to produce a combination of changes in supply and demand as is illustrated in Figure 5. Figure 5

In this example, both the supply of and the demand for hotel rooms increases and equilibrium quantity of occupied room night shifts from Q1 to Q2. Despite no increase in the price level (Pn), the consumer and producer surplus increase. Opposition to public subsidies for hotel development frequently arises from competing hotel interests because new hotel development may depress rate and occupancy in the market. Declines or lack of change in rate and occupancy levels are used as evidence that convention center hotels do not generate their purported economic impactii. But a micro economic framework shows that hotel owner income as measured by rate and occupancy levels does not measure economic impact. Rather, the concerns of competing hotel interests are better characterized as concerns over potentially damaging changes in the distribution of income within the local area hotel market. New economic impact may be generated in situations in which investment does not necessarily increase the overall levels of supply and demand. Investment in public facilities may change the slope of the supply or demand curve thereby increasing consumer surplus. In this way, the substitution of one tourism product for another may generate an increase in economic impact. Public investment in stadiums and arenas may cause this substitution effect as illustrated in Figure 6. Figure 6

Assume that the supply curve in Project A represents an existing array of entertainment facilities in a given market. The supply curve in Project B represents a displacement of some of that infrastructure with a new arena, stadium facility or other public facility. The demand for the new amenity may be such that it increases consumer surplus. As an example, the benefit of attending professional sporting events rather than other entertainment options may be greater to consumers even though the price and quantity of these amenities remains the same. This phenomenon is sometimes discussed in public policy circles as a quality of life issue. This concept runs counter to the common assumption in economic impact studies that either price or quantity of consumption must change in order to generate economic impact.

The economic models and hypothetical situations discussed in this paper are not meant to support the argument that all public investment in tourism amenities generates economic impact. Nor does this author take the position that public investments that would increase consumer or producer surpluses should all be undertaken. Public investment requires taxation, which displaces other private investment. Hotel taxes, which are commonly used to support public facility projects, are no exception to this rule. To the extent that the economic incidence of a hotel tax falls on owners, it reduces the availability of income for private reinvestment. Consequently, the decision to make a public investment should be done with the realistic expectation of improving market efficiencies and thereby increasing the overall level of investment in tourism infrastructure. Furthermore, public entities face a nearly infinite set of possible investment alternatives some of which will generate more economic impact than others. Consideration should always be given to alternative forms of public investment and, to the extent possible; projects should be compared based on their overall level of impact on the local economy. These types of issues are usually sorted in the public processes that establish public investment policies.

In this example, both the supply of and the demand for hotel rooms increases and equilibrium quantity of occupied room night shifts from Q1 to Q2. Despite no increase in the price level (Pn), the consumer and producer surplus increase. Opposition to public subsidies for hotel development frequently arises from competing hotel interests because new hotel development may depress rate and occupancy in the market. Declines or lack of change in rate and occupancy levels are used as evidence that convention center hotels do not generate their purported economic impactii. But a micro economic framework shows that hotel owner income as measured by rate and occupancy levels does not measure economic impact. Rather, the concerns of competing hotel interests are better characterized as concerns over potentially damaging changes in the distribution of income within the local area hotel market.

New economic impact may be generated in situations in which investment does not necessarily increase the overall levels of supply and demand. Investment in public facilities may change the slope of the supply or demand curve thereby increasing consumer surplus. In this way, the substitution of one tourism product for another may generate an increase in economic impact. Public investment in stadiums and arenas may cause this substitution effect as illustrated in Figure 6. Figure 6

Assume that the supply curve in Project A represents an existing array of entertainment facilities in a given market. The supply curve in Project B represents a displacement of some of that infrastructure with a new arena, stadium facility or other public facility. The demand for the new amenity may be such that it increases consumer surplus. As an example, the benefit of attending professional sporting events rather than other entertainment options may be greater to consumers even though the price and quantity of these amenities remains the same. This phenomenon is sometimes discussed in public policy circles as a quality of life issue. This concept runs counter to the common assumption in economic impact studies that either price or quantity of consumption must change in order to generate economic impact. The economic models and hypothetical situations discussed in this paper are not meant to support the argument that all public investment in tourism amenities generates economic impact. Nor does this author take the position that public investments that would increase consumer or producer surpluses should all be undertaken. Public investment requires taxation, which displaces other private investment. Hotel taxes, which are commonly used to support public facility projects, are no exception to this rule. To the extent that the economic incidence of a hotel tax falls on owners, it reduces the availability of income for private reinvestment. Consequently, the decision to make a public investment should be done with the realistic expectation of improving market efficiencies and thereby increasing the overall level of investment in tourism infrastructure.

Furthermore, public entities face a nearly infinite set of possible investment alternatives some of which will generate more economic impact than others. Consideration should always be given to alternative forms of public investment and, to the extent possible; projects should be compared based on their overall level of impact on the local economy. These types of issues are usually sorted in the public processes that establish public investment policies.
At point/allocation g: Individual A is on the higher possible indifference curve given Bs indifference curve and Individual B is on the highest possible indifference curve given As indifference curve. Therefore, g is a pareto efficient allocation Note: The two indifference curves are tangential to each other The curve connecting all Pareto efficient allocations is known as the contract curve. At each point on the contract curve, the MRSs for A and B are equal, i.e.

MRSAxy = MRSBxy 1st Fundamental Theorem of Welfare Economics: If all markets are perfectly competitive, the allocation of resources will be Pareto efficient. 2nd Fundamental Theorem of Welfare Economics: Any Pareto efficient allocation can be obtained as the outcome of competitive market processes, provided that the economy's initial endowment of resources can be redistributed, via lump sum taxes and subsidies, among agents. General Equilibrium and the Efficiency of Perfect Competition Partial equilibrium analysis is the process of examining the equilibrium conditions in individual markets and for households and firms separately General equilibrium is the condition that exists when all markets in an economy are in simultaneous equilibrium.

General Equilibrium and the Efficiency of Perfect Competition

A Technological Advance: The Electronic Calculator A significant technological change in a single industry affects many markets:

Households face a different structure of prices and must adjust their consumption of many products. Labor reacts to new skill requirements and is reallocated across markets. Capital is also reallocated.

Adjustment in an Economy with Two Sectors A higher price creates a profit opportunity in sector X. Simultaneously, lFormal Proof of a General Competitive Equilibriumower prices result in losses in industry Y. This section explains why perfect competition is efficient in dividing scarce resources among alternative uses. If the assumptions of a perfectly competitive economic system hold, the economy will produce an efficient allocation of resources.