General Equilibrium

We will talk about Pareto Efficiency The Free-Market Argument: Competitive Markets are Efficient Equality-Efficiency Trade off The Interventionist Argument Market Failure: An introduction to the chapters to come.
Slide 1

The Free-Market Argument

We will discuss the conditions for Pareto efficiency. We will show that competitive markets are Pareto efficient, given certain assumptions.

Slide 2

Examples of GE models
We will mostly work with simple examples of general equilibrium models. You already know the exchange economy in the Edgeworth box. We will talk about the so-called Robinson Crusoe economy: One input, one consumer. And the 2x2 production model with two consumers: 2 goods, 2 inputs, 2 consumers
Slide 3

Example of Robinson Crusoe Economy with linear PPF

Robinson Crusoe can spend the whole day letting sun shine on his belly (leisure) or he can gather coconuts. Crusoe can gather 3 coconuts per hour. Crusoes utility function over coconuts and leisure is given by U(c,l) =c1/3l2/3. Suppose Crusoe has 12 hours a day to spend on leisure and gathering coconuts.
Slide 4

Problem Crusoe must solve:

How to allocate the total amount of time (resource) between gathering coconuts and leisure so to maximize his utility? We can do this in two steps: 1. What are the production efficient allocations of Crusoes time? 2. Once we have production efficiency, what is the utility maximizing amount of coconuts and leisure?
Slide 5

Production Efficiency
Robinson can spend an hour of leisure or he can spend an hour gathering 3 coconuts. Since he has 12 hours available per day, he could spend 12 hours of leisure and zero hours of gathering coconuts. This is production efficient, because he spends every hour available to him to produce the maximum amount of leisure. Similarly he could spend all his time gathering coconuts and then ending up with 36 coconuts per day. Again this would be production efficient.
Slide 6

Production Efficiency Contd

How can Robinson efficiently produce a combination of leisure and coconuts? As Crusoe increases the production of coconuts by 1 coconut at a time, he sacrifices 1/3 hr or 20 minutes of leisure for each additional coconut. Therefore 1 coconut and 12-1/3 hrs of leisure are another point on the PPF. So are 2 coconuts and 12-2/3hrs of leisure; 3 coconuts and 12- 3/3hrs of leisure and so on and so forth. Thus, his production possibility frontier would look like this: Slide 7

Crusoes Production Possibility Frontier leisure

12 PPF: l = 12 (1/3)*c The slope of the PPF is equal to the opportunity cost of coconuts

Production Possibility Set 1/3

36 coconuts The slope of the PPF is also called the marginal rate of transformation (MRT leisure for coconut): in order to produce one additional coconut Crusoe Slide 8 sacrifices 1/3 hr of leisure.

leisure

Crusoes Pareto efficient allocation

12 Utility for Robinson increases 1/3 12 36 coconuts
Slide 9

8 Production possibility set in Crusoes problem plays a role similar to the budget set in the consumers problem.

Pareto Efficiency
What we just did graphically can be expressed in Math. Need to find tangency point between PPF and Indifference curves:

Slide 10

Pareto Efficient Allocation

Slide 11

Robinson Crusoe Economy with concave PPF

Suppose Crusoe does not care for leisure anymore. Instead he enjoys fish and coconuts: U(f,c) =f1/3c2/3. He can gather coconuts according to the production function c=lc1/2 and he can catch fish according to f =2 lf1/2 where lc denotes the amount of time he devotes gathering coconuts and lf denotes the time he spends catching fish. Overall, he has 12 hours he can use to pursue these activities.
Slide 12

How can we find the PPF now?

The production possibility frontier tells us which combinations of fish and coconuts are production efficient, that is how we can use Crusoes total time in such a way as to maximize the amount of fish given that we also want to produce a certain amount of coconuts.
Slide 13

Finding the PPF mathematically

Remember we want to find a relationship between fish and coconuts: If we produce that many coconuts, what is the maximum amount of fish we can produce? E.g. produce 2 coconuts. Since c = lc1/2 , the amount of time required to produce a certain amount of coconuts is given by lc=c2. Thus, 4 hrs are needed to produce 2 coconuts. Whats the maximum amount of fish Crusoe can produce given that he produces 2 coconuts?
Slide 14

 Crusoe has 8 hrs left for catching fish. Since f = 2 lf1/2 , Crusoe can catch 4*21/2 fish when he wants to produce 2 coconuts also. Repeat with various amounts of coconuts, and you get the whole PPF. Or, more generally, use amount of coconuts as a parameter to find out how many fish Crusoe can produce for any given number of coconuts.

Slide 15

 Given amount of coconuts requires lc=c2 units of time. Since lf = 12 lc , time left to produce fish is lf =12 - c2. Given this amount of time to catch fish, amount of fish caught is f = 2 lf1/2 = 2 (12 c2)1/2 . We now can relate any produced amount of coconuts to a maximum amount of fish: PPF is f = 2 (12 - c2)1/2 . The PPF looks likes this:
Slide 16

Concave PPF

Slide 17

Pareto Efficient Allocation

Robinsons utility increases

Slide 18

Pareto Efficient Allocation

In order to find the Pareto efficient allocation, we need to set MRT is equal to absolute
value of slope of PPF Also need to make sure that we really are on the PPF, hence fish is expressed as a function of coconuts in MRS.

To find slope of PPF, take derivative of equation describing PPF with respect to c.

Slide 19

Summing Up
We have looked at a very simple economy with production. We have learned how to find the PPF if there is only one input. We have learned how to find the Pareto efficient allocation of goods if there is only one consumer: (1) MRS = MRT and (2) need to be on PPF. In order to determine what is Pareto efficient we need production efficiency. Production efficiency is a necessary condition for Pareto efficiency.
Slide 20

Assumptions for the 2x2 production model

Compared to our previous model, we now add one more production factor (capital) and allow for more than one consumer. Two inputs: Capital K, Labor L Two consumption goods: good X, good Y Consumers: strictly convex indifference curves (decreasing MRS between goods). Producers: strictly convex isoquants (decreasing marginal rate of technical substitution between inputs). We also assume that production of the two goods does not exhibit increasing returns to scale. Only two people: Person 1 and person 2. Slide 21

Problems the economy must solve:

How to allocate the existing stock of capital and labor efficiently between the production of good X and the production of good Y. How to distribute these goods efficiently among the population once they are produced.

Slide 22

Consumption Efficiency
You already know consumption efficiency from the exchange economy. A distribution of goods is consumption efficient if it is not possible to reallocate these goods and make at least one person in the economy better off without making someone else worse off.
For two people and two goods, consumption efficiency translates into MRS1Y for X=MRS2Y for X, so that there are no further gains from trade. 23 Slide

Consumption Efficiency Contd

Suppose MRS1Y for X>MRS2Y for X, in particular lets assume that MRS1Y for X=1, and MRS2Y for X= . Person 1 is willing to give up one unit of good Y for one more unit of good X. Person 2 is willing to give up only half a unit of good Y for one more unit of good X. Person 2 would have to be compensated for the loss of 1 unit of good X with only half a unit of good Y.
Slide 24

Trade
- 1 unit of good Y + 1 unit of good X and same off
1 1 unit of good Y 1.5 units of good X After trade, both people are better off

+1 unit of good Y - 2 units of good X and same off

2

Slide 25

Improvement over initial allocation

Person 1 can give person 2 one unit of good Y in exchange for 1.5 units of good X. Person 2, to be as well off as before, would be willing to give up 2 units of good X, but only has to give 1.5 units to person 1. Person 2 is thus better off. Person 1, to be as well off as before, would require 1 unit of good X for giving up 1 unit of good Y. By receiving 1.5 units of good X instead, person 1 is also better off.
Slide 26

Generalization of Argument
It is easy to see that we can also find mutually beneficial trades if MRS1Y for X<MRS2Y for X. There are no further gains from trade, however, if MRS1Y for X=MRS2Y for X. If MRS1Y for X=MRS2Y for X then we have a consumption efficient allocation. The same logic applies to any two people in the economy and any two goods, so we can easily generalize this rule for many people.
Slide 27

Condition for Consumption Efficiency

A given set of goods in an economy should be allocated across a set of consumers until the marginal rate of substitution for each pair of goods is equal for each consumer.

Slide 28

Production Efficiency
An allocation of inputs (K and L) is production efficient if it is not possible to reallocate these inputs and produce more of at least one good in the economy without decreasing the amount of some other good that is produced.

Slide 29

Where do the fixed amounts of labor and capital come from?

They are determined by past actions of the society:
The amount of labor in the economy is determined by previous amounts of births and deaths in the population, and the size of the capital stock is determined by previous amounts of investment and depreciation.

In any case, we consider the existing labor force and capital stock as fixed elements that will not be affected by anything we do in our analysis.
Slide 30

Production Efficiency in the 2x2 production model

Use the Edgeworth Box to depict the situation of the production of two goods with capital and labor. Instead of consumer 1, we put good X on the lower left hand corner. Instead of consumer 2, we put good Y on the upper right hand corner. The Edgeworth Box depicts any allocation of labor and capital between the production of the two goods, so that the labor inputs in the production of both goods sum up to always the same total amount. The same is true for capital.

Slide 31

Edgeworth Box of Production

capital Isoquants of Y Good Y

Amount of capital devoted to production of good X

Isoquants of X labor
Amount of labor devoted to production of good X

Good X

Slide 32

Edgeworth Box of Production

capital Good Y

A Good X labor Point A is not production efficient.

Slide 33

Moving to e.g. this point from point A we can produce more of both goods.

Edgeworth Box of Production

capital Good Y

Good X

labor

This point is production efficient: in order to produce more of X we have to reduce production of Y and vice versa.
Slide 34

How much labor, how much capital should be used in the production of both goods?
Analogy to the consumption efficiency. Noting that the slope of the isoquants is the marginal rate of technical substitution of capital for labor, production efficiency occurs when MRTSXK for L=MRTSYK for L.
Slide 35

Production Efficiency Contd

Again suppose MRTSXK for L does not equal MRTSYK for L and MRTSXK for L>MRTSYK for L. For example assume that MRTSXK for L= 3 and MRTSYK for L=1/4. For good X, the output of good X increases 3 times as much if we increase labor by one unit than if we increase capital by one unit. For good Y, labor is only one quarter as productive as capital.
Slide 36

Improvement over initial allocation

Take away one unit of capital from the production of good X and put it into the production of good Y, we can take away 2 units of labor from the production of good two and put it into the production of good X. Production of good Y increases, because we took less than 4 units of labor in exchange for 1 more unit of capital. Production of good X increases, since we took away only 1 unit of capital when we could have taken away 6 units for an increase of labor by two units.

Slide 37

Condition for Production Efficiency

A given set of inputs available in an economy should be allocated across a set of producers until the marginal rate of technical substitution for each pair of inputs is equal for each producer.

Slide 38

Product Mix Efficiency

Which combination of goods will give us Paretoefficiency? We can have efficiency in production and in consumption, and yet there is still room for a Pareto improvement, because we are producing too much of one good and not enough of the other. Product mix efficiency puts together both sides, consumers and producers.
Slide 39

The Production Possibility Frontier with 2 Inputs

While the set of Pareto efficient allocations in the Edgeworth box of production makes all the efficient input combinations visible, the PPF gives us all the combinations of goods that are production efficient.

Slide 40

From Edgeworth Box of Production to PPF

capital X=24, Y=20 Good Y

X=12, Y=28 Good X Good Y 28 20 10 12 24

X=30, Y=10

labor PPF

30

Good X

Slide 41

The Slope of the PPF

Marginal rate of transformation (MRT) of good Y into good X, indicates how many units of good Y the economy would have to sacrifice (by transferring inputs from the production of good Y to the production of good X) in order to produce 1 more unit of good X. We can rephrase this statement using marginal costs of producing goods X and Y.

Slide 42

 It costs society MCX $ to produce an additional unit of good X. This money must come out of the production of good Y. A decrease in the production of good Y by one unit frees up MCY $. So the amount of good Y that society must sacrifice to produce one more unit of good X is MCX/ MCY. Hence MRTY for X = MCX/MCY.
Slide 43

MRTY for X = MCX/MCY

Putting Production and Consumption Together Graphically

We can draw an Edgeworth box from each of the points on the PPF and identify the consumption efficient allocations for each combination of goods. The MRS typically changes along the set of Pareto efficient allocations. The selected point on the PPF is product mix efficient if MRS=MRT.
Slide 44

Pareto Efficiency in Graph

Good Y X,Y PPF Person 2s highest utility given X and Y The green point gives us an allocation of goods that satisfies production efficiency and consumption efficiency, but does it satisfy product mix efficiency? Keep person 1 at this utility level. Good X
Slide 45

Pareto Efficiency in Graph

Good Y
With X and Y, we have found a point on the PPF that allows us to increase person 2s utility without making person 1 worse off as compared to X and Y. Do we have production efficiency now?

PPF

X,Y

Person 2s highest utility given X and Y Keep person 1 at Good X this utility level.
Slide 46

Pareto Efficiency in Graph

Good Y Person 2s highest utility given any X and any Y. X,Y PPF By shifting to yet another point on the PPF, we can again increase person 2s utility without making person 1 worse off. X,Y

Keep person 1 at this utility level.

Good X
Slide 47

Pareto Efficiency in Graph

Good Y Person 2s highest utility given any X and any Y. Slope of PPF less steep than slope of indifference curves Slope of PPF same as slope of indifference curves Slope of PPF steeper than slope of indifference curves

Keep person 1 at this utility level.

Good X
Slide 48

 To be more specific assume that MRSY for X=2 and MRTY for X=1. If we want to produce one more unit of good X, we have to give up one unit of good Y. Both consumers are the same off if they give up two units of good Y and receive one more unit of good X. But this means that we will make both of them better off by producing two more units of good X and sacrificing 2 units of good Y! Only if MRS=MRT is such a reallocation not possible. Slide 49

Suppose MRSY for X>MRTY for X.

Condition for Product Mix Efficiency

For any mix of outputs produced, the marginal rate of transformation of those goods in production (as defined by the slope of the PPF) must equal the marginal rates of substitution for all consumers using those goods. Formally, MRS1Y for X= MRS2Y for X= = MRSiY for X=MRTY for X, where i stands for consumer 3 or 4 or 5 up to the last consumer N.

Slide 50

Exercise
Suppose there are 2 consumers, Ara and Bahar, and two goods, good X and good Y. Aras utility function is given by UA=XY and Bahars utility function is given by UB=X1/4Y3/4. Both goods are produced with labor and capital and good Xs production function is fX=(KXLX)1/2 while good Ys production function is fY=(KYLY)1/2. Suppose there are 8 units of labor and 8 units of capital in this economy. It can be shown that the PPF for this economy is given by Y =8-X.
Slide 51

Exercise Contd
If half of the amount of capital and half of the amount of labor is used to produce good X, and both Ara and Bahar receive the same amount of both goods would this be Pareto efficient?

Slide 52

Answer
We need to check:
Production efficiency: MRTSX= MRTSY Consumption efficiency: MRSA= MRSB Product Mix efficiency: MRSA= MRSB=MRT

Production Efficiency MRTSX capital for labor =MPLX/MPKX=KX/LX=1 MRTSY capital for labor =MPLY/MPKY=KY/LY=1 Yes, production efficient.
Slide 53

Answer Contd
Consumption Efficiency Note that 4 units of good X and 4 units of good Y are produced. This means both Ara and Bahar each receive two units of good X and two units of good Y. MRSAra Y for X =MUXA/MUYA= YA /XA=1 MRSBahar Y for X =MUXB/MUYB= YB /3XB=1/3 MRSAra Y for X is not the same as MRSBahar Y for X . No, not consumption efficient.
Slide 54

Answer Contd
We do not have consumption efficiency. We dont have to check for product mix efficiency, because if one of the conditions is not satisfied, we already know that the allocation cannot be Pareto efficient.

Slide 55

Exercise Contd
Suppose both goods are produced with a capital to labor ratio of 1, and 5.5 units of good Y are produced and 2.5 units of good X. Moreover, Ara receives one unit of good X. How many units of good Y must Ara receive and how many units of good X and good Y must Bahar receive for the allocation to be Pareto efficient?
Slide 56

Answer
Production efficiency: We have 8 units of labor and eight units of capital. If for both goods the capital labor ratio is equal to one, then KX/LX=1= MPLX/MPKX and KY/LY=1= MPLY/MPKY so MRTSX capital for labor = MRTSY capital for labor Moreover 5.5= 8 2.5, so we are on the PPF. So production efficient.

Slide 57

Answer Contd
Next we need to ensure that consumption efficiency and product mix efficiency are satisfied. For consumption efficiency MRSAra Y for X = MRSBahar Y for X We know that XB =2.5 1=1.5, YA + YB = 5.5 YA /XA=YB /3XB. YA /1=(5.5- YA) /(3*1.5) YA =1, YB = 4.5, XB =1.5.
Slide 58

Answer Contd
For product mix efficiency MRS = MRT, YA /XA=YB /3XB = 1. The allocation KX=LX=2.5, KY=LY=5.5, XA=1 , XB=1.5 , YA=1, YB= 4.5 is Pareto efficient. We have shown that with this allocation of resources and consumption goods all three conditions of Pareto efficiency are satisfied.
Slide 59

Competitive Equilibrium
Now that we understand Pareto efficiency in a general equilibrium model with production, we want to find out if the competitive equilibrium in this model is Pareto efficient. First discuss what happens in the competitive equilibrium, then determine whether its Pareto efficient.
Slide 60

Perfectly Competitive Markets Satisfy the Conditions for Pareto Efficiency

Consumers maximize utility taking prices as given. From utility max MRS=price ratio.
If consumers are price takers, they all face the same prices and therefore all their marginal rates of substitution have to be equal. The competitive equilibrium satisfies consumption efficiency.

Slide 61

Perfectly Competitive Markets Satisfy the Conditions for Pareto Efficiency

Firms maximize profits and hence minimize costs. From profit maximization, MRTS=factor price ratio (because cost minimization is a necessary condition for profit maximization).
If all firms are price takers in the factor markets, then all firms have equal MRTS. The competitive equilibrium satisfies production efficiency.
Slide 62

Perfectly Competitive Markets Satisfy the Conditions for Pareto Efficiency

Firms maximize profits. From profit maximization of competitive firms (if the number of firms is sufficiently large) P=MC.
For any two goods, consumers set MRS=pX/pY. From profit max a firm produces an amount of X where pX=MCX, and a firm produces an amount of Y where pY=MCY. This implies pX/pY=MCX/MCY, but MCX/MCY=MRT and therefore MRS=MRT. The competitive equilibrium satisfies product mix efficiency.
Slide 63

The Two Fundamental Theorems of Welfare Economics

The First (FFTW): The competitive equilibrium is Pareto efficient. The Second (SFTW): Any Pareto efficient allocation can be achieved by the competitive equilibrium with the appropriate redistribution of initial endowments.
Slide 64

Market Failure and Redistribution

Market failure addresses the issue when the competitive equilibrium is not Pareto efficient. Takes FFTW as starting point. Redistribution (interventionist argument) is unhappy with the distribution of goods when economy is left to market forces alone. Takes SFTW as starting point.
Slide 65

The Interventionist Argument

The Second Fundamental Theorem of Welfare Economics is not very useful. It requires that income be redistributed in such a way, that people and firms cannot change their behavior in order to receive more transfers/pay less taxes (only lumpsum taxes and transfers allowed). This is next to impossible in the real world. We then have to trade off equity for efficiency.
Slide 66

Reading Suggestion

Amarty Sen, one of the Nobel Prize winners in Economics, has an article that examines the first and second fundamental theorems of welfare economics. The title is The Moral Standing of the Market, in Ellen Frankel Paul, Fred D. Miller, Jr., and Jeffrey Paul (eds) (1985), Ethics & Economics, pp.1-19, Basil Blackwell Publisher Limited. Slide 67

A Basis for Intervention: Rawlsian Justice

Maximin Rule: Maximize the welfare of the least well-off individual in the economy. Justification: People would agree to that if they have to choose under the veil of ignorance.

Slide 68

Example: Maximin Rule

State 1 Person 1s utility Person 2s utility Person 3s utility 8 10 12 State 2 20 5 15 State 3 53 10 7
X=10,Y=20 X=20,Y=20 X=40,Y=30

Slide 69

Which state of the world would Rawls advocate? State 1, the because
State 1 State 2 State 3 Person 1s utility Person 2s utility Person 3s utility

least wellX=10,Y= X=20,Y=2 X=40,Y=3 off person in 20 0 0 state 1 has the highest 8 20 53 utility compared to 10 5 10 the least well-off persons in 12 15 7 the other states.
Slide 70

What if only states 2 and 3 are available?

State 3, because the least well-off person in state 3 is better off than the least well-off person in state 2. Note that the maximin rule tolerates huge inequality as long as one state is better than the alternative states for the least well-off persons.
Slide 71

A Free Market Rebuttal to Rawls: Nozicks Process Justice

The competitive equilibrium is fair because it guarantees a fair process. Fair Process: nobody is coerced in doing something, every trade is voluntary. Critique: The process is fair but the starting point is not.

Slide 72

Equitable Income Distribution: Varians Envy-Free Justice

Divide resources equally between agents. Let them trade from a situation where everybody has the same initial endowment. Final allocation is envy-free. Nobody would be better off by having somebody elses consumption bundle. Critique: In order to equalize initial endowments, inefficiency might occur. Just because an allocation is envy-free, it doesnt mean it is equal.
Slide 73

Exercise
Annies utility: U=4X1+3X2X3 Bernds utility: U=2X1 X2 +5X3

Good X1 X2 X3

Annie 5 3 1

Bernd 1 3 5
Slide 74

Questions
a) Is this allocation envy free? b) Is this allocation Pareto efficient? c) Find an envy-free allocation, that is a Pareto improvement over the first allocation. d) Do you think that the allocation in c is desirable? Why or why not?
Slide 75

Answer to a)
Annie gets 4*5+3*3*1=29. Bernd gets 2*1*3+5*5=31. Annie envies Bernd, because with Bernds consumption bundle Annie would get 4*1+3*3*5= 49. Bernd envies Annie, because with Annies bundle he gets 2*5*3+5*1=35. The allocation is not envy-free.
Slide 76

Answer to b)
The original allocation is not Pareto efficient, we have just seen, that both people would be better off if they switched bundles with each other.

Slide 77

Answer to c)
We can switch the bundles and then both people will not envy each other anymore. This allocation is a Pareto improvement over the original allocation, because both people are better off than before. We could also give Bernd all of good 1 and Annie all of good 3. This is still envy-free. And theyll both be better off than with their initial bundle. Annie:4*0+3*3*6=54. Bernd: 2*6*3*+0=36.
Slide 78

Answer to d)
The allocations in c) are desirable, because we can make both people better off. On the other hand, inequality between Annie and Bernd increases.

Slide 79

FFTW and Market Failure

Rather than equity considerations, this approach questions whether the competitive equilibrium is Pareto efficient. We made several assumptions in order to show that the competitive equilibrium is Pareto efficient. If these assumptions do not hold in the real world, competitive markets are not efficient.
Slide 80

 Consumers and Producers are price takers. If not, people have market power (e.g. oligopoly, monopoly, monopsony). Producers face DRS or CRS technology. If not, natural monopoly. Symmetric information. If not, people can take advantage of their superior knowledge. Markets may not exist, or may not be efficient. Private goods. If not, markets provide too little of public goods and goods with positive externalities and too much of goods with negative externalities.
Slide 81

Assumptions in FFTW