Chapter 13 Competitive General Equilibrium

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General Equilibrium
Earlier chapters dealt with a partial equilibrium framework (characterized by a market-to market equilibrium). This chapter widens the perspective by fitting all the analytical pieces together into one large picture of efficiency in an economy wide context. This framework considers all markets in the economy simultaneously and is known as a general equilibrium analysis.

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Preference Assumptions
1.

2. 3.

4.

Indifference curves are convex to the appropriate origin. Indifference curves are smooth. Both goods are essential for all consumers. The thing that affects well-being are the quantities of the two goods consumed.
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Figure 13.1 The Edgeworth box diagram

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The Edgeworth Box

When

indifference curves are smooth and convex, if two are tangent at a point in an Edgeworth Box, that point is a Pareto-optimal allocation. Given smooth indifference curves, if MRS at some allocation is identical for two individuals then that allocation is Pareto-optimal.
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Efficiency in Consumption
Given

the assumptions previously stated: An allocation of goods is Paretooptimal in a many person exchange economy if MRS is identical for all individuals.

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The Contract Curve

All

the points in the Edgeworth box where the indifference curves are tangent describes the entire set of Pareto-optimal allocations. A line connecting all these points of tangency is call the contract curve.

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Figure 13.2 The contract curve

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Figure 13.3 Budget lines in an exchange economy

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Figure 13.4 Competitive equilibrium in an exchange economy

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From Figure 13.4

The

initial allocation is at point A. Given the announced price, line AE* is the budget line for Shelly and Marvin. Since they will both choose E*, the announced price is a competitive equilibrium price and E* is a competitive allocation. Since E* is on the contract curve, the competitive equilibrium is Pareto-optimal.
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Walras Law
When

there are n markets in a general equilibrium model, Walras law states that if demand is equal to supply in n-1 markets, then the demand is equal to supply in the nth market as well.

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First Theorem of Welfare Economics

Given

the assumptions made, the competitive equilibrium allocation of a many person exchange economy is Pareto-optimal. In other words, all gains from trade are realized in a competitive equilibrium.

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Second Theorem of Welfare Economics

With the assumed preferences, given any Pareto-optimal allocation, there is an initial allocation such that, given the initial allocation, the Pareto-optimal allocation is the competitive equilibrium allocation. (From Figure 13.4, this says that any allocation on the budget line will produce E*, the competitive equilibrium).

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Efficiency in General Equilibrium with Production

Production Assumptions: 1. Isoquants are smooth and convex. 2. Both inputs are essential in producing both goods. 3. Production functions exhibit constant returns to scale. 4. Production involves no externalities.
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Efficiency in Consumption Condition

Efficiency

in consumption requires that MRS is identical for all individuals. In other words, the allocation to individual consumers of the goods produced in an economy must be Pareto-optimal.

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Figure 13.5 The production possibilities set

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Efficiency In Production
Efficiency

in production requires that the combination of goods actually produced must be on the production possibility frontier (PPF). Efficiency in production Condition: Efficiency in production requires that the MRTS must be identical for all firms.
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Figure 13.6 An Edgeworth box for production

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Efficiency in the Product Mix

This

condition concerns the interface between production and consumption. The absolute value of the slope of the PPF is known as the marginal rate of transformation (MRT). The MRT measures the opportunity cost of the economy as a whole for a small increase in the amount of good 1 relative to good 2.
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Figure 13.7 The marginal rate of transformation

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Marginal Rate of Transformation

The

marginal rate of transformation can be expressed in terms of the marginal products in two different but equivalent ways: MRTS=MP12/MP11 = MP22/MP21

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Efficiency in the Product Mix

Efficiency

in the Product Mix Condition: Efficiency in the product mix requires that each consumers MRS be identical to the economys MRT.

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Figure 13.8 Efficiency in product mix

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Efficient Allocation of resources

1. 2. 3.

Each of the three efficiency conditions is necessary for an efficient allocation of resources: Efficiency in consumption requires that MRS is identical for all individuals. Efficiency in production requires that the MRTS must be identical for all firms. Efficiency in the product mix requires that each consumers MRS be identical to the economys MRT.
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Efficiency and General Competitive Equilibrium

First

Theorem of Welfare Economics: Given the assumptions made, the competitive equilibrium of this general equilibrium model with production is efficient.

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Figure 13.9 Efficiency in product mix for general competitive equilibrium

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Second Theorem of Welfare Economics

Given the assumed preferences, given any Pareto-optimal allocation (POA) of goods, that is attainable in the model, there is a distribution of ownership of inputs (DOI) such that POA is a competitive equilibrium allocation associated with DOI. In other words, to achieve equity, redistribute the ownership of inputs; to achieve efficiency, use competitive markets.

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Figure 13.10 Trade between Two Countries

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Sources of Inefficiency
What

produces an inefficient allocation of resources? There are many potential sources of inefficiencies, one is a monopoly.

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Monopoly and Inefficiency

1.

2.

For a monopoly the first 2 efficiency conditions still hold: Because all firms face the same input prices, each chooses an input bundle so that MRTS=w1e/w2e Because all consumers face the same product prices, each chooses a bundle at which the MRS=p1e/p2e
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Monopoly and Inefficiency

For a monopoly the inefficiency arises from a distortion of the product mix. The inefficiency arises because the profit maximizing monopolist produces where MR<P. Therefore for all consumers, the MRS>MRT and the allocation of resources is inefficient.
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