Chapter 16

General
Equilibrium and
Economic
Efficiency
Chapter 16 Slide 2
Topics to be Discussed
General Equilibrium Analysis
Efficiency in Exchange
Efficiency in Production
Chapter 16 Slide 3
General Equilibrium Analysis
Partial equilibrium analysis presumes
that activity in one market is
independent of other markets.
Chapter 16 Slide 4
General Equilibrium Analysis
General equilibrium analysis
determines the prices and quantity in
all markets simultaneously and takes
the feedback effect into account.
Chapter 16 Slide 5
General Equilibrium Analysis
A feedback effect is a price or
quantity adjustment in one market
caused by price and quantity
adjustments in related markets.
Chapter 16 Slide 6
General Equilibrium Analysis
Two Interdependent Markets--Moving
to General Equilibrium
Scenario
The competitive markets of:
DVDs
Movie theater tickets
D
V
D
M
Two Interdependent Markets:
Movie Tickets and DVDs
Price
Number
of Videos
Price
Number of
Movie Tickets
S
M
S
V
$6.00
Q
M
Q
V
$3.00
$6.35
Q
M
S*
M
Assume the government
imposes a $1 tax on
each movie ticket.
Q
V
D
V
$3.50
General Equilibrium Analysis:
Increase in movie ticket prices
increases demand for videos.
D
V
D
M
Two Interdependent Markets:
Movie Tickets and DVDs
Price
Number
of Videos
Price
Number of
Movie Tickets
S
M
S
V
$6.00
Q
M
Q
V
$3.00
The Feedback
effects continue.
$3.58
Q*
V
D*
V
$6.35
Q
M
D*
M
$6.82
Q*
M
S*
M
Q
V
D
V
$3.50
D
M
Q
M
$6.75
The increase in the price
of videos increases the
demand for movies.
Chapter 16 Slide 9
Observation
Without considering the feedback effect
with general equilibrium, the impact of
the tax would have been
underestimated
This is an important consideration for
policy makers.
Two Interdependent Markets:
Movie Tickets and DVDs
Chapter 16 Slide 10
Questions
What would be the feedback effect of a
tax increase on one of two
complementary goods?
What are the policy implications of using
a partial equilibrium analysis compared
to a general equilibrium in this scenario?
Two Interdependent Markets:
Movie Tickets and Videocassette Rentals
Chapter 16 Slide 11
Efficiency in Exchange
Exchange increases efficiency until
no one can be made better off
without making someone else worse
off (Pareto efficiency).
The Advantages of Trade
Trade between two parties is mutually
beneficial.
Chapter 16 Slide 12
Efficiency in Exchange
Assumptions
Two consumers
Two goods
Both people know each others
preferences
Exchanging goods involves zero
transaction costs
James & Karen have a total of 10 units
of food and 6 units of clothing.
Chapter 16 Slide 13
Efficiency in Exchange
The Edgeworth Box Diagram
Which trades can occur and which
allocation will be efficient can be
illustrated using a diagram called an
Edgeworth Box.
Exchange in an Edgeworth Box
10F
0
K
0
J
6C
10F
6C
Jamess
Clothing
Karens
Clothing
Karens Food
Jamess Food
2C
1C 5C
4C
4F 3F
7F 6F
+1C
-1F
The allocation
after trade is B: James
has 6F and 2C & Karen
has 4F and 4C.
A
B
The initial allocation
before trade is A: James
has 7F and 1C & Karen
has 3F and 5C.
Chapter 16 Slide 15
Efficiency in Exchange
Efficient Allocations
If Jamess and Karens MRS are the
same at B the allocation is efficient.
This depends on the shape of their
indifference curves.
Chapter 16 Slide 16
A
A: U
J
1
= U
K
1
,
but the MRS
is not equal.
All combinations
in the shaded
area are
preferred to A.
Gains from
trade
Karens
Clothing
Karens Food
U
K
1
U
K
2
U
K
3
Jamess
Clothing
Jamess Food
U
J
1
U
J
2
U
J
3
B
C
D
Efficiency in Exchange
10F
0
K
0
J
6C
10F
6C
Chapter 16 Slide 17
A
Karens
Clothing
Karens Food
U
K
1
U
K
2
U
K
3
Jamess
Clothing
Jamess Food
U
J
1
U
J
2
U
J
3
B
C
D
Efficiency in Exchange
10F
0
K
0
J
6C
10F
6C
Is B efficient?
Hint: is the
MRS equal
at B?
Is C efficient?
and D?
Chapter 16 Slide 18
Efficiency in Exchange
A
Karens
Clothing
Karens Food
U
K
1
U
K
2
U
K
3
Jamess
Clothing
Jamess Food
U
J
1
U
J
2
U
J
3
B
C
D
10F
0
K
0
J
6C
10F
6C
Efficient Allocations
Any move outside the
shaded area will make
one person worse off
(closer to their origin).
B is a mutually beneficial
trade--higher indifference
curve for each person.
Trade may be beneficial
but not efficient.
MRS is equal when
indifference curves are
tangent and the allocation
is efficient.

Chapter 16 Slide 19
Efficiency in Exchange
The Contract Curve
To find all possible efficient allocations
of food and clothing between Karen and
James, we would look for all points of
tangency between each of their
indifference curves.
Chapter 16 Slide 20
The Contract Curve
0
J
Jamess
Clothing
Karens
Clothing
0
K
Karens Food
Jamess Food
E
F
G
Contract
Curve
E, F, & G are
Pareto efficient . If
a change improves
efficiency, everyone
benefits.
Chapter 16 Slide 21
Efficiency in Exchange
Observations
1) All points of tangency between the
indifference curves are efficient.
2) The contract curve shows all
allocations that are Pareto efficient.
Pareto efficient allocation occurs when
trade will make someone worse off.
Chapter 16 Slide 22
Efficiency in Exchange
Consumer Equilibrium in a
Competitive Market
Competitive markets have many actual
or potential buyers and sellers, so if
people do not like the terms of an
exchange, they can look for another
seller who offers better terms.
Chapter 16 Slide 23
Efficiency in Exchange
Consumer Equilibrium in a
Competitive Market
There are many Jameses and Karens.
They are price takers
Price of food and clothing = 1 (relative
prices will determine trade)
U
K
1
U
K
2
P
Price Line
P
PP is the price line
and shows possible
combinations; slope is -1
U
J
1
U
J
2
Competitive Equilibrium
10F
0
K
0
J
6C
10F
6C
Jamess
Clothing
Karens
Clothing
Karens Food
Jamess Food
C
A
Begin at A:
Each James buys
2C and sells 2F
Each James would
move from
Uj1 to Uj2, which
is preferred (A to C).
Begin at A:
Each Karen buys 2F and
sells 2C. Each Karen
would move from
UK1 to UK2, which
is preferred (A to C).
U
K
1
U
K
2
P
Price Line
P
U
J
1
U
J
2
Competitive Equilibrium
10F
0
K
0
J
6C
10F
6C
Jamess
Clothing
Karens
Clothing
Karens Food
Jamess Food
At the prices chosen:
Quantity food
demanded (Karen)
equals quantity
food supplied
(James)--competitive
equilibrium.
At the prices chosen:
Quantity clothing demanded
(James) equals quantity
clothing supplied (Karen)
--competitive equilibrium.
C
A
Chapter 16 Slide 26
Efficiency in Exchange
Scenario
P
F
and P
C
= 3
Jamess MRS of clothing for food is 1/2.
Karens MRS of clothing for food is 3.
James will not trade.
Karen will want to trade.
The market is in disequilibrium.
Surplus of clothing
Shortage of food
Chapter 16 Slide 27
Efficiency in Exchange
Questions
How would the market reach
equilibrium?
How does the outcome from the
exchange with many people differ from
the exchange between two people?
Chapter 16 Slide 28
Efficiency in Exchange
The Economic Efficiency of
Competitive Markets
It can be seen at point C (as shown on
the next slide) that the allocation in a
competitive equilibrium is economically
efficient.
Chapter 16 Slide 29
Competitive Equilibrium
10F
0
K
0
J
6C
10F
6C
Jamess
Clothing
Karens
Clothing
Karens Food
Jamess Food
P
Price Line
U
J
1
U
K
1
A
P
U
J
2
U
K
2
C
Chapter 16 Slide 30
Efficiency in Exchange
Observations concerning C:
1) Since the two indifference curves
are tangent, the competitive
equilibrium allocation is efficient.
2) The MRS
CF
is equal to the ratio of
the prices, or MRS
J
FC
= P
C
/P
F
=
MRS
K
FC
.
Chapter 16 Slide 31
Efficiency in Exchange
Observations concerning C:
3) If the indifference curves were not
tangent, trade would occur.
4) The competitive equilibrium is
achieved without intervention.
Chapter 16 Slide 32
Efficiency in Exchange
Observations concerning C:
5) In a competitive marketplace, all
mutually beneficial trades will be
completed and the resulting
equilibrium allocation of resources
will be economically efficient (the
first theorem of welfare economics)
Chapter 16 Slide 33
Equity and Efficiency
Equity and Perfect Competition
A competitive equilibrium leads to a
Pareto efficient outcome that may or
may not be equitable.
Chapter 16 Slide 34
Equity and Efficiency
Points on the frontier
are Pareto efficient.
O
J
& O
K
are perfect
unequal distributions
and Pareto efficient.
To achieve equity
(more equal
distribution) must the
allocation be
efficient?
Jamess Utility
Karens
Utility
O
J
O
K
Chapter 16 Slide 35
Efficiency in Production
Assume
Fixed total supplies of two inputs; labor
and capital
Produce two products; food and clothing
Many people own and sell inputs for
income
Income is distributed between food and
clothing
Chapter 16 Slide 36
Efficiency in Production
Observations
Linkage between supply and demand
(income and expenditures)
Changes in the price of one input
triggers changes in income and demand
which establishes a feedback effect.
Use general equilibrium analysis with
feedback effects
Chapter 16 Slide 37
Efficiency in Production
Production in the Edgeworth Box
The Edgeworth box can be used to
measure inputs to the production
process.
Chapter 16 Slide 38
Efficiency in Production
Production in the Edgeworth Box
Each axis measures the quantity of an
input
Horizontal: Labor, 50 hours
Vertical: Capital, 30 hours
Origins measure output
O
F
= Food
O
C
= Clothing
60F
50F
40L 30L
Labor in clothing production
Efficiency in Production
50L 0
C
0
F
30K
Capital
in clothing
production
20L 10L
20K
10K
10L 20L 30L 40L 50L
Capital
in food
production
10K
20K
30K
30C
25C
10C
80F
Labor in Food Production
B
C
D
A
Each point measures inputs
to the production
A: 35L and 5K--Food
B: 15L and 25K--Clothing
Each isoquant shows input
combinations for a given output
Food: 50, 60, & 80
Clothing: 10, 25, & 30

Efficiency
A is inefficient
Shaded area is preferred to A
B and C are efficient
The production contract curve shows
all combinations that are efficient
Chapter 16 Slide 40
Efficiency in Production
Producer Equilibrium in a
Competitive Input Market
Competitive markets create a point of
efficient production.
Chapter 16 Slide 41
Efficiency in Production
Competitive Market Observations
The wage rate (w) and the price of capital (r) will be
the same for all industries.
Minimize production cost
MP
L
/MP
K
= w/r
w/r = MRTS
LK

MRTS = slope of the isoquant
Competitive equilibrium is on the production
contract curve.
Competitive equilibrium is efficient.
60F
50F
40L 30L
Labor in clothing production
Efficiency in Production
50L 0
C
0
F
30K
Capital
in clothing
production
20L 10L
20K
10K
10L 20L 30L 40L 50L
Capital
in food
production
10K
20K
30K
30C
25C
10C
80F
Labor in Food Production
B
C
D
A
Discuss the adjustment process that would
Move the producers from A to B or C.
Chapter 16 Slide 43
Efficiency in Production
The Production Possibilities Frontier
Shows the various combinations of food
and clothing that can be produced with
fixed inputs of labor and capital.
Derived from the contract curve
Chapter 16 Slide 44
Production Possibilities Frontier
Food
(Units)
Clothing
(units)
O
F
& O
C

are extremes.
Why is the production
possibilities frontier
downward sloping?
Why is it concave?
B, C, & D are
other possible
combinations.
A
A is inefficient. ABC
triangle is also inefficient
due to labor market
distortions.
60
100
O
F
O
C
B
C
D
Chapter 16 Slide 45
Production Possibilities Frontier
Food
(Units)
Clothing
(units)
60
100
O
F
O
C
A
B
C
D
B
1C
1F
D
2C
1F
MRT = MC
F
/MC
C
The marginal rate of
transformation (MRT)
is the slope of the
frontier at each point.
Chapter 16 Slide 46
Efficiency in Production
Output Efficiency
Goods must be produced at minimum
cost and must be produced in
combinations that match peoples
willingness to pay for them.
Efficient output and Pareto efficient
allocation
Occurs where MRS = MRT
Chapter 16 Slide 47
Efficiency in Production
Assume
MRT = 1 and MRT = 2
Consumers will give up 2 clothes for 1
food
Cost of 1 food is 1 clothing
Too little food is being produced
Increase food production (MRS falls and
MRT increases)
Chapter 16 Slide 48
Indifference
Curve
Output Efficiency
Food
(Units)
Clothing
(units)
60
100
Production
Possibilities
Frontier
MRS = MRT
C
How do you find the
MRS = MRT combination
with many consumers
who have different
indifference curves?
Chapter 16 Slide 49
Efficiency in Production
Efficiency in Output Markets
Consumers Budget Allocation
Profit Maximizing Firm

C F
P P MRS
C C F F
MC P and MC P
MRS
MC
MC
MRT
C
F

C
F
P
P
Chapter 16 Slide 50
U
2
) , ( @ MRT /
1 1
1 1
F C A P P
C F

Competition and Output Efficiency
Food
(Units)
Clothing
(units)
60
100
A
C
1
F
1
B
C
2
F
2
A shortage of
food and surplus
of clothing causes
the price of food
to increase and
the price of
clothing to decrease.
C
C*
F*
Adjustment continues until
P
F
=P
F
* and P
C
= P
C
*;
MRT = MRS; Q
D
=Q
S
for
food and clothing.
U
1

Chapter 16 Slide 51
An Overview---The Efficiency
of Competitive Markets
Conditions Required for Economic
Efficiency
Efficiency in Exchange
K
FC
J
FC
MRS MRS
Chapter 16 Slide 52
Conditions Required for Economic
Efficiency
Efficiency in Exchange (for a
competitive market)
K
FC C F
J
FC
MRS P P MRS /
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 53
Conditions Required for Economic
Efficiency
Efficiency in the Use of Inputs in
Production
C
LK
MRTS MRTS
F
LK
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 54
Conditions Required for Economic
Efficiency
Efficiency in the Use of Inputs in
Production (for a competitive market)
C
LK
MRTS / MRTS r w
F
LK
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 55
Conditions Required for Economic
Efficiency
Efficiency in the Output Market
consumers) all (for
FC FC
MRS MRT
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 56
Conditions Required for Economic
Efficiency
Efficiency in the Output Market (in a
competitive market)
C F C F
C F F
P P
P P
/ MC / MC MRT
MC , MC
FC
C


An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 57
Conditions Required for Economic
Efficiency
However, consumers maximize their
satisfaction in competitive markets
only if
FC FC
FC C F
P P
MRT MRS Therefore,
consumers) all (for MRS /

An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 58
Why Markets Fail
Market Power
In a monopoly in a product market, MR
< P
MC = MR
Lower output than a competitive market
Resources allocated to another market
Inefficient allocation
Chapter 16 Slide 59
Why Markets Fail
Market Power
Monopsony in the labor market
Restricted supply of labor in food
w
f
would rise, w
L
would fall
Clothing input:
Food input:
r w
c
C
LK
/ MRTS
C
LK c F
F
LK
r w r w MRTS / / MRTS
Chapter 16 Slide 60
Why Markets Fail
Incomplete Information
Lack of information creates a barrier to
resource mobility.
Externalities
When consumption or production
creates cost and benefits to third parties
which changes the cost and benefits of
decisions and create inefficiencies.
Chapter 16 Slide 61
Summary
Partial equilibrium analyses of markets
assume that related markets are
unaffected, while general equilibrium
analyses examine all markets
simultaneously.
An allocation is efficient when no
consumer can be made better off by trade
without making someone else worse off.
Chapter 16 Slide 62
Summary
A competitive equilibrium describes a set
of prices and quantities, so that when each
consumer chooses his or her most
preferred allocation, the quantity
demanded is equal to the quantity supplied
in every market.
The utility possibilities frontier measures all
efficient allocations in terms of the levels of
utility that each person achieves.
Chapter 16 Slide 63
Summary
An allocation of production inputs is
technically efficient if the output of
one good cannot be increased
without increasing the output of some
other good.
Chapter 16 Slide 64
Summary
The production possibilities frontier
measures all efficient allocations in terms
of the levels of output that can be
produced with a given combination of
inputs.
Efficiency in the allocation of goods to
consumers is achieved only when the
MRS of one good for another in
consumption is equal to the MRT of one
good for another in production.
End of Chapter 16
General
Equilibrium and
Economic
Efficiency