Chapter 19 Study Guide

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355 CHAPTER 19 General Equilibrium Analysis and Economic Efficiency CHAPTER ANALYSIS This chapter is concerned with the way various economic arrangements affect the welfare of the members of society. We recognize that markets are interrelated, and introduce general equilibrium analysis , which is the study of how equilibrium is determined in all markets simultaneously. It is then shown that the general competitive equilibrium is efficient. Chapter 20 introduces and discusses some situations for which a competitive market will not generate efficient outcomes. 19.1 Partial and General Equilibrium Analysis Compared Partial equilibrium analysis studies the determination of an equilibrium price and quantity in an individual market viewed as self-contained and independent of other markets. When partial equilibrium analysis is used, it is assumed that certain variables, such as the prices of other goods, are held constant when in fact they may actually change. The ceteris paribus assumption of partial equilibrium analysis permits us to focus on the factors most important in determining an equilibrium price and quantity in a given market. General equilibrium analysis recognizes the interrelationships among markets and focuses on the characteristics of equilibrium in each market simultaneously. All prices are permitted to vary. We have considered market interrelationships in studying goods that are complements or substitutes and in studying cross-price elasticity, however, these analyses do not take into account the interrelationships that exist among all markets. For example, a change in demand for automobiles will affect the demand for tires, a complementary good. However, it can also affect the price of cooking utensils by affecting the demand for steel, which affects the price of aluminum, which affects the price of all products made with aluminum, including cooking utensils. Spillover effects , which are ignored in partial equilibrium analysis, occur when a change in equilibrium in one market affects variables in other markets. Further, the spillover effects in one market may also induce changes in that market and have a feedback effect on the original market. A feedback effect takes place when a change in equilibrium in a market that is caused by events in other markets that are a result of the initial change in equilibrium in the market under consideration. For example, a change in the demand for automobiles may cause a disequilibrium in the market for motorcycles (spillover effect), but as the market for motorcycles adjusts toward a new equilibrium, it may affect the automobile market (feedback effect). As these examples show, markets are mutually interdependent, a fact that is taken into account in general equilibrium analysis. Economists use both partial equilibrium and general equilibrium analyses, depending on the

Study Guide to accompany Microeconomics: Theory and Applications , Eleventh Edition 356 problem under consideration. An important area in which general equilibrium analysis has been used successfully is international trade. 19.2 Economic Efficiency Economists are unwilling to make interpersonal comparisons of utility (or well-being) because an individual's well-being is subjective and personal. Instead, economists attempt to identify efficient , or Pareto optimal , outcomes. An allocation of resources is efficient (Pareto optimal) if it is impossible, through any feasible change in resource allocation, to make one person better off without making another person worse off. The assessments of being better or worse off are made by the individuals themselves. Any allocation of resources for which it is possible to make at least one person better off without making another person worse off is inefficient . There is more than one efficient allocation of resources. Figure 19.2 in the text illustrates a welfare frontier , which is a curve that separates welfare levels that are attainable from those that cannot be reached given the availability of resources. Any point on the welfare frontier is efficient, while any point inside the welfare frontier is inefficient. There is no way to identify the "best" point on the frontier, since interpersonal comparisons of utility would involve value judgements. 19.3 Conditions for Economic Efficiency Any economy must find a way to determine how much of each good to produce, how much of each input to use in the production of each good, and how to distribute the goods among consumers. It is desirable that these three tasks are performed in an efficient manner. In Chapter 6 we examined the distribution of goods among consumers using the Edgeworth exchange box diagram to illustrate exchange between two consumers. Recall that the contract curve was the locus of points where the consumer’s indifference curves were tangent to each other, indicating that the marginal rate of substitution for one consumer equaled the marginal rate of substitution for the other. The equality of the marginal rates of substitution is the necessary condition for consumption to be efficient. The concept was extended to many consumers; in general, an efficient distribution of goods requires the marginal rates of substitution between any two goods are equal for all consumers: MRS 1 = MRS 2 = …= MRS i . 19.4 Efficiency in Production Efficiency in production can be analyzed in a similar fashion to efficiency in consumption. An Edgeworth production box is a diagram identifying all of the ways two inputs, such as land and labor, can be allocated between industries in a simplified economy. The Edgeworth production box is analogous to the Edgeworth exchange box presented in Chapter 6. An Edgeworth production box is depicted by Figures 19.3 and 19.4 in the text. The contract curve is the locus of points at which an isoquant for food is tangent to an isoquant for clothing.

CHAPTER 19: General Equilibrium Analysis and Economic Efficiency 357 Any point on the contract curve is a possible equilibrium point because the condition of cost minimization, w/ υ = MP L /MP A = MRTS LA , is met. While the contract curve in an Edgeworth exchange box with indifference curves is the locus of equilibria that are efficient distribution of goods, the contract curve in an Edgeworth production box with isoquants is the locus of equilibria that are efficient allocations of inputs. At every point on the contract curve, the marginal rate of technical substitution for the production of one good equals the marginal rate of technical substitution for the production of the other good. 19.5 The Production Possibility Frontier and Efficiency in Output Figure 19-1 provides a contract curve for the production of wine and corn. Each point on the contract curve corresponds to a specific rate of wine and corn production that uses all the available land and labor. Figure 19-2 presents a production possibility frontier, which shows the alternative combinations of wine and corn that can be produced with the available land and labor. Each point on the contract curve corresponds to a point on the production possibility frontier. That is, point A in Figure 19-1 corresponds to point A in Figure 19-2, B to B, and so on. The slope of the production possibility frontier is called the marginal rate of transformation (MRT) which measures the rate at which one product can be “transformed” into another. If we are on the production possibility frontier it implies production is efficient.

Study Guide to accompany Microeconomics: Theory and Applications , Eleventh Edition 358 To produce an efficient output requires that the subjective preferences of consumers be balanced with the objective conditions of production. This condition is met when the slope of the production possibility frontier equals the marginal rates of substitution between the products. Since the marginal rates of substitution equal the price ratio, the marginal rate of transformation also equals the price ratio, MRS = MRT. Figure 19.6 in the text provides a graphical representation of this concept. Price equals marginal cost in a competitive industry, so we know that P c = MC c , P w = MC w , and MC w /MC c = P w /P c . That is, the ratio of each product's marginal cost equals the ratio of prices. The ratio of monetary marginal costs is the slope of the production possibility frontier, and the ratio of prices is the slope of the consumer budget line. Since consumers equate their MRS wc to the price ratio, the MRS of a consumer is equal to the MRT. When the total quantities of wine and corn demanded by all consumers equal the quantities produced, at the prevailing prices, the product markets are in equilibrium. 19.6 Competitive Markets and Economic Efficiency In general, economists are advocates of perfect competition because it satisfies all three conditions for economic efficiency. First, since each consumer equates his or her MRS with the price ratio, and the price ratio is the same for everyone, the MRSs of everyone will be equal. Therefore, this implies there is an efficient distribution of goods among consumers. Second, when each firm minimizes cost, it equates the marginal rate of technical substitution between the inputs to the input price ratio. Under competition, all firms face the same input prices, so the MRTS is the same for all firms. When the MRTS is the same for all firms, there is efficiency in production.

CHAPTER 19: General Equilibrium Analysis and Economic Efficiency 359 Finally, perfectly competitive firms equate price and marginal cost. The ratio of prices is equal to the MRS and the ratio of marginal costs is equal to the MRT. Therefore, the MRS is equal to the MRT, implying the efficient output is achieved and perfect competition is efficient. The chart below summarizes the conditions and criteria necessary for economic efficiency. Efficiency Conditions Criteria 1. Distribution of products MRS H wc = MRS S wc among consumers must be efficient. 2. Allocation of inputs must MRTS C LA = MRTS W LA be efficient. 3. The output mix must be efficient. MRS wc = MRT wc 19.7 The Causes of Economic Inefficiency A market may fail to attain Pareto optimality for several reasons. For example, economic inefficiency occurs when firms have market power. For a monopoly, price exceeds marginal cost which violates the condition for efficient output. If there are two goods, x and y, and one is monopolized (x), then P x /P y > MC x /MC y . Consumers equate their MRSs to the price ratio, so MRS yx = P x /P y . The ratio of the marginal costs equals the MRT. This implies MRS yx > MRT yx . Three other circumstances that prevent economic efficiency are imperfect competition, externalities, and public goods. Chapter 20 examines these situations in more detail. ILLUSTRATIONS Ecology and Economics Ecology is a branch of biology that deals with the relationships of organisms to their environment and to other organisms. Equilibrium will exist when the populations of the various organisms are constant over time. When this balance of nature is disrupted, the effects can be great. Suppose, for example, there are farmers and sheep ranchers near a wilderness area. Coyotes occasionally raid the flocks of sheep and kill off some of the sheep. The shepherds may seek to eliminate the coyote population. If they use a partial equilibrium analysis, they may conclude that eliminating the coyotes will save the lives of sheep but have no other effects. A general equilibrium approach recognizes that there are other effects. Coyotes also feed on rabbits and rodents. Extermination of coyotes will result in an increase in the population of rabbits and rodents, which may increase the rate at which crops are destroyed. Rodents carry diseases that may ultimately infect the sheep and reduce the size of the flocks. Given the interrelationship of the organisms in the environment, policies that are designed to affect one organism only will likely affect many other organisms as well. Similarly, policies designed to affect one economic

Study Guide to accompany Microeconomics: Theory and Applications , Eleventh Edition 360 market are likely to affect many other markets as well. Consumer Sovereignty The notion of consumer sovereignty is that a competitive market economy produces the goods and services that consumers want. Of course, this does not imply that each and every consumer is able to buy every type of good they want. Some things, such as vacations to the moon, are too costly to produce. Markets generally do not produce goods that only a few people want because the cost of production would be too high. There are critics of market organization who claim that the market fails to produce what people "really" want, or need. Instead, the market provides things people really do not want but are persuaded to buy through heavy advertising. Technically, the model of perfect competition assumes perfect information so there is no role for advertising in competitive markets. However, the real world is characterized by imperfect information and advertising provides a useful role. However, there are numerous examples of heavily-advertised products that failed to garner a market. A prominent example was the Edsel, introduced by Ford a number of years ago. A more recent example is the XFL. The football league was sponsored by a successful wrestling company, shown on two networks, and heavily advertised. After obtaining decent ratings at first, the ratings steadily declined as consumers decided in large numbers that they did not want the XFL. Consequently, the XFL failed in spite of heavy advertising. KEY CONCEPTS general equilibrium analysis partial equilibrium analysis spillover effect feedback effect Pareto optimality efficient Inefficient welfare frontier Edgeworth production box marginal rate of transformation REVIEW QUESTIONS True/False 1. The difference between general equilibrium analysis and partial equilibrium analysis is the extent to which market interrelationships are considered. 2. If we are interested in only one market, then spillover effects are important only if they generate feedback effects. 3. Every point on the welfare frontier is efficient.

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