General Equilibrium, Market Failure, Economic Efficiency

1
Chapter 16

• General Equilibrium, Market Failure, Economic
  Efficiency

2
Topics to be Discussed

• General Equilibrium Analysis
• Efficiency in Exchange
• Equity and Efficiency
• Efficiency in Production

3
Topics to be Discussed

• The Gains from Free Trade
• An Overview The Efficiency of Competitive
  Markets
  
• Why Markets Fail

4
General Equilibrium Analysis

• Up to this point, we have been focused on partial
  equilibrium analysis
  
• Activity in one market has little or no effect on
  other markets
  
• Market interrelationships can be important
• Complements and substitutes
• Increase in firms input demand can cause market
  price of the input and product to rise

5
General Equilibrium Analysis

• To study how markets interrelate, we can use
  general equilibrium analysis
  
• Simultaneous determination of the prices and
  quantities in all relevant markets, taking into
  account feedback effects
  
• The feedback effect is the price or quantity
  adjustment in one market caused by price and
  quantity adjustments in related markets

6
Two Interdependent Markets Moving to General
Equilibrium

• Scenario
• The competitive markets of
• DVD rentals
• Movie theater tickets
• These goods are substitutes
• Changing prices in one market are likely to
  affect the other market

7
Two Interdependent Markets Moving to General
Equilibrium

• Scenario
• Equilibrium price of movies is 6.00
• Equilibrium price of DVD rentals is 3.00
• Government places a 1.00 tax on each movie
  ticket
  
• Need to look at effect of tax on
• Market for DVDs
• Feedback effects in movie market

8
Two Interdependent Markets Movies and DVDs
1 tax on each movie ticket causes supply to fall
General Equilibrium Analysis Increase in movie t
icket prices
increases demand for videos.
Price
Price
Number of Videos
Number of Movie Tickets
9
Two Interdependent Markets Movies and DVDs
The increase in the price of videos increases the

demand for movies.
General Equilibrium Analysis The Feedback effect
s continue.
Price
Price
Number of Videos
10
Two Interdependent Markets Movies and DVDs

• 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
  
• You can check for yourself that in the market for
  complements, the tax would be overestimated

11
Reaching General Equilibrium

• Must be able to determine the equilibrium price
  of both movies and DVDs simultaneously
  
• We must simultaneously find two prices that
  equate quantity demanded and quantity supplied in
  all related markets
  
• The requires finding the solution to four
  equations demand and supply for DVDs and movies

12
Efficiency in Exchange

• We showed before that competitive markets are
  efficient because consumer and producer surpluses
  are maximized
  
• We can study this in more detail by examining an
  exchange economy
  
• Market in which two or more consumers trade two
  goods among themselves
  
• Same for two countries

13
Efficiency in Exchange

• An efficient allocation of goods is one where no
  one can be made better off without making someone
  else worse off
  
• Pareto efficiency
• Voluntary trade between two parties is mutually
  beneficial and increases economic efficiency

14
The Advantages of Trade

• Assumptions
• Two consumers (countries)
• Two goods
• Both people know each others preferences
• Exchanging goods involves zero transaction costs
• James and Karen have a total of 10 units of food
  and 6 units of clothing

15
The Advantage of Trade

• To determine if they are better off, we need to
  know the preferences for food and clothing

16
The Edgeworth Box Diagram

• A diagram showing all possible allocations of
  either two goods between two people or of two
  inputs between two production processes is called
  an Edgeworth Box

17
The Edgeworth Box Diagram

• Food is measured across the horizontal axis
• Clothing is measured on the vertical axis
• Length of box is the total amount of food 10
  units
  
• Height of box is the total amount of clothing 6
  units

18
The Edgeworth Box Diagram

• Each point describes the market baskets of both
  consumers
  
• James basket is read from origin OJ
• Karens basket is read from origin OK, in the
  reverse direction
  
• James has 7 units of food and 1 unit of clothing
  point A
  
• Karen has 3 units of food and 5 units of clothing
  point A from different axis

19
Exchange in an Edgeworth Box
10F
0K
6C
The initial allocation before trade is A James
has 7F and 1C Karen has 3F and 5C.
6C
0J
10F
20
Efficiency in Exchange
10F
0K
6C
A UJ1 UK1, but the MRS is not equal. All com
binations in the shaded area are preferred to A
.
6C
0J
10F
21
Efficiency in Exchange
10F
0K
6C
D is also a possible efficient allocation
depending on bargaining
At point C, MRSs are equal and allocation is
efficient
Point B is on higher IC but is not efficient
6C
0J
10F
22
Efficiency in Exchange

• 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

23
Consumer Equilibrium in a Competitive Market
10F
0K
Karens Food
6C
Begin at A Each James buys 2C and sells 2F movi
ng from UJ1 to UJ2, which
is preferred (A to C).
Begin at A Each Karen buys 2F and sells 2C movin
g from
UK1 to UK2, which is preferred (A to C).
Karens Clothing
James Clothing
6C
0J
10F
James Food
24
The Contract Curve
Karens Food
0K
E, F, G are Pareto efficient.
James Clothing
Karens Clothing
0J
James Food
25
Contract Curve

• All points of tangency between the indifference
  curves are efficient
  
• MRS of individuals is the same
• No more room for trade
• The contract curve shows all allocations that are
  Pareto efficient
  
• Pareto efficient allocation occurs when further
  trade will make someone worse off

26
Consumer Equilibrium in a Competitive Market

• The amount of clothing that Karen wanted to sell
  is equal to the amount of clothing that James
  wanted to buy
  
• An equilibrium is a set of prices at which the
  quantity demanded equals the quantity supplied in
  every market
  
• Also called competitive equilibrium

27
Consumer Equilibrium in a Competitive Market

• Not all prices lead to equilibrium
• Disequilibrium is only temporary in a competitive
  market
  
• Excess demand will cause price to rise
• Excess supply will cause price to fall
• In our example, we have excess supply of clothing
  and excess demand of food
  
• Should expect the price of food to increase
  relative to price of clothing
  
• Prices adjust until equilibrium is reached

28
Consumer Equilibrium in a Competitive Market

• In a general equilibrium setting where all
  markets are perfectly competitive, we can show
  the same result
  
• Best example of Adam Smiths invisible hand
• Economy will automatically allocate all resources
  efficiently without need for regulatory control
  
• Supports argument for less government
  intervention and more highly competitive markets

29
Consumer Equilibrium in a Competitive Market

• Competitive equilibrium
• Because the indifference curves are tangent, all
  MRSs are equal between consumers
  
• Because each indifference curve is tangent to the
  price line, each persons MRS is equal to the
  price ratio of the two goods

30
Equity and Efficiency

• Although there are many efficient allocations,
  some may be more fair than others
  
• The difficult question is, what is the most
  equitable allocation?
  
• We can show that there is no reason to believe
  that efficient allocation from competitive
  markets will give an equitable allocation

31
Four Views of Equity
32
Equity and Perfect Competition

• A competitive equilibrium can occur at any point
  on the contract curve depending on the initial
  allocation
  
• Since not all competitive equilibriums are
  equitable, we rely on the government to help
  reach equity by redistributing income
  
• Taxes
• Public services

33
Equity and Perfect Competition

• Any equilibrium that is equitable can be achieved
  by redistributing resources and may be efficient
  
• Typical ways to redistribute goods, however, are
  costly
  
• Taxes lead to bad incentives
• Firms devote fewer resources to production in
  order to avoid taxes
  
• Encourage individuals to work less

34
Efficiency in Production

• From the discussion of exchange of two goods, we
  can extend to the efficient use of inputs used
  for production
  
• Assume
• Two fixed inputs capital and labor
• Produce same two goods food and clothing
• Many consumers own inputs to production and earn
  income from selling them
  
• Income allocated between goods

35
Production in an Edgeworth Box
50L
0C
30K
The initial allocation is A. Every combination of
labor and capital used to produce two goods is
represented as a point in the box.
30K
0F
50L
36
Production in an Edgeworth Box
50L
15L
0C
30K
3 isoquants representing food production
3 isoquants representing food and clothing
production
5K
25K
30K
0F
50L
35L
37
Production in an Edgeworth Box
50L
15L
0C
30K
Production Contract Curve
5K
25K
30K
0F
50L
35L
38
Producer Equilibrium Competitive Input Markets

• We saw before that if producers minimize costs,
  they will choose inputs to the point where the
  ratio of the marginal products of the two inputs
  is equal to the ratio of input prices

39
Producer Equilibrium Competitive Input Markets

• Ratio of marginal products is the same as the
  marginal rate of technical substitution of labor
  for capital

40
Why Markets Fail

• Market Power
• Those with market power choose the price and
  quantity
  
• Less output is sold than in competitive markets
• Inefficiency
• Can have market power as producers or as inputs

41
Why Markets Fail

• Incomplete Information
• Consumers must have accurate information about
  market prices or production quality for markets
  to operate efficiently
  
• Lack of information can change supply
• Buy products with no value
• Dont buy enough of products with value
• Some markets may never develop

42
Why Markets Fail

• Externalities
• Market prices do not always reflect the
  activities of either producers or consumers
  
• Consumption or production has indirect effect on
  other consumption or production not reflected in
  market prices
  
• May be impossible to get insurance because
  suppliers of insurance lack information

43
Why Markets Fail

• Public Goods
• Nonexclusive, nonrival goods that can be made
  available cheaply but which, once available, are
  difficult to prevent others from consuming
  
• Company thinking about researching a new
  technology if cant get patent
  
• Once its made pubic, others can duplicate it