Outline of Chapter 5

1
Outline of Chapter 5

• Competitive Equilibrium (CE) in the One Period
  Model
• Government
• Optimality of the CE
• Responses of Firms and Consumers to Shocks
  (exogenous variables)

2

• Government
• Purchases Goods (G) which represent public goods.
  
• In principle these good provide benefits to our
  representative consumer through the utility
  function.
• The government pays for its goods with lump sum
  taxes (T). We can view this as taking real
  resources from the private sector
• Govt Budget Constraint G T

3

• Competitive Equilibrium (CE)
• A CE is a set of quantities and prices such that
• 1) Markets Clear (demandsupply)
• labor market
• 2) All participants in the model are
  optimizing
• consumers
• firms
• 3) All budget constraints are satisfied
• consumer
• Firm
• government

4

• Optimality
• The production possibilities frontier (PPF) tell
  us the maximal quantities of each good that we
  can produce
• We derive the economies PPF using the
  production function
• Firm optimization implies that we will produce at
  the point where the slope of the PPF (or minus
  the slope of production function) is equal to the
  negative of the real wage (which also happens to
  be the slope of the consumers budget constraint)
• This implies that in the CE the consumers
  marginal rate of substitution is being set equal
  to the economies marginal rate of transformation

5

• Can we improve on the allocation of resources in
  the economy?
• What would a benevolent dictator choose?
• Definition A Pareto Efficient Allocation is one
  in which there is no way to reallocate resources
  to make some people better off without making
  others worse off
• The first fundamental welfare theorem states that
  under certain conditions a competitive
  equilibrium is pareto optimal
• What is the role for government?
• What are the conditions under which the theorem
  holds?
• The idea of Pareto Optimality helps us think
  about whether or not a CE is a good outcome.

6

• The CE in our one period model
• We remain at the CE unless there is some
  exogenous disturbance to the model
• After an exogenous shock to the model the
  endogenous variables adjust (instantaneously) to
  reach a new equilibrium
• Example 1 Productivity Shock
• Example 2 Government Spending Shock
• Can these exogenous shocks explain business cycle
  facts?
• What are the implications for the role of
  government?