Chapter 16
General
Equilibrium and
Economic
Efficiency
Chapter 16 Slide 2
Topics to be Discussed
? General Equilibrium Analysis
? Efficiency in Exchange
? Equity and Efficiency
? Efficiency in Production
Chapter 16 Slide 3
Topics to be Discussed
? The Gains from Free Trade
? On Overview--The Efficiency of
Competitive Markets
? Why Markets Fail
Chapter 16 Slide 4
General Equilibrium Analysis
? Partial equilibrium analysis presumes
that activity in one market is
independent of other markets,
Chapter 16 Slide 5
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 6
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 7
General Equilibrium Analysis
? Two Interdependent Markets--Moving
to General Equilibrium
? Scenario
?The competitive markets of,
? Videocassette rentals
? Movie theater tickets
DV DM
Two Interdependent Markets,
Movie Tickets and Videocassette Rentals
Price
Number
of Videos
Price
Number of
Movie Tickets
SM SV
$6.00
QM QV
$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,
DV DM
Two Interdependent Markets,
Movie Tickets and Videocassette Rentals
Price
Number
of Videos
Price
Number of
Movie Tickets
SM SV
$6.00
QM QV
$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 10
? 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 Videocassette Rentals
Chapter 16 Slide 11
? 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 12
The Interdependence
of International Markets
? Brazil and the United States export
soybeans and are,therefore,
interdependent,
? Brazil limited exports in the late
1960’s and early 1970’s,
? Eventually the export controls were to
be removed,and Brazilian exports
were expected to increase,
Chapter 16 Slide 13
? Partial Analysis
? Brazilian domestic soybean price will fall
and domestic demand for soybean
products would increase,
The Interdependence
of International Markets
Chapter 16 Slide 14
? General Analysis
? In the U.S,the price of soybeans and
output would increase; U.S,exports
would increase and Brazilian exports
would fall (even after regulations
ended),
The Interdependence
of International Markets
Chapter 16 Slide 15
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 16
Efficiency in Exchange
? Assumptions
? Two consumers (countries)
? 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 17
The Advantage of Trade
James 7F,1C -1F,+1C 6F,2C
Karen 3F,5C +1F,-1C 4F,4C
Individual Initial Allocation Trade Final Allocation
Karen’s MRS of food for clothing is 3,
James’s MRS of food for clothing is 1/2,
Karen and James are willing to trade,Karen
trades 1C for 1F,When the MRS is not equal,
there is gain from trade,The economically
efficient allocation occurs when the MRS is equal,
Chapter 16 Slide 18
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 0K
0J
6C
10F
6C
James’s
Clothing
Karen’s
Clothing
Karen’s Food
James’s 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 20
Efficiency in Exchange
? Efficient Allocations
? If James’s and Karen’s MRS are the
same at B the allocation is efficient,
?This depends on the shape of their
indifference curves,
Chapter 16 Slide 21
A
A,UJ1 = UK1,
but the MRS
is not equal,
All combinations
in the shaded
area are
preferred to A,
Gains from
trade
Karen’s
Clothing
Karen’s Food
UK1 UK2 UK3
James’s
Clothing
James’s Food
UJ1
UJ2
UJ3 B
C
D
Efficiency in Exchange
10F 0K
0J
6C
10F
6C
Chapter 16 Slide 22
A
Karen’s
Clothing
Karen’s Food
UK1 UK2 UK3
James’s
Clothing
James’s Food
UJ1
UJ2
UJ3 B
C
D
Efficiency in Exchange
10F 0K
0J
6C
10F
6C
Is B efficient?
Hint,is the
MRS equal
at B?
Is C efficient?
and D?
Chapter 16 Slide 23
Efficiency in Exchange
A
Karen’s
Clothing
Karen’s Food
UK1 UK2 UK3
James’s
Clothing
James’s Food
UJ1
UJ2
UJ3 B
C
D
10F 0K
0J
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 24
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 25
The Contract Curve
0J
James’s
Clothing
Karen’s
Clothing
0K Karen’s Food
James’s Food
E
F
G
Contract
Curve
E,F,& G are
Pareto efficient, If
a change improves
efficiency,everyone
benefits,
Chapter 16 Slide 26
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 27
Efficiency in Exchange
? Application,The policy implication of
Pareto efficiency when removing import
quotas,
1) Remove quotas
? Consumers gain
? Some workers lose
2) Subsidies to the workers that cost less
than the gain to consumers
Chapter 16 Slide 28
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 29
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)
UK1 UK2
P
Price Line
P’
PP’ is the price line
and shows possible
combinations; slope is -1
UJ1
UJ2
Competitive Equilibrium
10F 0K
0J
6C
10F
6C
James’s
Clothing
Karen’s
Clothing
Karen’s Food
James’s 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),
UK1 UK2
P
Price Line
P’
UJ1
UJ2
Competitive Equilibrium
10F 0K
0J
6C
10F
6C
James’s
Clothing
Karen’s
Clothing
Karen’s Food
James’s 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 32
Efficiency in Exchange
? Scenario
? PF and PC = 3
? James’s MRS of clothing for food is 1/2,
? Karen’s 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 33
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 34
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 35
Competitive Equilibrium
10F 0K
0J
6C
10F
6C
James’s
Clothing
Karen’s
Clothing
Karen’s Food
James’s Food
P
Price Line
UJ1
UK1
A
P’
UJ2
UK2
C
Chapter 16 Slide 36
Efficiency in Exchange
? Observations concerning C,
1) Since the two indifference curves
are tangent,the competitive
equilibrium allocation is efficient,
2) The MRSCF is equal to the ratio of
the prices,or MRSJFC = PC/PF =
MRSKFC,
Chapter 16 Slide 37
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 38
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 39
Efficiency in Exchange
? Policy Issues
? What is the role of government?
Chapter 16 Slide 40
Equity and Efficiency
? Is an efficient allocation also an
equitable allocation?
? Economists and others disagree about
how to define and quantify equity,
Chapter 16 Slide 41
Equity and Efficiency
? The Utility Possibilities Frontier
? Indicates
?the level of satisfaction that each of
two people achieve when they have
traded to an efficient outcome on the
contract curve,
?all allocations that are efficient,
Chapter 16 Slide 42
H
*Movement from one
combination to another
(E to F) reduces one
persons utility,
*All points on the frontier
are efficient,
Utility Possibilities Frontier
James’s Utility
OJ
OK
E
F
G
Karen’s
Utility
L
*Any point inside the
frontier (H) is inefficient,
*Combinations beyond the
frontier (L) are not
obtainable,Lets compare
H to E and F,
Chapter 16 Slide 43
Equity and Efficiency
? E & F are efficient,
? Compared to H,E &
F make one person
better off without
making the other
worse off,
James’s Utility
Karen’s
Utility
OJ
OK
E
F
H
G
Chapter 16 Slide 44
Equity and Efficiency
? Is H equitable?
? Assume the only
choices are H & G
? Is G more equitable?
It depends on
perspective,
? At G James total utility
> Karen’s total utility
James’s Utility
Karen’s
Utility
OJ
OK
E
F
H
G
Chapter 16 Slide 45
Equity and Efficiency
? Is H equitable?
? Assume the only
choices are H & G
? Is G more equitable?
It depends on
perspective,
? H may be more
equitable because the
distribution is more
equal,therefore,an
inefficient allocation
may be more equitable,James’s Utility
Karen’s
Utility
OJ
OK
E
F
H
G
Chapter 16 Slide 46
Equity and Efficiency
? Social Welfare Functions
? Used to describe the particular weights
that are applied to each individual’s
utility in determining what is socially
desirable
Chapter 16 Slide 47
Four Views of Equity
? Egalitarian
? All members of society receive equal
amounts of goods
? Rawlsian
? Maximize the utility of the least-well-off
person
Chapter 16 Slide 48
Four Views of Equity
? Utilitarian
? Maximize the total utility of all members
of society
? Market-oriented
? The market outcome is the most
equitable
Chapter 16 Slide 49
Equity and Efficiency
? The Social Welfare Function and
Equity
? Equity is dependent on a normative
priority ranging from Egalitarian to
Market-orientation,
Chapter 16 Slide 50
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 51
Equity and Efficiency
? Points on the frontier
are Pareto efficient,
? OJ & OK are perfect
unequal distributions
and Pareto efficient,
? To achieve equity
(more equal
distribution) must the
allocation be
efficient?
James’s Utility
Karen’s
Utility
OJ
OK
Chapter 16 Slide 52
Equity and Efficiency
? Second Theorem of Welfare
Economics
? If individual preferences are convex,
then every efficient allocation is a
competitive equilibrium from some initial
allocation of goods,
Chapter 16 Slide 53
Equity and Efficiency
? Second Theorem of Welfare
Economics
? Consider the cost of programs to
redistribute income and the trade off
between equity and efficiency,
Chapter 16 Slide 54
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 55
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 56
Efficiency in Production
? Production in the Edgeworth Box
? The Edgeworth box can be used to
measure inputs to the production
process,
Chapter 16 Slide 57
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
?OF = Food
?OC = Clothing
60F
50F
40L 30L
Labor in clothing production
Efficiency in Production
50L 0C
0F
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 59
Efficiency in Production
? Producer Equilibrium in a
Competitive Input Market
? Competitive markets create a point of
efficient production,
Chapter 16 Slide 60
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
? MPL/MPK = w/r
? w/r = MRTSLK
? 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 0C
0F
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 62
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 63
Production Possibilities Frontier
Food
(Units)
Clothing
(units)
OF & OC
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
OF
OC
B
C
D
Chapter 16 Slide 64
Production Possibilities Frontier
Food
(Units)
Clothing
(units)
60
100
OF
OC
A
B
C
D
B
1C
1F
D
2C
1F
MRT = MCF/MCC
The marginal rate of
transformation (MRT)
is the slope of the
frontier at each point,
Chapter 16 Slide 65
Efficiency in Production
? Output Efficiency
? Goods must be produced at minimum
cost and must be produced in
combinations that match people’s
willingness to pay for them,
?Efficient output and Pareto efficient
allocation
?Occurs where MRS = MRT
Chapter 16 Slide 66
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 67
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 68
Efficiency in Production
? Efficiency in Output Markets
? Consumer’s Budget Allocation
? Profit Maximizing Firm
?
CF PP M R S ?
CCFF MCP a n d MCP ??
M R S
MC
MC M R T
C
F ???
C
F
P
P
Chapter 16 Slide 69
U2
),( @ M R T/ 1111 FCAPP CF ?
Competition and Output Efficiency
Food
(Units)
Clothing
(units)
60
100
A C
1
F1
B
C2
F2
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
PF = PF* and PC = PC*;
MRT = MRS; QD = QS for
food and clothing,U1
Chapter 16 Slide 70
The Gains from Free Trade
? Comparative Advantage
? Country 1 has a comparative advantage
over country 2 in producing a good if the
cost of producing that good,relative to
the cost of producing other goods,in 1,
is lower that the cost of producing the
good in 2,relative to the cost of
producing other goods in 2,
Chapter 16 Slide 71
The Gains from Free Trade
? Comparative Advantage
? Comparative advantage is a relative
measurement,not absolute,
? A country with an absolute advantage in
the production of all goods will not have
a comparative advantage in the
production of all goods,
?Example,Holland and Italy produce
cheese and wine
Chapter 16 Slide 72
Hours of Labor Required to Produce
Holland 1 2
Italy 6 3
Cheese
(1 lb.)
Wine
(1 gal.)
Holland has an absolute
advantage in both products,
Chapter 16 Slide 73
Hours of Labor Required to Produce
Holland 1 2
Italy 6 3
Cheese
(1 lb.)
Wine
(1 gal.)
Holland’s comparative advantage
over Italy is in cheese,the cost of cheese
is 1/2 the cost of wine and Italy’s cost of
cheese is twice the cost of wine,
Chapter 16 Slide 74
Hours of Labor Required to Produce
Holland 1 2
Italy 6 3
Cheese
(1 lb.)
Wine
(1 gal.)
Italy’s comparative advantage is wine,
which is half the cost of cheese,
Chapter 16 Slide 75
Hours of Labor Required to Produce
Holland 1 2
Italy 6 3
Cheese
(1 lb.)
Wine
(1 gal.)
Without Trade,Assume PW = PC in Holland & Italy,
Holland has 24 hrs,of labor--max,wine = 12 gals &
max,cheese = 24 lbs,or a combination
Chapter 16 Slide 76
Hours of Labor Required to Produce
Holland 1 2
Italy 6 3
Cheese
(1 lb.)
Wine
(1 gal.)
With Trade,Italy produces 8 gal,and
trades 6; consumes 6 lbs,and 2 gals,
Without Trade,3 lbs,and 2 gals,
Chapter 16 Slide 77
Pre-trade
prices
U1
The Gains from Trade
Wine
(gallons)
Cheese
(pounds)
A
Without trade,production &
consumption at A in Holland,
MRT = Pw/PC = 2 World prices
B
CB
WB
With trade (assume relative
price Pw = PC),Produce
at B,MRT = 1
CD
WD
D
U2
Consumption at D after trade,
Holland imports the wind
and exports cheese,
Who gains and who
loses from trade?
Chapter 16 Slide 78
The Effects of Automobile Import Quotas
? A Changing Automobile Market
? Imports (as a percentage of domestic sales)
? 1965 -- 6.1%
? 1980 -- 28.8%
? In 1981 a voluntary export restraint (VER) was
negotiated,
? In 1980 Japan exported 2.5 million cars to
the U.S,
? In 1981 with the VER exports fell to 1.68
million cars,
Chapter 16 Slide 79
? Measuring the Impact of the VER
1) Japanese car prices rose nearly
$1,000/car in 1981-1982,and
revenue increase by $2 billion,
2) Demand for U.S,cars increased
U.S,profits by $10 billion
The Effects of Automobile Import Quotas
Chapter 16 Slide 80
? Measuring the Impact of the VER
3) U.S,car prices were $350 to
$400/auto higher than they would
have been without VER,or
consumers were worse off by $3
billion,
4) U.S,sales rose by 500,000 units
creating about 26,000 jobs,
The Effects of Automobile Import Quotas
Chapter 16 Slide 81
? Measuring the Impact of the VER
5) Cost/Job = $4.3 billion (consumer
cost)/26,000 jobs)
= $160,000
The Effects of Automobile Import Quotas
Quantifying the Costs of Protection
Producer Gains Consumer Losses Efficiency Losses
Industry ($ millions) ($millions) ($millions)
Book manufacturing 305 500 29
Orange juice 390 525 130
Textiles an apparel 22,000 27,000 4,850
Carbon steel 3,800 6,800 330
Color televisions 190 420 7
Sugar 550 930 130
Dairy products 5,000 5,500 1,370
Meat 1,600 1,800 145
Chapter 16 Slide 83
An Overview---The Efficiency
of Competitive Markets
? Conditions Required for Economic
Efficiency
? Efficiency in Exchange
K
FC
J
FC M R SM R S ?
Chapter 16 Slide 84
? Conditions Required for Economic
Efficiency
? Efficiency in Exchange (for a
competitive market)
K
FCCF
J
FC M R SPPM R S ?? /
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 85
? Conditions Required for Economic
Efficiency
? Efficiency in the Use of Inputs in
Production
C
LKM R T SM R T S ?
F
LK
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 86
? Conditions Required for Economic
Efficiency
? Efficiency in the Use of Inputs in
Production (for a competitive market)
C
LKM R T S/M R T S ?? rw
F
LK
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 87
? Conditions Required for Economic
Efficiency
? Efficiency in the Output Market
c o n s u m e rs ) a l l( fo r FCFC M R SM R T ?
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 88
? Conditions Required for Economic
Efficiency
? Efficiency in the Output Market (in a
competitive market)
CFCF
CFF
PP
PP
/MC/MC M R T
MC,MC
FC
C
??
??
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 89
? Conditions Required for Economic
Efficiency
? However,consumers maximize their
satisfaction in competitive markets
only if
FCFC
FCCF PP
M R T M R S T h e r e f o r e,
c o n s u m e r s ) a l l( f o r M R S /
?
?
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 90
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 91
Why Markets Fail
? Market Power
? Monopsony in the labor market
?Restricted supply of labor in food
?wf would rise,wL would fall
?Clothing input,
?Food input,
rw cCLK /M R T S ?
CLKcFFLK rwrw M R T S //M R T S ???
Chapter 16 Slide 92
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 93
Why Markets Fail
? Public Good
? Markets undersupply public goods
because of difficulty associated with
measuring consumption,
Chapter 16 Slide 94
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 95
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 96
Summary
? Because a competitive equilibrium need
not be equitable,the government may
wish to help redistribute wealth from rich to
poor,
? 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 97
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,
Chapter 16 Slide 98
Summary
? Free international trade expands a
country’s production possibilities
frontier,
? Competitive markets may be
inefficient for one or more of four
reasons,
End of Chapter 16
General
Equilibrium and
Economic
Efficiency
General
Equilibrium and
Economic
Efficiency
Chapter 16 Slide 2
Topics to be Discussed
? General Equilibrium Analysis
? Efficiency in Exchange
? Equity and Efficiency
? Efficiency in Production
Chapter 16 Slide 3
Topics to be Discussed
? The Gains from Free Trade
? On Overview--The Efficiency of
Competitive Markets
? Why Markets Fail
Chapter 16 Slide 4
General Equilibrium Analysis
? Partial equilibrium analysis presumes
that activity in one market is
independent of other markets,
Chapter 16 Slide 5
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 6
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 7
General Equilibrium Analysis
? Two Interdependent Markets--Moving
to General Equilibrium
? Scenario
?The competitive markets of,
? Videocassette rentals
? Movie theater tickets
DV DM
Two Interdependent Markets,
Movie Tickets and Videocassette Rentals
Price
Number
of Videos
Price
Number of
Movie Tickets
SM SV
$6.00
QM QV
$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,
DV DM
Two Interdependent Markets,
Movie Tickets and Videocassette Rentals
Price
Number
of Videos
Price
Number of
Movie Tickets
SM SV
$6.00
QM QV
$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 10
? 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 Videocassette Rentals
Chapter 16 Slide 11
? 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 12
The Interdependence
of International Markets
? Brazil and the United States export
soybeans and are,therefore,
interdependent,
? Brazil limited exports in the late
1960’s and early 1970’s,
? Eventually the export controls were to
be removed,and Brazilian exports
were expected to increase,
Chapter 16 Slide 13
? Partial Analysis
? Brazilian domestic soybean price will fall
and domestic demand for soybean
products would increase,
The Interdependence
of International Markets
Chapter 16 Slide 14
? General Analysis
? In the U.S,the price of soybeans and
output would increase; U.S,exports
would increase and Brazilian exports
would fall (even after regulations
ended),
The Interdependence
of International Markets
Chapter 16 Slide 15
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 16
Efficiency in Exchange
? Assumptions
? Two consumers (countries)
? 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 17
The Advantage of Trade
James 7F,1C -1F,+1C 6F,2C
Karen 3F,5C +1F,-1C 4F,4C
Individual Initial Allocation Trade Final Allocation
Karen’s MRS of food for clothing is 3,
James’s MRS of food for clothing is 1/2,
Karen and James are willing to trade,Karen
trades 1C for 1F,When the MRS is not equal,
there is gain from trade,The economically
efficient allocation occurs when the MRS is equal,
Chapter 16 Slide 18
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 0K
0J
6C
10F
6C
James’s
Clothing
Karen’s
Clothing
Karen’s Food
James’s 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 20
Efficiency in Exchange
? Efficient Allocations
? If James’s and Karen’s MRS are the
same at B the allocation is efficient,
?This depends on the shape of their
indifference curves,
Chapter 16 Slide 21
A
A,UJ1 = UK1,
but the MRS
is not equal,
All combinations
in the shaded
area are
preferred to A,
Gains from
trade
Karen’s
Clothing
Karen’s Food
UK1 UK2 UK3
James’s
Clothing
James’s Food
UJ1
UJ2
UJ3 B
C
D
Efficiency in Exchange
10F 0K
0J
6C
10F
6C
Chapter 16 Slide 22
A
Karen’s
Clothing
Karen’s Food
UK1 UK2 UK3
James’s
Clothing
James’s Food
UJ1
UJ2
UJ3 B
C
D
Efficiency in Exchange
10F 0K
0J
6C
10F
6C
Is B efficient?
Hint,is the
MRS equal
at B?
Is C efficient?
and D?
Chapter 16 Slide 23
Efficiency in Exchange
A
Karen’s
Clothing
Karen’s Food
UK1 UK2 UK3
James’s
Clothing
James’s Food
UJ1
UJ2
UJ3 B
C
D
10F 0K
0J
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 24
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 25
The Contract Curve
0J
James’s
Clothing
Karen’s
Clothing
0K Karen’s Food
James’s Food
E
F
G
Contract
Curve
E,F,& G are
Pareto efficient, If
a change improves
efficiency,everyone
benefits,
Chapter 16 Slide 26
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 27
Efficiency in Exchange
? Application,The policy implication of
Pareto efficiency when removing import
quotas,
1) Remove quotas
? Consumers gain
? Some workers lose
2) Subsidies to the workers that cost less
than the gain to consumers
Chapter 16 Slide 28
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 29
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)
UK1 UK2
P
Price Line
P’
PP’ is the price line
and shows possible
combinations; slope is -1
UJ1
UJ2
Competitive Equilibrium
10F 0K
0J
6C
10F
6C
James’s
Clothing
Karen’s
Clothing
Karen’s Food
James’s 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),
UK1 UK2
P
Price Line
P’
UJ1
UJ2
Competitive Equilibrium
10F 0K
0J
6C
10F
6C
James’s
Clothing
Karen’s
Clothing
Karen’s Food
James’s 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 32
Efficiency in Exchange
? Scenario
? PF and PC = 3
? James’s MRS of clothing for food is 1/2,
? Karen’s 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 33
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 34
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 35
Competitive Equilibrium
10F 0K
0J
6C
10F
6C
James’s
Clothing
Karen’s
Clothing
Karen’s Food
James’s Food
P
Price Line
UJ1
UK1
A
P’
UJ2
UK2
C
Chapter 16 Slide 36
Efficiency in Exchange
? Observations concerning C,
1) Since the two indifference curves
are tangent,the competitive
equilibrium allocation is efficient,
2) The MRSCF is equal to the ratio of
the prices,or MRSJFC = PC/PF =
MRSKFC,
Chapter 16 Slide 37
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 38
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 39
Efficiency in Exchange
? Policy Issues
? What is the role of government?
Chapter 16 Slide 40
Equity and Efficiency
? Is an efficient allocation also an
equitable allocation?
? Economists and others disagree about
how to define and quantify equity,
Chapter 16 Slide 41
Equity and Efficiency
? The Utility Possibilities Frontier
? Indicates
?the level of satisfaction that each of
two people achieve when they have
traded to an efficient outcome on the
contract curve,
?all allocations that are efficient,
Chapter 16 Slide 42
H
*Movement from one
combination to another
(E to F) reduces one
persons utility,
*All points on the frontier
are efficient,
Utility Possibilities Frontier
James’s Utility
OJ
OK
E
F
G
Karen’s
Utility
L
*Any point inside the
frontier (H) is inefficient,
*Combinations beyond the
frontier (L) are not
obtainable,Lets compare
H to E and F,
Chapter 16 Slide 43
Equity and Efficiency
? E & F are efficient,
? Compared to H,E &
F make one person
better off without
making the other
worse off,
James’s Utility
Karen’s
Utility
OJ
OK
E
F
H
G
Chapter 16 Slide 44
Equity and Efficiency
? Is H equitable?
? Assume the only
choices are H & G
? Is G more equitable?
It depends on
perspective,
? At G James total utility
> Karen’s total utility
James’s Utility
Karen’s
Utility
OJ
OK
E
F
H
G
Chapter 16 Slide 45
Equity and Efficiency
? Is H equitable?
? Assume the only
choices are H & G
? Is G more equitable?
It depends on
perspective,
? H may be more
equitable because the
distribution is more
equal,therefore,an
inefficient allocation
may be more equitable,James’s Utility
Karen’s
Utility
OJ
OK
E
F
H
G
Chapter 16 Slide 46
Equity and Efficiency
? Social Welfare Functions
? Used to describe the particular weights
that are applied to each individual’s
utility in determining what is socially
desirable
Chapter 16 Slide 47
Four Views of Equity
? Egalitarian
? All members of society receive equal
amounts of goods
? Rawlsian
? Maximize the utility of the least-well-off
person
Chapter 16 Slide 48
Four Views of Equity
? Utilitarian
? Maximize the total utility of all members
of society
? Market-oriented
? The market outcome is the most
equitable
Chapter 16 Slide 49
Equity and Efficiency
? The Social Welfare Function and
Equity
? Equity is dependent on a normative
priority ranging from Egalitarian to
Market-orientation,
Chapter 16 Slide 50
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 51
Equity and Efficiency
? Points on the frontier
are Pareto efficient,
? OJ & OK are perfect
unequal distributions
and Pareto efficient,
? To achieve equity
(more equal
distribution) must the
allocation be
efficient?
James’s Utility
Karen’s
Utility
OJ
OK
Chapter 16 Slide 52
Equity and Efficiency
? Second Theorem of Welfare
Economics
? If individual preferences are convex,
then every efficient allocation is a
competitive equilibrium from some initial
allocation of goods,
Chapter 16 Slide 53
Equity and Efficiency
? Second Theorem of Welfare
Economics
? Consider the cost of programs to
redistribute income and the trade off
between equity and efficiency,
Chapter 16 Slide 54
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 55
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 56
Efficiency in Production
? Production in the Edgeworth Box
? The Edgeworth box can be used to
measure inputs to the production
process,
Chapter 16 Slide 57
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
?OF = Food
?OC = Clothing
60F
50F
40L 30L
Labor in clothing production
Efficiency in Production
50L 0C
0F
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 59
Efficiency in Production
? Producer Equilibrium in a
Competitive Input Market
? Competitive markets create a point of
efficient production,
Chapter 16 Slide 60
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
? MPL/MPK = w/r
? w/r = MRTSLK
? 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 0C
0F
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 62
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 63
Production Possibilities Frontier
Food
(Units)
Clothing
(units)
OF & OC
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
OF
OC
B
C
D
Chapter 16 Slide 64
Production Possibilities Frontier
Food
(Units)
Clothing
(units)
60
100
OF
OC
A
B
C
D
B
1C
1F
D
2C
1F
MRT = MCF/MCC
The marginal rate of
transformation (MRT)
is the slope of the
frontier at each point,
Chapter 16 Slide 65
Efficiency in Production
? Output Efficiency
? Goods must be produced at minimum
cost and must be produced in
combinations that match people’s
willingness to pay for them,
?Efficient output and Pareto efficient
allocation
?Occurs where MRS = MRT
Chapter 16 Slide 66
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 67
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 68
Efficiency in Production
? Efficiency in Output Markets
? Consumer’s Budget Allocation
? Profit Maximizing Firm
?
CF PP M R S ?
CCFF MCP a n d MCP ??
M R S
MC
MC M R T
C
F ???
C
F
P
P
Chapter 16 Slide 69
U2
),( @ M R T/ 1111 FCAPP CF ?
Competition and Output Efficiency
Food
(Units)
Clothing
(units)
60
100
A C
1
F1
B
C2
F2
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
PF = PF* and PC = PC*;
MRT = MRS; QD = QS for
food and clothing,U1
Chapter 16 Slide 70
The Gains from Free Trade
? Comparative Advantage
? Country 1 has a comparative advantage
over country 2 in producing a good if the
cost of producing that good,relative to
the cost of producing other goods,in 1,
is lower that the cost of producing the
good in 2,relative to the cost of
producing other goods in 2,
Chapter 16 Slide 71
The Gains from Free Trade
? Comparative Advantage
? Comparative advantage is a relative
measurement,not absolute,
? A country with an absolute advantage in
the production of all goods will not have
a comparative advantage in the
production of all goods,
?Example,Holland and Italy produce
cheese and wine
Chapter 16 Slide 72
Hours of Labor Required to Produce
Holland 1 2
Italy 6 3
Cheese
(1 lb.)
Wine
(1 gal.)
Holland has an absolute
advantage in both products,
Chapter 16 Slide 73
Hours of Labor Required to Produce
Holland 1 2
Italy 6 3
Cheese
(1 lb.)
Wine
(1 gal.)
Holland’s comparative advantage
over Italy is in cheese,the cost of cheese
is 1/2 the cost of wine and Italy’s cost of
cheese is twice the cost of wine,
Chapter 16 Slide 74
Hours of Labor Required to Produce
Holland 1 2
Italy 6 3
Cheese
(1 lb.)
Wine
(1 gal.)
Italy’s comparative advantage is wine,
which is half the cost of cheese,
Chapter 16 Slide 75
Hours of Labor Required to Produce
Holland 1 2
Italy 6 3
Cheese
(1 lb.)
Wine
(1 gal.)
Without Trade,Assume PW = PC in Holland & Italy,
Holland has 24 hrs,of labor--max,wine = 12 gals &
max,cheese = 24 lbs,or a combination
Chapter 16 Slide 76
Hours of Labor Required to Produce
Holland 1 2
Italy 6 3
Cheese
(1 lb.)
Wine
(1 gal.)
With Trade,Italy produces 8 gal,and
trades 6; consumes 6 lbs,and 2 gals,
Without Trade,3 lbs,and 2 gals,
Chapter 16 Slide 77
Pre-trade
prices
U1
The Gains from Trade
Wine
(gallons)
Cheese
(pounds)
A
Without trade,production &
consumption at A in Holland,
MRT = Pw/PC = 2 World prices
B
CB
WB
With trade (assume relative
price Pw = PC),Produce
at B,MRT = 1
CD
WD
D
U2
Consumption at D after trade,
Holland imports the wind
and exports cheese,
Who gains and who
loses from trade?
Chapter 16 Slide 78
The Effects of Automobile Import Quotas
? A Changing Automobile Market
? Imports (as a percentage of domestic sales)
? 1965 -- 6.1%
? 1980 -- 28.8%
? In 1981 a voluntary export restraint (VER) was
negotiated,
? In 1980 Japan exported 2.5 million cars to
the U.S,
? In 1981 with the VER exports fell to 1.68
million cars,
Chapter 16 Slide 79
? Measuring the Impact of the VER
1) Japanese car prices rose nearly
$1,000/car in 1981-1982,and
revenue increase by $2 billion,
2) Demand for U.S,cars increased
U.S,profits by $10 billion
The Effects of Automobile Import Quotas
Chapter 16 Slide 80
? Measuring the Impact of the VER
3) U.S,car prices were $350 to
$400/auto higher than they would
have been without VER,or
consumers were worse off by $3
billion,
4) U.S,sales rose by 500,000 units
creating about 26,000 jobs,
The Effects of Automobile Import Quotas
Chapter 16 Slide 81
? Measuring the Impact of the VER
5) Cost/Job = $4.3 billion (consumer
cost)/26,000 jobs)
= $160,000
The Effects of Automobile Import Quotas
Quantifying the Costs of Protection
Producer Gains Consumer Losses Efficiency Losses
Industry ($ millions) ($millions) ($millions)
Book manufacturing 305 500 29
Orange juice 390 525 130
Textiles an apparel 22,000 27,000 4,850
Carbon steel 3,800 6,800 330
Color televisions 190 420 7
Sugar 550 930 130
Dairy products 5,000 5,500 1,370
Meat 1,600 1,800 145
Chapter 16 Slide 83
An Overview---The Efficiency
of Competitive Markets
? Conditions Required for Economic
Efficiency
? Efficiency in Exchange
K
FC
J
FC M R SM R S ?
Chapter 16 Slide 84
? Conditions Required for Economic
Efficiency
? Efficiency in Exchange (for a
competitive market)
K
FCCF
J
FC M R SPPM R S ?? /
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 85
? Conditions Required for Economic
Efficiency
? Efficiency in the Use of Inputs in
Production
C
LKM R T SM R T S ?
F
LK
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 86
? Conditions Required for Economic
Efficiency
? Efficiency in the Use of Inputs in
Production (for a competitive market)
C
LKM R T S/M R T S ?? rw
F
LK
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 87
? Conditions Required for Economic
Efficiency
? Efficiency in the Output Market
c o n s u m e rs ) a l l( fo r FCFC M R SM R T ?
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 88
? Conditions Required for Economic
Efficiency
? Efficiency in the Output Market (in a
competitive market)
CFCF
CFF
PP
PP
/MC/MC M R T
MC,MC
FC
C
??
??
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 89
? Conditions Required for Economic
Efficiency
? However,consumers maximize their
satisfaction in competitive markets
only if
FCFC
FCCF PP
M R T M R S T h e r e f o r e,
c o n s u m e r s ) a l l( f o r M R S /
?
?
An Overview---The Efficiency
of Competitive Markets
Chapter 16 Slide 90
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 91
Why Markets Fail
? Market Power
? Monopsony in the labor market
?Restricted supply of labor in food
?wf would rise,wL would fall
?Clothing input,
?Food input,
rw cCLK /M R T S ?
CLKcFFLK rwrw M R T S //M R T S ???
Chapter 16 Slide 92
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 93
Why Markets Fail
? Public Good
? Markets undersupply public goods
because of difficulty associated with
measuring consumption,
Chapter 16 Slide 94
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 95
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 96
Summary
? Because a competitive equilibrium need
not be equitable,the government may
wish to help redistribute wealth from rich to
poor,
? 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 97
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,
Chapter 16 Slide 98
Summary
? Free international trade expands a
country’s production possibilities
frontier,
? Competitive markets may be
inefficient for one or more of four
reasons,
End of Chapter 16
General
Equilibrium and
Economic
Efficiency
