Transcript General Equilibrium

Chapter 12:
GENERAL EQUILIBRIUM AND THE
EFFICIENCY OF PERFECT COMPETITION
General Equilibrium
 Markets and Products are heavily
interdependent


The demand for auto mechanics depends on the demand for
automobiles
Input and output markets need to be considered together, as a
whole, instead of independently
 General Equilibrium: all markets are in
simultaneous equilibrium


An event that disturbs equilibrium in one market will probably
disturb equilibrium in other markets, too
Electronic calculator discussion, personal computers, Apple’s
iPod, housing market from 2000-2005, airlines, and
automobiles
EFFICIENCY AND PERFECTLY COMPETITIVE
EQUILIBRIUM
 Pareto Efficiency / Pareto Optimality
 A condition in which no change is possible that will make
some members of society better off without making some
other members of society worse off
 A change is Pareto optimal if it benefits at least one
person and harms no one (b/c we’re getting closer to
Pareto efficiency)
an efficient system is one where all Pareto optimal moves have
been exhausted
 Example: budget cuts in Massachusetts – in your book
 Can you think of any???

The Efficiency of Perfect Competition

Perfectly competitive system leads to an efficient (Pareto
optimal) allocation of resources
Efficient Allocation of Resources among Firms
 Firms maximize profits and therefore minimize costs in the
long-run
 Efficient Distribution of Outputs among Households
 Free and open markets, voluntary exchange – no redistribution
of outputs will make anyone better off
 Producing what People Want
 P=MC (Households’ willingness to pay is equal to opportunity
cost of resources needed to produce a good)

SOURCES OF MARKET FAILURE
 Conditions of Perfect Competition do NOT
always hold in real world
 Market Failure – occurs when resources are
allocated inefficiently b/c of one of the following:
SOURCES OF MARKET FAILURE
(1) Imperfect Markets
Firms have some control over price and are therefore not as
competitive
 Most extreme example: monopoly controls all output in an
industry
 IMPERFECTLY COMPETITIVE INDUSTRIES =
INEFFICIENT ALLOCATION OF RESOURCES

SOURCES OF MARKET FAILURE
(2) Public Goods (social goods)
Goods and services that give society collective benefits and are
collectively consumed
 2 criteria: nonexclusion and shared consumption
 will be underproduced or not produced at all in laissez-faire
economy
 does an individual firm have any incentive to provide national
defense?
 Government may have to intervene to provide these

SOURCES OF MARKET FAILURE
(3) Externalities
Costs or benefits on people outside an activity or transaction that
are not accounted for
 More on these in a later chapter!
 Positive externalities: public parks, flu vaccines
 Negative externality: pollution emitted from factories, loud music

SOURCES OF MARKET FAILURE
(4) Imperfect Information

Absence of full knowledge about product characteristics, available
prices, etc.
#1
 (1) The housing market began rebounding in 2009.
What other markets have been impacted by the
changes in the housing market?

If we were only going to consider the impact on the housing
market itself…

When we consider all markets impacted…
Pareto Efficient?
 (2) Let’s say that you value your favorite shirt at
$110. Someone else values it at $150, and that person
is willing to pay you $120 for your shirt. Would
selling your shirt to this person for $120 be Pareto
efficient? Why or why not?
Pareto Efficient?
 (3) When PNC Park was built, it cost $262 million
($237 for construction and $25 million for site
acquisition). This has obviously generated a lot of
profit for the local businesses on the North Shore.
Do you think that this was Pareto efficient?
Pareto Efficient?
 (4) Suppose a policy change will generate $100,000
of benefits for low-income families and $120,000 of
costs for high-income families.
Pareto Efficient?
 (5) I asked you yesterday in class, but now you can
think about it more…can you think of any Pareto
efficient moves that our politicians could currently
make?
The Efficiency of Perfect Competition
 (6) In your own words, explain what P=MC means
and why this is so good (efficient) for society.
Sources of Market Failure
 (7) If a company has enough control in an industry
to raise prices and earn a higher profit (think of an
extreme example such as Duquesne Light), do you
think an efficient output will be produced for
society? Why or why not?




This is what we are going to learn…think about it:
A monopolist can obviously charge a higher price – but what
does this mean about the quantity that people will demand?
A monopolist will NOT face a perfectly elastic demand curve –
they can raise price and sacrifice quantity (this will still earn
them higher profits!)
So the answer is NO – they will not produce as much (and
therefore not the efficient amount)
Sources of Market Failure
 (8) What are public goods? Explain in your own
words what the two different criteria mean. Give an
example of a public good (that we did not already
discuss in class), and explain how the two different
criteria are met.
Sources of Market Failure
 (9) Will the private sector produce the efficient
amount of public goods? Why or why not? What
does this mean for the government?
Sources of Market Failure
 (10) What is a negative externality? Give an
example from your own life (that we did not already
talk about).
Sources of Market Failure
 (11) What is a positive externality? Give an example
(that we did not already talk about).
Sources of Market Failure
 (12) Assume that price underestimates the value
that society places on the flu vaccine. If firms
produce where P = MC, will private firms be
underproducing, overproducing, or producing the
optimal amount of flu vaccine for society?

Underproducing!
Sources of Market Failure
 (13) Without regulation from the government, will
private firms underproduce, overproduce, or produce
the optimal amount of pollution? Why?

Overproduce!
Sources of Market Failure
 (14) As a summary, then, indicate whether society (laissez-
faire, without government intervention) will underproduce,
overproduce, or produce the efficient amount of the
following types of goods:
 Public goods
 Underproduce
 Goods that create positive externalities
 Underproduce
 Goods that create negative externalities
 Overproduce
 Goods in a perfectly competitive market
 Efficient amount!
Practice questions for tomorrow…
The process of examining the equilibrium conditions
in individual markets and for individual households
and firms separately is called
a) Efficiency
b)General equilibrium analysis
c) Partial equilibrium analysis
d)Competitive equilibrium analysis
Answer: C
 The condition that exists when all markets in an
economy are in simultaneous equilibrium is called:
a) General equilibrium
b)Efficiency
c) Partial equilibrium
d)Competitive equilibrium
 Answer: A
 When a significant technological change affects one
industry, which of the following is likely to be
affected?
a) Costs, output, and prices are likely to be affected in the
industry in question, but probably not in other industries
b) The change will affect many markets, except the labor or
capital markets.
c) The supply side of the market is affected, or production, but
not the demand side, or consumption.
d) The change could affect many markets, including the
markets for labor and capital.
Answer: D
 An economic system has reached Pareto optimality
when:
a) Some members of society can be made better off while
someone else is made worse off.
b) Some members of society can be made better off, while
making everyone else better off as well.
c) No one can be made better off without making someone
else worse off.
d) Some members of society can be made better off, without
making someone else worse off.
e) Everyone is made better off from a reallocation of
resources.
Answer: C
 A change in the allocation of resources is said to be
(potentially) efficient when it can be demonstrated
that:
a)
b)
c)
d)
e)
The value of the gains is less than the value of the losses.
There are only gains associated with the change.
The value of the gains exceeds the value of the losses
associated with the change.
The value of the gains just equals the value of the losses.
There are no gains or losses associated with the change.
Answer: C
 If price is less than marginal cost, production of the
good in question should:
a) Increase
b)Decrease
c) Remain the same
Answer: B
 Which of the following is the condition that ensures
that the right things are produced?
a) Marginal cost equals average cost and average cost is
minimized
b)Price equals average revenue
c) Price equals marginal cost.
d)Price equals average cost and average cost is
minimized
Answer: C