Transcript Ch 16 - Cut down version

Chapter 16
General Equilibrium
Cut Down Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Main Topics
The nature of general equilibrium
Positive analysis of general equilibrium
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The Nature of General Equilibrium
 Already studied competitive equilibrium in a single
isolated market: partial equilibrium analysis
 Useful when supply and demand for a good are largely
independent of activities in other markets
 However, markets are often interdependent (e.g., if
complements or substitutes)
 General equilibrium analysis is the study of
competitive equilibrium in many markets at the same
time
 Allows us to understand the consequences of interdependence
among markets
 Factors that affect supply and demand in one market can have
ripple effects in other markets
 Accounts for feedback between markets
 Markets can be linked because the price or production of one
good affects the demand or cost of another….think substitutes
or complements.
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Figure 16.1: General Equilibrium
Above is the general equilibrium in the markets for Pie
and Ice cream. Both equilibriums take the other product
(and product price) into account in identifying its own
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product clearing price and quantity.
Positive Analysis of
General Equilibrium
 General equilibrium analysis can provide more
accurate answers than partial equilibrium analysis
does to positive questions
 Examine the effects of a sales tax on ice cream
 Assume pie and ice cream are complements
 Assume no supply linkages
 General equilibrium effects of the tax include:
 Demand curve for pie shifts downward, so price of pie falls
 This produces a feedback effect on the ice cream market
 Effects of the tax ripple back and forth between the markets
 Need a new tool to determine the prices that will
prevail in both markets in a general equilibrium
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Market-Clearing Curves
First step in identifying a general equilibrium is
to find the market-clearing curve for each good
Shows the combinations of prices for that good and
related goods that bring supply and demand for the
good into balance
Prices of the goods are on the axes
For two goods that are complements, the
market-clearing curves will be downward
sloping
Example: an increase in the price of pie reduces the
demand for ice cream, which lowers the partial
equilibrium price of ice cream
For substitutes, the curves will be upward
sloping
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Figure 16.2: A Market-Clearing Curve
Slide A shows the ice cream curve with 3 different
demand curves that correspond to different prices for
pie. Slide B is the general equil. market-clearing curve for
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both products.
Figure 16.2: A Market-Clearing Curve
Slide A shows the pie curve with 3 different demand
curves that correspond to different prices for ice cream.
Slide B is the general equil. market-clearing curve for
both products.
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General Equilibrium in
Two Markets
If a price combination lies on both marketclearing curves, then both markets are in
equilibrium
This is a general equilibrium
Find a general equilibrium by plotting both
market-clearing curves on the same graph
Horizontal axis shows the price of one good;
vertical axis shows the price of the other good
Intersection of the two market-clearing curves
reveals the general equilibrium prices
The two goods markets clear at these prices
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Figure 16.4: General Equilibrium
Price Combination
General
equilibrium prices
are $12 per pie
and $6 per gallon
of ice cream
Pie and ice cream
markets both clear
at these prices
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Effects of a Sales Tax:
Partial Equilibrium
Continue the ice cream example
Examine effects of $3 per gallon sales tax on ice
cream
Begin from initial equilibrium price of $6 per gallon,
25 million gallons
Tax shifts supply curve upward by $3
New partial equilibrium is at intersection of the
new supply curve and initial demand curve
Price of pie held constant at $12 per pie
(Consumer) Price of ice cream rises by $1.67
per gallon, less than the amount of the tax
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Effect of a Sales Tax:
Gen. Equilibrium
Need new market-clearing curve for ice cream,
to find general equilibrium effects of tax
Tax shifts market-clearing curve for ice cream
upward
New curve lies exactly $1.67 above the old one
Magnitude of the shift equals partial equilibrium
effect of the tax
Look for intersection of new market-clearing
curve for ice cream and old market-clearing
curve for pie
Shows new general equilibrium
Pie price is $11 per pie, ice cream price is $8 per
gallon
These prices clear both markets
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Effect of a Sales Tax:
Gen. Equilibrium
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Sales Tax Effect : General Equilibrium
As a result of the tax, demand curves for both
goods shift
Sales tax on ice cream reduces the price of a
pie by $1
Because pie and ice cream are complements
Partial equilibrium analysis understates the
effect of the tax on the price of ice cream
Based on partial anal., ice cream prices rise only by
$1.67, but based on general equil, prices rise by $2.
Lower pie price leads to greater demand for ice
cream
Reinforces pressure for ice cream price to rise
General equilibrium analysis accounts for this
feedback; partial equilibrium analysis does not
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Figure 16.6: Effects of a Tax, part 2
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