Transcript Executive MPA Foundation Week II Economics I-IV

Chapters 6 & 19.1 & 19.2: Exchange Efficiency, and Prices
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General and Partial Equilibrium Analysis
• Partial equilibrium analysis - the study of how individual markets
function in isolation
– Ceteris paribus
– What we’ve been doing!
• Partial equilibrium analysis ignores:
– Spillover effects - a change in equilibrium in one market may affect other
markets too
– Feedback effects - a change in equilibrium in a market that is caused by
events in other markets that, in turn, are the result of an initial change in
equilibrium in the market under consideration
• General equilibrium analysis - study of economic outcomes when
one simultaneously considers the the interconnected system of
markets
– Here we are not making ceteris paribus assumptions
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A Simply Exchange Economy
• An Edgeworth box is a useful tool to help understand general
equilibrium in a simply exchange economy with two consumers
– Provides an understanding of the value of exchange
– Defines points of optimality for the economy
• Edgeworth box allows us to judge different allocations between
individuals in an economy
– An allocation “A” is superior to an allocation “B” if at least one individual
prefers “A” to “B” and all others are at least as happy with “A” as “B”
• “A” is said to be Pareto superior to “B”
• Pareto optimality (efficiency) - set of allocations (between
individuals) where it is impossible to make one person better off
without making at least some others worse off
– Contract curve defines the set of Pareto optimal points - all voluntary
contracts must lie on the contract curve
• Inefficient - the condition under which, though a reallocation of
resources at lease one person could be made better off w/o making
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anyone else worse off
Edgeworth Box
Contract
Curve
Beth’s quantity of clothes
Adam’s quantity of clothes
Beth’s quantity of food
Adam’s indifference
curves
Beth’s indifference
curves
Adam’s quantity of food
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An Example of a Disequilibrium Relative
Price Ratio
Food
220
Beth
200
Clothes
60
80
Clothes
80
60
Pf = Pc
Adam
200
Food
220
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The Invisible Hand & Welfare Theorems
• The first theorem of welfare economics also known as the
Invisible Hand Theorem states that “An equilibrium produced by
competitive markets will exhaust all possible gains from
exchange”
– Adam Smith
– Every competitive equilibrium allocation is efficient
• The second theorem of welfare economics says that, under
relatively unrestricted conditions, any allocation on the contract
curve can be sustained as a competitive equilibrium
– May require reallocation of initial endowments
• Cautions:
– These theorems apply, but only under certain conditions
• We will discuss later whether/when they exist
– These theorems do not imply that individuals would not prefer different
equilibrium points, in general they would, but they are the best that
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individuals can do given their initial endowments
The Inefficiency of Taxes/Subsidies in
General Equilibrium
• Taxes or subsidies in an economy change the relative
price ratio between goods, which leads to
• In equilibrium consumers will still have a common value
of MRS, and producers will still have a common value of
MRTS, but inefficiency arises from the fact that
producers and consumers see different price ratios
– Consumption decisions are based on gross prices (prices
inclusive of taxes and subsidies)
– Production decisions are based on net prices (prices received
by producer after tax is paid or subsidy received)
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Would the World Be Better Without Taxes?
•
Not necessarily because:
1. The optimums produced from a competitive economy only
apply under certain conditions
– We will discuss some of the exceptions to these conditions shortly
2. As a society we might care about other things in addition to
efficiency, such as equity, human rights, etc.
•
Still, in general, we limit the inefficiency caused by
taxation if we impose taxes that keep price distortions
to a minimum
–
E.g. same tax rate applied to all products, or a head tax
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Chapters 7: Production
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Production
• Any activity that creates present or future activity
• We assume an input output relationship defined by the
production function defining a relationship by which
inputs are combined to produce output
– Q = F(K, L, E)
• K = capital, L = labor, E= Entrepreneurship
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Fixed and Variable Inputs
• Two types of inputs, variable and fixed
– Variable inputs are those whose quantity can be relatively easily altered
– Fixed inputs are those whose quantity cannot be altered within a given time
period
• Short-run - the longest period of time during which at least one of
the inputs used in production cannot be varied
• Long-run - shortest period of time required to alter the amounts of
every input
– Note that all inputs are variable in the long run
• Note that neither the short or long run is defined by specific time
periods, and that the short and long runs may be different for
different production processes
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Law of Diminishing Marginal Returns
• Total product - Q = F(K,L), omit E for simplicity
• Marginal product - change in total product with a change of one of
the inputs, holding constant all others
Q
Q


– MP = MPL
L K  K L
• Note production function implies diminishing marginal returns
– Law of Diminishing Marginal Returns - increase in output from an increase
ina variable input, ceteris paribus, must eventually decline
• Average product - average product produced with a given level of
input
– APL = Q/L
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Numerical Example of Production
(in the Short Run)
Q  10K .5 L.5
Labor

(in short run K = K =1)
Total
Product
Average
Product
Marginal
Product
1
10.00
10.00
10
2
14.14
7.07
4.14
3
17.32
5.77
3.18
4
20.00
5.00
2.68
5
22.36
4.47
2.36
6
24.49
4.08
2.13
7
26.46
3.78
1.96
8
28.28
3.54
1.83
9
30.00
3.33
1.72
10
31.62
3.16
1.62
11
33.17
3.02
1.54
12
34.64
2.89
1.47
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Graphical Representation of Production
(in the Short Run)
Q
Slope = Marginal Product at L*
Slope = Average
Product at L*
Total Product
L*
L
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Relationship Between Production Curves
Q
Q  F(K ,L)

L
Q
APL
L
MPL
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Relationship Between Production Curves
Q
Q  F(K ,L)

L
Q
Q10 - Q9
APL
L
MPL
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Production in the Long run
• In the long run all factors of production can be varied
• Isoquant represents the set of all input combinations that
yield a given level of output
– The production equivalent of an indifference curve
• Marginal rate of technical substitution (MRTS) is the rate
at which one input can be exchanged for another without
altering the total level of output
– MRTS around a point A
MPLA K
dK


MPKA L
dL
q q 0
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Graphical Representation of Marginal
Rate of Technical Substitution
K
MRTS  K L
K



L
L
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Returns to Scale
• The proportional change in production that occurs with a
given change in all inputs defines the returns to scale
– Constant returns to scale if Q = F(K, L) = F(K, L)
– Increasing returns to scale if Q = F(K, L) > F(K, L)
– Decreasing returns to scale if Q = F(K, L) < F(K, L)
• In theory we should never observe decreasing returns to scale
• Note that decreasing returns to scale has nothing to do
with diminishing marginal returns
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Returns to Scale on the Isoquant Map
K
16
14
Q=420
12
Q=400
10
Q=360
8
Q=300
6
Q=240
Q=180
4
Q=90
2
Q=30
1
2
3
4
5
6
7
8
L
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