EC 126: Introductory Microeconomics II TOPIC 2 EQULIBRIUM April - - PowerPoint PPT Presentation

EC 126: Introductory Microeconomics II TOPIC 2 EQULIBRIUM

April 2017

Topic Coverage Outline 2.1 Introduction

2.2 Partial and General Equilibrium concept 2.3 Efficient Allocation of Resources and Edgeworth Box Diagram Concept 2.4 The General equilibrium of exchange 2.5 General Equilibrium of Production 2.6 Simultaneous Equilibrium in Exchange and Production 2.7 Efficiency in output perfectly competition market

2.1 Introduction

2.2 Partial and General Equilibrium concept 2.3 Efficient Allocation of Resources and Edgeworth Box Diagram Concept 2.4 The General equilibrium of exchange 2.5 General Equilibrium of Production 2.6 Simultaneous Equilibrium in Exchange and Production 2.7 Efficiency in output perfectly competition market

2.1 Introduction

• Previous topics have been examined under the cateris

peribus assumption

– Consumer behaviour - holding income constant – Production decisions of producers – price of factors of production constant – Product markets – ignoring other markets – Factor markets ignoring commodity markets

Markets have been studied in isolation

• But Markets are interdependent

One good is an input to other product Substitute goods Complement goods

Previous topics have been examined under the cateris peribus assumption

Consumer behaviour - holding income constant Production decisions of producers – price of factors of production constant Product markets – ignoring other markets – Factor markets ignoring commodity markets

• Markets have been studied in isolation
• But Markets are interdependent

– One good is an input to other product – Substitute goods – Complement goods

2.1 Introduction

• Wrong assumption in previous analysis -Changes in

price in one market do not have effect in other markets

• One market cann’t adjust without disturbing the

equilibrium of other markets

• There is feedback effect

A feedback effect is a price or quantity adjustment in

• ne market caused by price and quantity adjustment

in related markets Consider Feedback effect between Competitive market ( Figure 1) Wrong assumption in previous analysis -Changes in price in one market do not have effect in other markets

• One market cann’t adjust without disturbing the

equilibrium of other markets

• There is feedback effect
• A feedback effect is a price or quantity adjustment in
• ne market caused by price and quantity adjustment

in related markets

• Consider Feedback effect between Competitive

market ( Figure 1)

• Fig. 1(a): Beef market
• Fig. 1(b): Fish market
• Fig. 1(b): Fish market

2.2 Partial and General Equilibrium i. Partial Equilibrium

• determination of equilibrium prices and quantities

independent of effects from other markets Previous discussion based on PE (eg. SS&DD) PE is sufficient to understand market behaviour

i. Partial Equilibrium

determination of equilibrium prices and quantities independent of effects from other markets

• Previous discussion based on PE (eg. SS&DD)
• PE is sufficient to understand market behaviour

ii General equilibrium

• simultaneous determination of the prices and

quantities in all relevant markets taking explicitly feedback effects into account

• 1st General Equilibrium model was developed by Leon Walras

– known as Walrasian system

• Takes account of the interrelation among prices and

quantities

• Consider tax imposition
• GE analyze impact of one market to all markets is not

feasible

• Refer beef and fish market

ii General equilibrium

• simultaneous determination of the prices and

quantities in all relevant markets taking explicitly feedback effects into account

• 1st General Equilibrium model was developed by Leon Walras

– known as Walrasian system

• Takes account of the interrelation among prices and

quantities

• Consider tax imposition
• GE analyze impact of one market to all markets is not

feasible

• Refer beef and fish market

2.3 Efficient Allocation of Resources and Edgeworth Box

Diagram Concept

• market is efficient - maximizes cansumer and producer

surplus

• GE analysis - we use simple graphical model in order to

study the efficiency in resource allocation.

– known as Edgeworth Box Diagram (EBD)

• We start with exchange economy (2 consumers who

trade 2 goods) – can apply to 2 countries Allocation of two goods is either economically inefficient - if the consumers (in this case 2) can make themselves better off by trading with each other efficient - if no one can be made better off without making someone else worse off

• The term Pareto efficiency is used to refer the point of

efficient allocation of resources

market is efficient - maximizes cansumer and producer surplus GE analysis - we use simple graphical model in order to study the efficiency in resource allocation.

known as Edgeworth Box Diagram (EBD)

We start with exchange economy (2 consumers who trade 2 goods) – can apply to 2 countries

• Allocation of two goods is either economically
• inefficient - if the consumers (in this case 2) can make

themselves better off by trading with each other

• efficient - if no one can be made better off without

making someone else worse off

• The term Pareto efficiency is used to refer the point of

efficient allocation of resources

Edgeworth Box Diagram

• Shows all possible allocations

a) two goods between two people b) two inputs between two production processes

• shows the interaction between two economic

activities

Construction of EWB (Figure 2)

2 goods and 2 consumers in exchange 2 industries and 2 inputs (L&K) in production

Each point describes the bundle of both consumers

• What is an efficient point?

Edgeworth Box Diagram Shows all possible allocations

a) two goods between two people b) two inputs between two production processes

• shows the interaction between two economic

activities

• Construction of EWB (Figure 2)

– 2 goods and 2 consumers in exchange – 2 industries and 2 inputs (L&K) in production

• Each point describes the bundle of both consumers
• What is an efficient point?

Figure 2: Edgeworth Box Diagram

2.4 The General equilibrium of exchange

• Assumptions:

– There are only two consumers – There are two commodities X and Y – There is no production Efficient allocation condition - MRSXY is the same for the two consumers

• Insert the ICs for two consumers into EWBD
• (See Figure 3)

Note distribution of commodities between 2 consumers Assumptions: There are only two consumers There are two commodities X and Y There is no production

• Efficient allocation condition - MRSXY is the same for the

two consumers

• Insert the ICs for two consumers into EWBD
• (See Figure 3)
• Note distribution of commodities between 2 consumers

• Fig. 3: Edgeworth box diagram for exchange

– 1st Consumer: X = OP & Y = OR – 2nd Consumer: X = OF – OP & Y= OM- OR

• Total amount: X = OF & Y = OM
• ICs : 1st consumer – A1 to A4

2nd consumer - H1 to H4 Satisfaction of two consumers increases in opposite directions Aim is to establish a point of an efficient allocation Each point in the EWB diagram shows a specific allocation

not all points constitute efficient allocation

1st Consumer: X = OP & Y = OR 2nd Consumer: X = OF – OP & Y= OM- OR

• Total amount: X = OF & Y = OM
• ICs : 1st consumer – A1 to A4

2nd consumer - H1 to H4

• Satisfaction of two consumers increases in opposite

directions

• Aim is to establish a point of an efficient allocation
• Each point in the EWB diagram shows a specific

allocation

• not all points constitute efficient allocation

• Point Q in is not on efficient, Why?

– Indifference curves intersect – There is room of further trading

• exact point to which they will move cannot be

predicted

• Depends on the bargain power of each individual – it

can be either X2 or X3 further exchange of the goods between the consumers can be at a point between X2 or X3 say X

• This is known most or superior efficient point
• Thus in EBD there might be more than one point of efficient

allocation

Point Q in is not on efficient, Why?

Indifference curves intersect There is room of further trading

exact point to which they will move cannot be predicted

• Depends on the bargain power of each individual – it

can be either X2 or X3

• further exchange of the goods between the consumers

can be at a point between X2 or X3 say X

• This is known most or superior efficient point
• Thus in EBD there might be more than one point of efficient

allocation

• At Points X2, X3 and X, MRTXY is the same for all

consumers

• the economy has attained the GE of exchange/

consumption

• Consumption contract curve:

– locus of points of consumers’ indifference curves tangencies curve that shows all efficient allocation of goods between two consumers or of inputs between prod. functions

At Points X2, X3 and X, MRTXY is the same for all consumers

• the economy has attained the GE of exchange/

consumption

Consumption contract curve:

locus of points of consumers’ indifference curves tangencies – curve that shows all efficient allocation of goods between two consumers or of inputs between prod. functions

Assignment

1. Asha and Rose arrived at a point on a contract curve after swapping goods back and forth. Does this mean that neither of them can find a point off the contract curve that preferable to the point at which they have arrived?

• 2. If the answer in Question 1 above is NO, why do

economists claim that points on contract curve are to be preferred

• 3. When an allocation is Pareto efficient, then no

further trade can make everyone better off; and everyone is strictly better off than at the initial

• endowments. True or False? Explain

1. Asha and Rose arrived at a point on a contract curve after swapping goods back and forth. Does this mean that neither of them can find a point off the contract curve that preferable to the point at which they have arrived?

• 2. If the answer in Question 1 above is NO, why do

economists claim that points on contract curve are to be preferred

• 3. When an allocation is Pareto efficient, then no

further trade can make everyone better off; and everyone is strictly better off than at the initial

• endowments. True or False? Explain

• 5. General Equilibrium of Production
• Efficiency in Factor substitutions
• Firm’s equilibrium attained - combination of inputs

which minimize the cost are chosen

• slope of isoquant = slope of isocost curve (Recall EC 116 )

For the two firms, the joint equilibrium can be derived using the EWB Assumptions:

Simple economy (2 goods are produced- 2 industries) There are two inputs in fixed amount

Efficiency in Factor substitutions Firm’s equilibrium attained - combination of inputs which minimize the cost are chosen

• slope of isoquant = slope of isocost curve (Recall EC 116 )
• For the two firms, the joint equilibrium can be

derived using the EWB

• Assumptions:

– Simple economy (2 goods are produced- 2 industries) – There are two inputs in fixed amount

• Condition at equilibrium -MRTSLK is the same

for all industries

• Insert Figure 4
• Total amount: L = OL & K = OK
• Each point in EWB shows a specific allocation of L & K

Consider allocation at point Z Point Z is not efficient

isoquants intersect Resources can be further reallocated

Condition at equilibrium -MRTSLK is the same for all industries

• Insert Figure 4

Total amount: L = OL & K = OK

• Each point in EWB shows a specific allocation of L & K
• Consider allocation at point Z
• Point Z is not efficient
• isoquants intersect
• Resources can be further reallocated

• Fig. 4: Edgeworth box diagram for production

• L and K can be reallocated between two industries to

move to point U or V

• Further reallocation of the factors of production can

be at a point between U and V i.e. W

• most or superior efficient point – Pareto efficient point
• The MRTSL,K at points U, V and W, is the same for all

firms

• the economy has attained the GE of production

Production contract curve - lines that joins points of tangencies, MRTSL,K is equal for all firms

• At curve, MRTs L,K (for X) = MRTs L,K (for Y) = w/r

L and K can be reallocated between two industries to move to point U or V Further reallocation of the factors of production can be at a point between U and V i.e. W

• most or superior efficient point – Pareto efficient point
• The MRTSL,K at points U, V and W, is the same for all

firms

• the economy has attained the GE of production
• Production contract curve - lines that joins points of

tangencies, MRTSL,K is equal for all firms

• At curve, MRTs L,K (for X) = MRTs L,K (for Y) = w/r

Review Questions (cont.)

• For every allocation on production contract

curve, in a simple economy of production, there must be at least one allocation on contract curve that is Pareto superior. Discuss briefly Does a perfect competitive market condition necessarily hold for general equilibrium of production in a simple economy to exist? Explain your answer Review Questions (cont.) For every allocation on production contract curve, in a simple economy of production, there must be at least one allocation on contract curve that is Pareto superior. Discuss briefly

• Does a perfect competitive market condition

necessarily hold for general equilibrium of production in a simple economy to exist? Explain your answer

• 6. Simultaneous Equilibrium in Exchange

and Production

• Recall equilibrium of production of 2 goods using

fixed inputs (Insert Figure 4)

• Slope of PPF = IRC
• MRTX,Y = Px/Py

Consumers’ maximizing utility point,

• MRSX,Y (for consumer A)= MRSX,Y (for consumer B)= Px/Py
• Goods must not only be produced at minimum cost

but should consider people’s willingness to pay Recall equilibrium of production of 2 goods using fixed inputs (Insert Figure 4)

• Slope of PPF = IRC
• MRTX,Y = Px/Py
• Consumers’ maximizing utility point,
• MRSX,Y (for consumer A)= MRSX,Y (for consumer B)= Px/Py
• Goods must not only be produced at minimum cost

but should consider people’s willingness to pay

• Fig. 5 Equilibrium point in product-mix

– MRS – measures consumer’s willingness to pay for an additional unit of X by consuming less Y – MRT - cost of an additional unit of X by producing less Y

• Economy produces output efficiently,

– MRSX,Y (A)= MRSX,Y (B)= MRTX,Y = Px/Py

• Insert Figure 6
• Points D, C and E are technically efficient but not in

consumer’s perspective point of equilibrium is at C i.e. MRSX,Y = MRTX,Y (for one consumer)

• production sector plans are consistent with what

consumers want to buy

MRS – measures consumer’s willingness to pay for an additional unit of X by consuming less Y MRT - cost of an additional unit of X by producing less Y

Economy produces output efficiently,

MRSX,Y (A)= MRSX,Y (B)= MRTX,Y = Px/Py

Insert Figure 6

• Points D, C and E are technically efficient but not in

consumer’s perspective

• point of equilibrium is at C i.e. MRSX,Y = MRTX,Y (for one

consumer)

• production sector plans are consistent with what

consumers want to buy

• Fig. 6: PPF and Indifference Curves

• Combine EWBs for exchange and production

– Place exchange box inside PPF

• PCC can be used to generate PPF and each point on

the PPF is a point on PPC

• Insert Figure 7

EWB for exchange is OYo Exo and total output, Xo and Yo

Xo and Yo output is distributed between consumers A and B Point E is equilibrium of the firm

• MRT = PX/PY and MRT = MRS

Combine EWBs for exchange and production

Place exchange box inside PPF

• PCC can be used to generate PPF and each point on

the PPF is a point on PPC Insert Figure 7

• EWB for exchange is OYo Exo and total output, Xo and Yo
• Xo and Yo output is distributed between consumers

A and B

• Point E is equilibrium of the firm
• MRT = PX/PY and MRT = MRS

• Fig. 7: Equilibrium of both exchange and production

• point of equilibrium exists at H

– when Xo and Yo are produced

• FF’ and GG’ have the same slope
• At point H: A gets XA and YA units of output

B gets ?? How do we get the amount of L and K used in production at point E? Points of equilibrium may be more than one point of equilibrium exists at H when Xo and Yo are produced

• FF’ and GG’ have the same slope

At point H: A gets XA and YA units of output B gets ??

• How do we get the amount of L and K used in

production at point E?

• Points of equilibrium may be more than one

• simultaneous GE of exchange and production implies

an ideal managed economy – consumers have different preferences for the same commodities

• How will one decides the level of good X and Y

public

• cost is so huge

simultaneous GE of exchange and production implies an ideal managed economy consumers have different preferences for the same commodities How will one decides the level of good X and Y public

• cost is so huge

Efficiency in perfectly competition market

• Well functioning competitive market can achieve the

same efficient outcome

• In perfectly competitive output markets, consumers

allocate their budget,

• MRS = Px/py

Each profit maximizing firm will produce its output where, PX = MCx and Py = MCy i.e, MRT = MCx/MCy = Px/Py = MRS

• MB of consuming an additional unit of each product is

equal to its MC

Well functioning competitive market can achieve the same efficient outcome In perfectly competitive output markets, consumers allocate their budget, MRS = Px/py

• Each profit maximizing firm will produce its output

where, PX = MCx and Py = MCy

• i.e, MRT = MCx/MCy = Px/Py = MRS
• MB of consuming an additional unit of each product is

equal to its MC

Review Questions

• 4. “In a two-good economy with production and

exchange, the slope of the production possibility curve at any point represents marginal cost”. YES/NO? Briefly explain to support your answer

• 5. “The centrally planned economies, like that of

former Soviet Union, performed so poorly because economic planning based on simultaneous general equilibrium analysis of Exchange and production”. Briefly discuss

• 4. “In a two-good economy with production and

exchange, the slope of the production possibility curve at any point represents marginal cost”. YES/NO? Briefly explain to support your answer

• 5. “The centrally planned economies, like that of

former Soviet Union, performed so poorly because economic planning based on simultaneous general equilibrium analysis of Exchange and production”. Briefly discuss