Notesale: Turn your study into money

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General Equilibrium and Market Efficiency
A simple exchange economy:
Imagine a simple economy in which there are only two consumers, A and B, and just two goods,
Food and Clothing
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Suppose there is a total of 100 units of food and 200 units of clothing in each time period
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The remaining 25 units of
food and 130 units of clothing are allocated to B
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The initial endowments are unlikely to represent the optimal allocation and if both parties can be
made better off through exchange then trade is likely to occur
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We assume that preference orderings are complete, consequently we
know that each party will have an indifference curve passing through the initial endowment point
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The indifference curves for the two parties that pass
through any such point will necessarily be tangent to one another, i
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there is no longer a shaded
area
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Once these rates are equalised all voluntary exchange
will cease
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A Pareto Superior allocation is an allocation that at least one
individual prefers and others like at least as well
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Put
another way, it identifies all the efficient ways of dividing goods between the two consumers
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The Pareto criteria have force only in relation to the allocation with which
the two players begin
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For example A is much worse off at U than at G despite the
fact that G is neither Pareto optimal or Pareto preferred to U
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In market economies most exchanges have a much more impersonal
character
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His function is to keep
adjusting relative prices until the quantities demanded of each good match the quantities supplied
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The yellow line represents the budget constraint
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In order
to reconcile this the price of clothing relative to food must be increased
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This brings us to Adam Smith's Invisible Hand Theorem: An equilibrium produced by competitive
markets will exhaust all possible gains from exchange
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The Invisible Hand tells is that every competitive equilibrium allocation is
efficient, but suppose you are a social critic; you feel that under the initial endowment point B
receives too much of each good and A too little
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The Second Theorem of Welfare Economics says that, under relatively unrestrictive
conditions, any allocation on the contract curve can be sustained as a competitive equilibrium
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We know that an allocation like E, or any
other efficient allocation, lies at a point of tangency between indifference curves
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9, the locus HH' is the mutual tangent between IA2 and IB2
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If we redistribute the initial endowments from J
to M, and announce a price ratio equal to the slope of HH', Ann and Bill will then
be led by the invisible hand to E
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So why don’t
we simply redistribute the initial endowment so as to achieve the desire final outcome directly? The
difficulty in practice is that the social institutions responsible for redistributing
income have little idea of the shapes and locations of individual consumer
indifference curves
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And for an initial endowment of given value, they will generally achieve a

much better result if they are free to make their own purchase decisions
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As the nineteenth-century
British economist John Stuart Mill saw clearly, society can redistribute incomes in
accordance with whatever norms of justice it deems fitting, at the same time relying
on market forces to assure that those incomes are spent to achieve the most good
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In practice, however, the
product mix in the economy is the result of purposeful decisions about allocation of productive
inputs
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Recall from Chapter 9 that the slope of an isoquant at any point is called the MRTS at that point and
this is the rate at which capital can be exchanged for labour without effecting the total level of
production
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Suppose the equilibrium food and clothing prices are PF* and PC*, respectively
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If the firms maximize their profits,
is there any reason to suppose that the resulting general equilibrium will satisfy the
requirements of efficiency in production? That is, is there any reason to suppose
that the MRTS between capital and labour will be the same for each firm? If both
firms have conventional, convex-shaped isoquants, the answer is yes
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Finally, this tells us
that competitive general equilibrium is efficient, not only in the allocation of a given endowment of
consumption goods, but also in the allocation of the factors used to produce those goods
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For example, an economy may efficiently
produce 90% and 10% and distribute these output efficiently but it is likely that everyone would be
happier with a more even product mix
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To define an efficient product mix we translate the contract curve from the Edgeworth Production
Box into a Production Possibilities Frontier (PPF)
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The slope of the PPF
at any point is called the marginal rate of transformation (MRT) at that point, and it measures the
opportunity cost of clothing in terms of food
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The MRT is equal to the ratio of marginal costs, that is: MRT = MC1/MC2
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It should therefore produce at the point

on its PPF at which the MRT is exactly equal to the international price ratio
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In the illustration given, international trading possibilities led the economy to produce
more clothing and less food than it used to
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If food production is relatively intensive
in the use of labour and clothing production is relatively intensive in the use of capital,
the shift in product mix would drive up the price of capital and drive down the
price of labour
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People whose incomes come exclusively from the sale of their own
labour would actually do worse than before, even though the value of total output is
higher
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It does not prove that everyone necessarily will
get more
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Consumption decisions are based on the gross price, including taxes,
while production decisions are based on the net price, excluding taxes
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Subsidies also upset the conditions required for efficiency
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Consequently we will get too
much of a subsidized product and too little of a taxed product under general equilibrium
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However, in more realistic models a tax on
all commodities would be analogous to an income tax
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From the standpoint of efficiency, a better tax would be a head tax
(also called a lump sum tax), one that is levied on each person irrespective of his or her labour
supply decisions
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Other Sources of Inefficiency
Monopoly:
The general equilibrium effects of monopoly are closely analogous to those of a commodity tax
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This means
that the price is higher than the marginal cost of production and therefore the MRT (the ratio of
marginal costs) will no longer be equal to the ratio of product prices and therefore the general
equilibrium is no longer efficient
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It is worth noting that as a consequence of the Monopolist's reduced consumption of input factors,
since its output is reduced, there will be a greater amount of resources available to the competitive
sector of the economy
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Why do the latest technology goods sell out so quickly?
Stories of Apple products and other technology products selling out quickly are not hard to come by
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The reason they do this is because selling out of a product generates
excellent free publicity and when brand loyalty is important producers could find this sort of
advertising very valuable
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In the case of negative externalities in
production, the effect on efficiency is much the same as that of a subsidy
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As a consequence we end up with too much of a good with a negative
externality and too little of one with a positive externality
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