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Econ 4010 Lecture 17

# Econ 4010 Lecture 17 - 16 General Equilibrium...

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<Lecture 17> 16. General Equilibrium and Economic Efficiency So far we have analysed how - a rational consumer behaves given any fixed prices and income - a profit-maximizing firm behaves given any fixed prices of inputs, prices of outputs and technology The above problems generated demand functions and supply functions. Equilibrium A condition in which all acting influences are canceled by others, resulting in a stable, balanced, or unchanging system. In economics, equilibrium is a situation in which no agent has an incentive to change any of her/his choices, given the constraints s/he faces. The basic idea is that prices ought to be set as to “clear the market”. Intuitively, if given a price the demand for a good exceeds supply, then the price is “too low” and must be adjusted upwards. If instead supply exceeds demand the price is “too high” and ought to be adjusted downwards to restore equilibrium. In economics we make distinction between partial equilibrium and general equilibrium analysis. Partial Equilibrium Analysis the study of a market in isolation: how equilibrium is determined in one particular market. General Equilibrium Analysis the study of how equilibrium is determined in all markets simultaneously. Example : Equilibrium in two markets Market of good 1: Q 1 D = 15 – 3p 1 + p 2 / Q 1 s = 2 + p 1 Market of good 2: Q 2 D = 6 – 2p 2 + p 1 / Q 2 s = 1 + p 2 Q1. What is the general equilibrium level of prices and output in this economy? Market 1 equilibrium: demand = supply: 15 – 3p 1 + p 2 = 2 + p 1 p 1 = 13/4 + p 2 /4 Market 2 equilibrium: demand = supply: 6 – 2p 2 + p 1 = 1 + p 2 p 2 = 5/3 + p 1 /3 Two equations in two unknowns! We get p 2 = 3 and p 1 = 4 => Q 1 e = 6, Q 2 e = 4 Q2. Suppose an exogenous shock increases demand in market 1 to: Q 1 D = 18 – 3p 1 + p 2 . What is the new general equilibrium? 1

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Market 1 equilibrium: demand = supply: 18 – 3p 1 + p 2 = 2 + p 1 p 1 = 4 + p 2 /4 Market 2 equilibrium: demand = supply: 6 – 2p 2 + p 1 = 1 + p 2 p 2 = 5/3 + p 1 /3 We get p 2 = 36/11 and p 1 = 53/11 => Q 1 e = 75/11, Q 2 e = 47/11 Q3. Suppose you used the partial equilibrium price and output level in market 2 in order to compute the market 1 equilibrium. What would be your conclusion for market 1? If we re-solve for market 1 price with the new demand but p 2 e = 3, we obtain p 1 e = 4.75. Efficiency An allocation is Pareto efficient if it is feasible and if there is no other feasible allocation that makes one or more agents better off without making anyone else worse off.
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Econ 4010 Lecture 17 - 16 General Equilibrium...

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