<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 profitmaximizing 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 resolve 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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 Spring '09
 Cheng
 Economics, Equilibrium, competitive equilibrium, general equilibrium, Partial Equilibrium Analysis

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