Chapter 16

Chapter 16 - Chapter 16 General Equilibrium Our analysis of competitive markets has thus far focused on a single market It has not treated the

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Unformatted text preview: Chapter 16 General Equilibrium Our analysis of competitive markets has thus far focused on a single market. It has not treated the entire economy as an interrelated system in which there are equilibrium forces that cross markets, and for this reason the model is often called a partial equilibrium model . 1 With the assumption of quasilinear tastes, the model gives not only a convenient way of illustrating equilibrium in a single market, but it also allows us to measure welfare along market demand and supply curves in a manner consistent with how the material is typically presented in introductory economics texts. The simplicity of the model makes it a powerful tool for economists to develop insights about markets, and, as we have suggested in the last chapter, it provides a convenient benchmark for us to think about economic forces that may “distort” markets. At the same time, the partial equilibrium model is restrictive in a number of ways. We have already illustrated that a deviation from quasilinearity in tastes creates complications for the sim- ple “introductory economics” approach because of the emergence of income or wealth effects. In addition, we have to assume that the single market that is being analyzed is “small” relative to other markets, thus not impacting prices in those other markets. But often markets are fundamen- tally interrelated, with changes in one market spilling over into others through changes in input prices, through substitution effects as consumers switch between products and through the creation of wealth effects (due to non-quasilinear tastes). General equilibrium models therefore view the economy as a closed system of related markets, explicitly taking into account the effects that are assumed away in partial equilibrium analysis. Such models can be particularly important in policy analysis — because policies represent institutional changes that affect many markets and create feedback effects that are ignored if we consider only a single market at a time. Over the past 50 years, economists have therefore developed a large number of increasingly sophisticated models of this “general equilibrium” kind — with different models making different simplifying assumptions depending on the particular application for which they are designed. 2 These models now show up in different forms in virtually all sub-fields in economics. It is beyond the scope of this text to provide a thorough review of these approaches, and you will encounter them in different forms in a variety of future classes. For now, we will simply illustrate some very simple examples — and show how the first welfare theorem remains fully intact as we move away 1 This Chapter is built on the foundations of consumer theory as illustrated in Chapter 6 as well as a basic understanding of producer theory as illustrated in Chapter 11....
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This note was uploaded on 05/13/2010 for the course ECON 105D taught by Professor Cur during the Fall '09 term at Duke.

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Chapter 16 - Chapter 16 General Equilibrium Our analysis of competitive markets has thus far focused on a single market It has not treated the

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