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SGABCh15 - CHAPTER The Invisible Hand and the First Welfare...

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C H A P T E R 15 The “Invisible Hand” and the First Welfare Theorem Chapter 14 introduced the positive idea of equilibrium in the context of a compet- itive environment — and Chapter 15 now moves onto the more normative assess- ment of a competitive equilibrium within the context of the first welfare theorem. Put differently, Chapter 14 focuses on predicting changes in economic environ- ments in competitive settings while Chapter 15 now focuses on welfare as defined by consumer surplus and profit (or producer surplus). In Chapter 14 the consumer side of the market did not play a prominent role — we simply said that the market demand curve arises from the sum of individual demands. This is all we need for prediction. In the Chapter 15, on the other hand, we return to some themes from consumer theory — particularly the insight that welfare is measured on marginal willingness to pay (or compensated demand) curves and that these are the same as regular (or uncompensated) demand curves (that we use for prediction) only in the case of quasilinear tastes. Chapter Highlights The main points of the chapter are: 1. It is generally not possible to interpret curves that emerge from aggregat- ing individual consumer demand (or labor supply) curves as if they emerged from an individual’s optimization problem. Interpreting aggregate economic relationships that emerge from utility maximization in such a way is possible only if redistributing resources within the aggregated group leads to individ- ually offsetting changes in behavior — i.e. offsetting income effects . 2. It is possible to treat aggregate (or market) demand curves as if they emerged from an individual optimization problem if there are no income effects — i.e. if the good of interest is quasilinear . In that special case, (uncompen- sated) demand curves are also equal to marginal willingness to pay (or com-
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325 15A. Solutions to Within-Chapter-Exercises for Part A pensated demand) curves, enabling us to measure consumer surplus on the market demand curve . 3. Since economic relationships emerging from profit maximization by firms do not involve income effects, there are no analogous issues with interpret- ing aggregate or market supply curves (or labor demand curves) as if they emerged from a single optimization problem. As a result, we can measure producer surplus (or profit) on the market supply curve without making any particular assumptions. 4. Under a certain set of conditions, market equilibrium leads to output levels that mirror what would be chosen by omniscient social planners that aim to maximize overall social surplus. This is known as the first welfare theorem of economics which specifies the conditions under which markets allocate resources efficiently .
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