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Unformatted text preview: Partial Equilibrium: Positive Analysis Simon Board * This Version: November 28, 2009 First Version: December 1, 2008. In this Chapter we consider consider the interaction between different agents and firms, and solve for equilibrium prices and quantities. Section 1 introduces the idea of partial equilibrium. Section 2 looks at how we aggregate agent’s demand curves and firm’s supply curves to form market demand and market demand supply. Section 3 defines an equilibrium, and discusses basic properties thereof. Section 4 looks at short-run equilibrium, where entry and exit are not possible. Finally, Section 5 considers long-run equilibrium, where entry and exit are possible. 1 Partial Equilibrium When studying partial equilibrium, we consider the equilibrium in one market, taking as ex- ogenous prices in other markets and agents’ incomes, as well as preferences and technology. The main advantage of this model is simplicity: the equilibrium price is found by equating supply and demand. The model can also be used for welfare analysis, evaluating the effect of tax changes or the introduction of tariffs. However, the assumption that we can analyse one market independently of others can be dubious in some cases. As an alternative, economists sometimes study general equilibrium. In this model, we fix preferences and technology and suppose agents are endowed with goods and shares. We then * Department of Economics, UCLA. http://www.econ.ucla.edu/sboard/. Please email suggestions and typos to email@example.com. 1 Eco11, Fall 2008 Simon Board solve for all prices simultaneously, equating supply and demand in each market. While this approach is far more general (hence the name), it is harder to analyse. To illustrate the difference between partial and general equilibrium consider the worldwide market for cars. 1 A partial equilibrium analysis would add up the world’s demand for cars to form a market demand curve. It would also add up the different firms’ supply curves to form a market supply curve. The price of cars can then be found where demand equals supply. Intuitively, if the price were lower the would be excess demand and the price would be bid up; if the price were higher there would be excess supply and competition among suppliers would drive the price down. An exogenous increase in demand from China, due to Government construction of highways, would then shift up the demand curve, raising equilibrium price and quantity. In a general equilibrium model, there would be many other effects. First, the value of car firms would rise, increasing the income of their shareholders. Second, the increased demand for cars would push up the price of complements, such as oil. Third, there would be an increase in demand for inputs, such as steel, so commodity prices would rise. Ultimately, there is no single correct model: rather, there is a tradeoff between complexity and realism which depends on the markets at hand and the questions one is interested in.on the markets at hand and the questions one is interested in....
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