Economic Principles I

Lecture 19:
General Equilibrium and Economic
Efficiency
Partial and General Equilibrium
Analysis of individual markets in isolation is called
partial equilibrium analysis
Analysis of markets simultaneously is called
general equilibrium analysis
A general equilibrium is when supply equates to
demand in all markets in the economy
So an event which disturbs one market may spill
over to others
A simple general equilibrium
system
Product Market
Labour Market
Firms Households
Output Demand
Output Supply
Input Supply
Input Demand
Important questions
Is it possible for all markets to be simultaneously
in equilibrium?
What conditions would need to hold?
How can we assess how well an economic system
works in practice?
Allocative efficiency it produces what people
want at least cost
Equity the distribution of resources and
rewards is fair
An example of general
equilibrium adjustment
Demand for services
shifts outwards from D
X
0

to D
X
1

Demand for
manufactured goods
shifts inwards from D
Y
0

to D
Y
1

Economic profits in
services; losses in
manufacturing
Firms exit manufacturing
and move to services
eventually eliminating
profits and losses
Industry X: Services
Industry Y: Manufacturing
0
P
Q
0
P
Q
S
1
X

S
1
Y

p
1
X

D
1
X

Q
1
X

p
1
Y

D
1
Y

Q
1
Y

Q
0
X

p
0
X

D
0
X

S
0
X

MC
X

ATC
X

q
0
X

profit
q
1
X

p
0
Y

D
0
Y

S
0
Y

Q
0
Y

MC
Y

ATC
Y

q
0
Y

loss
q
1
Y

0

q
0

q
Firm in Industry X
Firm in Industry Y
Conditions of general equilibrium
Equilibrium in the economy requires the
establishment of equilibrium in both sectors
Resources in the economy shift to follow the
change in consumer preferences
Consequently employment shifts from the
manufacturing to the service sector
Is there a set of prices that will equate supply and
demand in all markets simultaneously?
Using advanced maths Arrow and Debreu have shown
that in theory there is.
Allocative efficiency in a competitive
economy
Assumptions
All firms and households are price takers
Households have perfect information about product
quality and prices
Firms have perfect knowledge about input prices and
technology
No externalities or public goods
If these hold then the competitive economy is
allocatively efficient
The Pareto Condition
Allocative efficiency means that we use available
resources to maximise social well-being
How do we know if social well-being is maximised?
Pareto efficiency
An economy is Pareto-efficient if we cannot make
anyone better off without making someone else worse
off
A competitive economy, with perfect information and
no externalities, is Pareto-efficient
A value-free
perspective?
But nearly all changes in the economy have
winners and losers?
If the value of the gains to the winners exceed
the value of the losses to the losers then a
reallocation is potentially efficient
An allocation may be efficient but is it fair?
Fairness is a value judgement
What will be produced?
The key condition is that all goods and
services will be produced up to the point
where P
x
=MC
x
for all Xs
If P
x
>MC
x
society gains from producing
more X
If P
x
<MC
x
society gains from producing less
X (and more of something else)
How will it be produced?
Firms must use the lowest cost technology
(technical efficiency)
Inputs must be allocated across firms in the best
possible way
This means every firm must hire workers up to
the point where: cost of an extra worker (wage) =
value of extra output produced
If not, we could move workers between firms and
increase total output for no increase in total cost
Who will get what is produced?
All households will choose combinations of
goods at the point where MRS=P
x
/P
y

Consumer valuations of goods are revealed
in household market behaviour
Free and open markets are essential
All households maximise satisfaction
(subject to budget) and all firms maximise
profit
Problems with general
equilibrium
But the world just isnt like this?
Monopolies and oligopolies
Externalities
Public goods
Uncertainty and lack of
information
So what is the use of general
equilibrium theory
Efficiency benchmarking
The ideal competitive economy provides a
benchmark
Problems such as monopoly and externalities
introduce inefficiencies
The ideal allows to evaluate the consequences (in
terms of lost efficiency) of market failure and to
assess the potential benefits of government
intervention to make things better
Conclusion
In this lecture we looked at general equilibrium
Ideal competitive economies are Pareto-efficient
Relaxing the assumptions of the perfect
competitive economy, in order to describe the
world more realistically, reveals the problems
that the free market does not solve for itself.
Economic Principles I
Lecture 19:
General Equilibrium and Economic
Efficiency