autumn lecture 6 competitive equilibrium

8/6/2019 Autumn Lecture 6 Competitive Equilibrium

http://slidepdf.com/reader/full/autumn-lecture-6-competitive-equilibrium 1/23

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BSc(Econ) Financial Economics

BSc Statistics and Economics

Introduction to Economics

Lecture 6

Competitive EquilibriumChapter 12



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Ideas� Concept of General Equilibrium as opposed

to Partial Equilibrium.

� Concept of Efficiency.

� Establish that the Competitive Equilibriumis efficient.



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The economy as a whole

� All markets in the economy are linked toeach other

� A change in one market will in principleaffect all markets

� How is equilibrium in the economy as a

whole achieved?� Why is a competitive market economy

efficient? (And in what sense?)



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Example: North Sea Oil� Discoveries increased income and wealth in and

around Abedeen.

� Reduced UK oil imports.� Caused the £ to appreciate (late 1970s/early

1980s).

� Squeezed manufacturing in the midlands and

elsewhere.� Led to cheaper imports and hence the consumers

were better off.



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Example: CorporationT

ax� In short run ± tax on rents (short run profits)

± Few repercussions

� Long run

± Effects on wages and prices

± Effects on capital/labour ratio

± Effects on capital in corporate/non-corporate firms

� Who bears the burden? Investors? Firms?

Workers? Consumers?



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Who bears the burden?



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Partial Equilibrium Analysis� Analyse a market in isolation

� Alfred Marshall

� When is it OK to do this?

� Small knock-on effects on rest of economy

� Example: tax on tobacco ± Small fraction of budget

± Effects on other markets widely spread



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Partial Equilibrium Analysis



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Is PE Analysis Adequate?



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Basic Competitive Model� 3 markets: labour; goods; capital

� Households: supply labour, demand goods,

save (supply capital)

� Firms: demand labour, supply goods, invest

(demand capital)

� 3 prices: wage rate, price level, rate of

return on capital



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Budget Constraints� These markets are linked through budgetconstraints which are accounting identities:

± Households:

Income from capital + labour income= spending on goods + saving

± Firms:Cost of labour + cost of capital (accounting

profits) = value of sales of goodsRetained profits + borrowing = investment incapital



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Market Equilibrium Conditions� When all three markets simultaneously clear

� Supply of labour = demand for labour

± Wage adjusts

� Supply of goods = demand for goods

± Price adjusts

� Supply of capital = demand for capital

± Rate of return (interest rate) adjusts



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General Equilibrium� Change in one part of the economy may

affect all markets

� Final effects may differ very much from

impact effects of policies (tax changes,

tariffs on imports)

� Leon Walras



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Example: technical progress� Shift in production function

� Labour and capital more productive

� Profits rise

� Shareholders¶ incomes rise

� More saving and spending on goods

� Bigger demand for capital goods� Demand for labour. Up or down?

� Etc



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Efficiency� When is a competitive market economy

³efficient´?

� What is meant by ³efficient´?



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Pareto Efficiency� An allocation of resources is Pareto

Efficient when there is no alteration of it

that could make someone better off without

making someone else worse off

� Vilfredo Pareto (1848-1923)

± Economist and Sociologist



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A ³Pareto Improvement´� A change in the allocation of resources that

makes someone better off without making

someone else worse off.

� Why use these elliptical concepts?

± They avoid interpersonal comparisons of utility

or welfare.



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A Competitive Market Economy

is Pareto Efficient� What do we need?

� Exchange efficiency

± If you can Pareto improve, people will trade

� Production efficiency

± Firms profit-maximise

� Product Mix Efficiency ± The economy itself is producing the efficient

mix of products.



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Exchange Efficiency� Whatever is produced in the economy must be

distributed among individuals in an efficient way, i.e.a fixed total amount of goods cannot be re-allocatedamong consumers to make one better off while makingno-one worse off.

� All consumers face same prices.

� All choose goods so that

P X / MU X = P Y / MU Y or MRS = P X / P Y

� Example: if A¶s MRS = 2 and B¶s MRS = 1 betweenapples and oranges, then B giving 1½ apples for A¶s 1orange is Pareto improving.

� Trades will occur until MRS is equalised everywhere.



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Production Efficiency� Can labour and capital be re-allocated among firms

to increase production of one firm while notreducing the production of any other?

� All face same wage rate (w) and cost of capital (r )

� All employ labour and capital so that

MC = w/ MPL = r/ MPK

MPL / MPK = w/r

� Thus the Marginal Rate of Technical Substitutionequates everywhere.

� Economy on production possibility frontier.



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Product Mix Efficiency

� How many apples and how many oranges shouldthe economy produce?

� Profit maximising firms: MRT = pO/ p A = slope of

PPF.� Utility maximising consumers: MRS = pO/ p A =

slope of indifference curve

� So MRS = MRT .

� But if there is excess demand for oranges andexcess supply for apples, then pO/ p A will rise until product mix efficiency is attained.



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Welfare Economics

� First Fundamental Theory of Welfare

Economics:

An economy in competitive equilibrium is

Pareto efficient.

� Second Fundamental Theory of Welfare

Economics:

Any Pareto efficient resource allocation thatsociety desires can be obtained through the

market mechanism.



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Government Role� If decentralisation leads to efficiency, then is the

government redundant apart from establishinglegal framework within which to enforce markettransaction?

� Free market advocates: Friedrich von Hayck /Milton Friedman

� But

± Imperfect competition

± Imperfect information

± Externalities

� This does not however necessarily mean that thegovernment intervention will improve matters!

autumn lecture 6 competitive equilibrium

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