GENERAL EQUILIBRIUM AND THE EFFICIENCY OF PERFECT COMPETITION

Chapter 12:

General Equilibrium

Markets and Products are heavily interdependent The demand for auto mechanics depends on the

demand for automobiles Input and output markets need to be considered

together, as a whole, instead of independentlyGeneral Equilibrium: all markets are in

simultaneous equilibrium An event that disturbs equilibrium in one market will

probably disturb equilibrium in other markets, too Electronic calculator discussion, personal computers,

Apple’s iPod, housing market from 2000-2005, airlines, and automobiles

EFFICIENCY AND PERFECTLY COMPETITIVE EQUILIBRIUM

Pareto Efficiency / Pareto Optimality A condition in which no change is possible that

will make some members of society better off without making some other members of society worse off

A change is Pareto optimal if it benefits at least one person and harms no one (b/c we’re getting closer to Pareto efficiency) an efficient system is one where all Pareto optimal moves

have been exhausted Example: budget cuts in Massachusetts – in your book Can you think of any???

The Efficiency of Perfect Competition

Perfectly competitive system leads to an efficient (Pareto optimal) allocation of resources Efficient Allocation of Resources among Firms

Firms maximize profits and therefore minimize costs in the long-run

Efficient Distribution of Outputs among Households Free and open markets, voluntary exchange – no

redistribution of outputs will make anyone better off Producing what People Want

P=MC (Households’ willingness to pay is equal to opportunity cost of resources needed to produce a good)

SOURCES OF MARKET FAILURE

Conditions of Perfect Competition do NOT always hold in real world

Market Failure – occurs when resources are allocated inefficiently b/c of one of the following:

SOURCES OF MARKET FAILURE

(1) Imperfect Markets Firms have some control over price and are therefore not

as competitive Most extreme example: monopoly controls all output in

an industry IMPERFECTLY COMPETITIVE INDUSTRIES =

INEFFICIENT ALLOCATION OF RESOURCES

SOURCES OF MARKET FAILURE

(2) Public Goods (social goods) Goods and services that give society collective benefits

and are collectively consumed 2 criteria: nonexclusion and shared consumption will be underproduced or not produced at all in laissez-

faire economy does an individual firm have any incentive to provide

national defense? Government may have to intervene to provide these

SOURCES OF MARKET FAILURE

(3) Externalities Costs or benefits on people outside an activity or

transaction that are not accounted for More on these in a later chapter! Positive externalities: public parks, flu vaccines Negative externality: pollution emitted from factories,

loud music

SOURCES OF MARKET FAILURE

(4) Imperfect Information Absence of full knowledge about product characteristics,

available prices, etc.

#1

(1) The housing market began rebounding in 2009. What other markets have been impacted by the changes in the housing market?

If we were only going to consider the impact on the housing market itself…

When we consider all markets impacted…

Pareto Efficient?

(2) Let’s say that you value your favorite shirt at $110. Someone else values it at $150, and that person is willing to pay you $120 for your shirt. Would selling your shirt to this person for $120 be Pareto efficient? Why or why not?

Pareto Efficient?

(3) When PNC Park was built, it cost $262 million ($237 for construction and $25 million for site acquisition). This has obviously generated a lot of profit for the local businesses on the North Shore. Do you think that this was Pareto efficient?

Pareto Efficient?

(4) Suppose a policy change will generate $100,000 of benefits for low-income families and $120,000 of costs for high-income families.

Pareto Efficient?

(5) I asked you yesterday in class, but now you can think about it more…can you think of any Pareto efficient moves that our politicians could currently make?

The Efficiency of Perfect Competition

(6) In your own words, explain what P=MC means and why this is so good (efficient) for society.

Sources of Market Failure

(7) If a company has enough control in an industry to raise prices and earn a higher profit (think of an extreme example such as Duquesne Light), do you think an efficient output will be produced for society? Why or why not? This is what we are going to learn…think about it: A monopolist can obviously charge a higher price – but

what does this mean about the quantity that people will demand?

A monopolist will NOT face a perfectly elastic demand curve – they can raise price and sacrifice quantity (this will still earn them higher profits!)

So the answer is NO – they will not produce as much (and therefore not the efficient amount)

Sources of Market Failure

(8) What are public goods? Explain in your own words what the two different criteria mean. Give an example of a public good (that we did not already discuss in class), and explain how the two different criteria are met.

Sources of Market Failure

(9) Will the private sector produce the efficient amount of public goods? Why or why not? What does this mean for the government?

Sources of Market Failure

(10) What is a negative externality? Give an example from your own life (that we did not already talk about).

Sources of Market Failure

(11) What is a positive externality? Give an example (that we did not already talk about).

Sources of Market Failure

(12) Assume that price underestimates the value that society places on the flu vaccine. If firms produce where P = MC, will private firms be underproducing, overproducing, or producing the optimal amount of flu vaccine for society? Underproducing!

Sources of Market Failure

(13) Without regulation from the government, will private firms underproduce, overproduce, or produce the optimal amount of pollution? Why? Overproduce!

Sources of Market Failure

(14) As a summary, then, indicate whether society (laissez-faire, without government intervention) will underproduce, overproduce, or produce the efficient amount of the following types of goods:

Public goods Underproduce

Goods that create positive externalities Underproduce

Goods that create negative externalities Overproduce

Goods in a perfectly competitive market Efficient amount!

Practice questions for tomorrow…

The process of examining the equilibrium conditions

in individual markets and for individual householdsand firms separately is calleda)Efficiencyb)General equilibrium analysisc)Partial equilibrium analysisd)Competitive equilibrium analysis

Answer: C

The condition that exists when all markets in an economy are in simultaneous equilibrium is called:

a)General equilibriumb)Efficiencyc)Partial equilibrium d)Competitive equilibrium

Answer: A

When a significant technological change affects one industry, which of the following is likely to be affected?

a)Costs, output, and prices are likely to be affected in the industry in question, but probably not in other industries

b)The change will affect many markets, except the labor or capital markets.

c)The supply side of the market is affected, or production, but not the demand side, or consumption.

d)The change could affect many markets, including the markets for labor and capital.

Answer: D

An economic system has reached Pareto optimality when:

a)Some members of society can be made better off while someone else is made worse off.

b)Some members of society can be made better off, while making everyone else better off as well.

c)No one can be made better off without making someone else worse off.

d)Some members of society can be made better off, without making someone else worse off.

e)Everyone is made better off from a reallocation of resources.

Answer: C

A change in the allocation of resources is said to be (potentially) efficient when it can be demonstrated that:

a)The value of the gains is less than the value of the losses.

b)There are only gains associated with the change.c)The value of the gains exceeds the value of the losses

associated with the change.d)The value of the gains just equals the value of the losses.e)There are no gains or losses associated with the change.

Answer: C

If price is less than marginal cost, production of the good in question should:

a)Increaseb)Decreasec)Remain the same

Answer: B

Which of the following is the condition that ensures that the right things are produced?

a)Marginal cost equals average cost and average cost is minimized

b)Price equals average revenuec)Price equals marginal cost.d)Price equals average cost and average cost is

minimizedAnswer: C