Eco205 Chapter 10 – General Equilibrium and Welfare 3 April 2013
A Perfectly Competitive Price System
General equilibrium model
- An economic model of a complete system of markets
Partial equilibrium model
- An economic model of a single market
In all of these many markets, a few basic principles are assumed to hold:
All individuals and firms take prices as given—they are price takers.
All individuals maximize utility.
All firms maximize profits.
All individuals and firms are fully informed; there are no transactions costs, and
there is no uncertainty.
A Simple General Equilibrium Model
Economically efficient allocation of resources – is an allocation of resourcesA Simple General Equilibrium Modelproducer
surplus is maximized. Point E is economically efficient: it
Quantity of Y both is productively efficient (on the
Any point inside the frontier would be inefficient because it would PPF) and it maximizes utility.
provide less utility than can potentially be achieved in this situation. Compare point E to point F
The efficiency of X*, Y* also has a ‘‘demand’’ component because, E
from among all those points on PP, this allocation of resources
provides greatest utility. This reinforces the notion that the ultimate U2
goal of economic activity is to improve the welfare of people U1
The efficient allocation shown at point E in is characterized by a Quantity of X
tangency between the production possibility frontier and consumer’s
indifference curve. The increasingly steep slope of the frontier shows© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
production is increased.
On the other hand, the slope of an indifference curve shows how people are willing to trade one good for another in
consumption (the marginal rate of substitution). That slope flattens as people consume more X because they seek
balance in what they have.
The tangency therefore shows that one sign of efficiency is that the relative opportunity costs of goods in production
should equal the rate at which people are willing to trade these goods for each other. In that way, an efficient allocation
ties together technical information about relative costs from the supply side of the market with information about
preferences from the demand side. If these slopes were not equal (point F) the allocation of resources would be
The Efficiency of Perfect Competition (refer to slides for
First theorem of welfare economics -
competitive price system will bring about an economically
efficient allocation of resources
With an arbitrary initial price ratio, firms will produce X1,
Y ; the economy’s budget constraint will be given by line
CC. With this budget constraint, individuals demand X , ’
Y1, that is, there is an excess demand for good X (X 1 X1)
and an excess supply of good Y (Y – 1 ). The workings of
the market will move these prices toward their equilibrium levels P *,P , the price ratio would be Px*/Py*. At those
X Y prices, society’s budget constraint will be given by the line C*C*, and supply and demand will be in equilibrium. The
combination X*, Y* of goods will be chosen, and this allocation is efficient.
Why Markets Fail To Achieve Economic Efficiency
Imperfect competition includes all those situations in which economic actors exert some market power in deter