EC 126: Introductory Microeconomics II TOPIC 2 EQULIBRIUM April - PowerPoint PPT Presentation

EC 126: Introductory Microeconomics II TOPIC 2 EQULIBRIUM April 2017

Topic Coverage Outline 2.1 Introduction 2.1 Introduction 2.2 Partial and General Equilibrium concept 2.2 Partial and General Equilibrium concept 2.3 Efficient Allocation of Resources and Edgeworth Box 2.3 Efficient Allocation of Resources and Edgeworth Box Diagram Concept Diagram Concept 2.4 The General equilibrium of exchange 2.4 The General equilibrium of exchange 2.5 General Equilibrium of Production 2.5 General Equilibrium of Production 2.6 Simultaneous Equilibrium in Exchange and Production 2.6 Simultaneous Equilibrium in Exchange and Production 2.7 Efficiency in output perfectly competition market 2.7 Efficiency in output perfectly competition market

2.1 Introduction • Previous topics have been examined under the cateris Previous topics have been examined under the cateris peribus assumption peribus assumption – Consumer behaviour - holding income constant Consumer behaviour - holding income constant – Production decisions of producers – price of factors of Production decisions of producers – price of factors of production constant production constant – Product markets – ignoring other markets Product markets – ignoring other markets – Factor markets ignoring commodity markets – Factor markets ignoring commodity markets • Markets have been studied in isolation Markets have been studied in isolation  But Markets are interdependent  But Markets are interdependent – One good is an input to other product One good is an input to other product – Substitute goods Substitute goods – Complement goods Complement goods

2.1 Introduction • Wrong assumption in previous analysis -Changes in Wrong assumption in previous analysis -Changes in price in one market do not have effect in other price in one market do not have effect in other markets markets  One market cann’t adjust without disturbing the  One market cann’t adjust without disturbing the equilibrium of other markets equilibrium of other markets  There is feedback effect  There is feedback effect • A feedback effect is a price or quantity adjustment in A feedback effect is a price or quantity adjustment in one market caused by price and quantity adjustment one market caused by price and quantity adjustment in related markets in related markets • Consider Feedback effect between Competitive Consider Feedback effect between Competitive market ( Figure 1) market ( Figure 1)

Fig. 1(a): Beef market Fig. 1(b): Fish market Fig. 1(b): Fish market

2.2 Partial and General Equilibrium i. i. Partial Equilibrium Partial Equilibrium • determination of equilibrium prices and quantities determination of equilibrium prices and quantities independent of effects from other markets independent of effects from other markets • Previous discussion based on PE (eg. SS&DD) Previous discussion based on PE (eg. SS&DD) • PE is sufficient to understand market behaviour PE is sufficient to understand market behaviour

ii General equilibrium ii General equilibrium   simultaneous determination of the prices and simultaneous determination of the prices and quantities in all relevant markets taking explicitly quantities in all relevant markets taking explicitly feedback effects into account feedback effects into account 1 st General Equilibrium model was developed by Leon Walras 1 st General Equilibrium model was developed by Leon Walras   – known as Walrasian system – known as Walrasian system   Takes account of the interrelation among prices and Takes account of the interrelation among prices and quantities quantities   Consider tax imposition Consider tax imposition   GE analyze impact of one market to all markets is not GE analyze impact of one market to all markets is not feasible feasible   Refer beef and fish market Refer beef and fish market

2.3 Efficient Allocation of Resources and Edgeworth Box Diagram Concept • market is efficient - maximizes cansumer and producer market is efficient - maximizes cansumer and producer surplus surplus GE analysis - we use simple graphical model in order to GE analysis - we use simple graphical model in order to • study the efficiency in resource allocation. study the efficiency in resource allocation. – known as Edgeworth Box Diagram (EBD) known as Edgeworth Box Diagram (EBD) • We start with exchange economy (2 consumers who We start with exchange economy (2 consumers who trade 2 goods) – can apply to 2 countries trade 2 goods) – can apply to 2 countries • Allocation of two goods is either economically Allocation of two goods is either economically inefficient - if the consumers (in this case 2) can make inefficient - if the consumers (in this case 2) can make • themselves better off by trading with each other themselves better off by trading with each other efficient - if no one can be made better off without efficient - if no one can be made better off without • making someone else worse off making someone else worse off  The term Pareto efficiency is used to refer the point of  The term Pareto efficiency is used to refer the point of efficient allocation of resources efficient allocation of resources

Edgeworth Box Diagram Edgeworth Box Diagram • Shows all possible allocations Shows all possible allocations a) two goods between two people a) two goods between two people b) two inputs between two production processes b) two inputs between two production processes  shows the interaction between two economic  shows the interaction between two economic activities activities • Construction of EWB (Figure 2) Construction of EWB (Figure 2) – 2 goods and 2 consumers in exchange 2 goods and 2 consumers in exchange – 2 industries and 2 inputs (L&K) in production 2 industries and 2 inputs (L&K) in production • Each point describes the bundle of both consumers Each point describes the bundle of both consumers  What is an efficient point?  What is an efficient point?

Figure 2: Edgeworth Box Diagram

2.4 The General equilibrium of exchange • Assumptions: Assumptions: – There are only two consumers There are only two consumers – There are two commodities X and Y There are two commodities X and Y – There is no production There is no production • Efficient allocation condition - MRS XY is the same for the Efficient allocation condition - MRS XY is the same for the two consumers two consumers  Insert the ICs for two consumers into EWBD  Insert the ICs for two consumers into EWBD  (See Figure 3)  (See Figure 3) • Note distribution of commodities between 2 consumers Note distribution of commodities between 2 consumers

Fig. 3: Edgeworth box diagram for exchange

– 1 st Consumer: X = OP & Y = OR 1 st Consumer: X = OP & Y = OR – 2 nd Consumer: X = OF – OP & Y= OM- OR 2 nd Consumer: X = OF – OP & Y= OM- OR  Total amount: X = OF & Y = OM  Total amount: X = OF & Y = OM  ICs : 1 st consumer – A 1 to A 4  ICs : 1 st consumer – A 1 to A 4 2nd consumer - H1 to H4 2nd consumer - H1 to H4 • Satisfaction of two consumers increases in opposite Satisfaction of two consumers increases in opposite directions directions • Aim is to establish a point of an efficient allocation Aim is to establish a point of an efficient allocation • Each point in the EWB diagram shows a specific Each point in the EWB diagram shows a specific allocation allocation • not all points constitute efficient allocation not all points constitute efficient allocation

• P oint Q in is not on efficient, Why? P oint Q in is not on efficient, Why? – Indifference curves intersect Indifference curves intersect – There is room of further trading There is room of further trading • exact point to which they will move cannot be exact point to which they will move cannot be predicted predicted • Depends on the bargain power of each individual – it • Depends on the bargain power of each individual – it can be either X 2 or X 3 can be either X 2 or X 3 • further exchange of the goods between the consumers further exchange of the goods between the consumers can be at a point between X2 or X3 say X can be at a point between X2 or X3 say X  This is known most or superior efficient point  This is known most or superior efficient point  Thus in EBD there might be more than one point of efficient  Thus in EBD there might be more than one point of efficient allocation allocation

• At Points X2, X3 and X, MRT XY is the same for all At Points X2, X3 and X, MRT XY is the same for all consumers consumers  the economy has attained the GE of exchange/  the economy has attained the GE of exchange/ consumption consumption • Consumption contract curve: Consumption contract curve: – locus of points of consumers’ indifference curves locus of points of consumers’ indifference curves tangencies tangencies – curve that shows all efficient allocation of goods between curve that shows all efficient allocation of goods between two consumers or of inputs between prod. functions two consumers or of inputs between prod. functions