Intermediate Microeconomic Theory

🧃Intermediate Microeconomic Theory Unit 7 – General Equilibrium & Economic Welfare

General equilibrium theory examines how multiple markets interact and reach equilibrium simultaneously. It explores concepts like Pareto efficiency, competitive equilibrium, and the Edgeworth box to analyze resource allocation and market interactions. The First and Second Welfare Theorems link competitive equilibrium to Pareto efficiency, providing insights into market outcomes. Social welfare functions aggregate individual preferences, while market interdependencies and feedback loops complicate economic analysis and policy decisions.

Key Concepts

  • General equilibrium analyzes the behavior of multiple markets simultaneously and how they interact with each other
  • Pareto efficiency is a state where no one can be made better off without making someone else worse off
  • Competitive equilibrium is a situation where all markets clear and no agent has an incentive to change their behavior
  • Edgeworth box is a graphical tool used to analyze the efficiency of resource allocation between two individuals or groups
  • First Welfare Theorem states that under certain assumptions, a competitive equilibrium leads to a Pareto efficient allocation of resources
    • Assumes perfect competition, complete markets, and no externalities or public goods
  • Second Welfare Theorem states that under certain assumptions, any Pareto efficient allocation can be achieved through a competitive equilibrium with appropriate initial redistributions
  • Social welfare function is a way to aggregate individual preferences into a measure of overall social welfare

Market Interactions

  • In a general equilibrium setting, changes in one market can have spillover effects on other markets through price adjustments and resource reallocation
  • Substitution effect occurs when a change in the price of one good leads consumers to substitute towards or away from other goods
  • Income effect occurs when a change in the price of a good affects consumers' real income and thus their demand for all goods
  • Feedback loops can amplify or dampen the effects of market disturbances as they propagate through the economy
    • Positive feedback loops (e.g., increased demand leading to higher prices, which further increases demand) can lead to instability
    • Negative feedback loops (e.g., increased supply leading to lower prices, which reduces supply) can help stabilize markets
  • Interdependence of markets means that analyzing one market in isolation may lead to incorrect conclusions about the overall impact of policy changes or other shocks

General Equilibrium Model

  • Walrasian general equilibrium model assumes perfect competition, complete markets, and no externalities or public goods
    • Agents are price-takers and have complete information about prices and qualities of goods
    • No market power, transaction costs, or barriers to entry or exit
  • Equilibrium is characterized by a set of prices such that supply equals demand in all markets simultaneously
    • Excess demand (supply) in one market puts upward (downward) pressure on prices until equilibrium is reached
  • Existence of equilibrium can be proven under certain assumptions using fixed-point theorems (e.g., Brouwer's or Kakutani's)
  • Uniqueness of equilibrium is not guaranteed in general, but can be shown under more restrictive assumptions (e.g., gross substitutability)
  • Stability of equilibrium depends on the adjustment process and the properties of excess demand functions
    • Tatonnement process adjusts prices in proportion to excess demand, but may not always converge to equilibrium
    • Non-tatonnement processes allow for trading at disequilibrium prices and may have different stability properties

Efficiency in Production and Consumption

  • Productive efficiency occurs when it is impossible to produce more of one good without producing less of another (i.e., on the production possibility frontier)
    • Marginal rate of technical substitution (MRTS) must be equal across all firms producing the same goods
  • Allocative efficiency occurs when resources are allocated to their highest-valued uses (i.e., marginal benefit equals marginal cost)
    • Marginal rate of substitution (MRS) must be equal across all consumers consuming the same goods
  • In a competitive equilibrium, both productive and allocative efficiency are achieved
    • Firms maximize profits by setting MRTS equal to input price ratios
    • Consumers maximize utility by setting MRS equal to output price ratios
  • Edgeworth box can be used to illustrate efficient allocations as points on the contract curve where MRS is equal for both consumers
  • Production possibility frontier (PPF) shows the maximum combinations of goods that can be produced given available resources and technology
    • Points inside the PPF are inefficient, while points outside are unattainable

Pareto Optimality

  • Pareto improvement is a change that makes at least one person better off without making anyone else worse off
  • Pareto optimal (or Pareto efficient) allocation is one where no Pareto improvements are possible
    • All gains from trade have been exhausted
  • First Welfare Theorem states that a competitive equilibrium is Pareto optimal under certain assumptions
    • Intuition: if there were any Pareto improvements left, agents would have an incentive to trade until they were achieved
  • Second Welfare Theorem states that any Pareto optimal allocation can be achieved as a competitive equilibrium with appropriate initial redistributions
    • Intuition: by redistributing endowments, we can "choose" which of the many possible Pareto optimal allocations to implement
  • Pareto criterion is often used as a normative benchmark for evaluating policy changes or market outcomes
    • However, it does not address distributional concerns or make interpersonal comparisons of utility

Welfare Economics

  • Social welfare function (SWF) is a way to aggregate individual preferences into a measure of overall social welfare
    • Different SWFs embody different value judgments about inequality, fairness, and interpersonal comparisons
    • Examples: utilitarian (sum of utilities), Rawlsian (maximize utility of worst-off individual), Nash (product of utilities)
  • Arrow's Impossibility Theorem shows that no SWF can satisfy a set of seemingly reasonable axioms simultaneously
    • Axioms include Pareto principle, independence of irrelevant alternatives, unrestricted domain, and non-dictatorship
  • Compensation principles (Kaldor-Hicks, Scitovsky) try to extend Pareto criterion to evaluate changes that create winners and losers
    • A change is an improvement if winners could hypothetically compensate losers and still be better off
    • However, actual compensation may not occur, and principles can lead to inconsistent rankings
  • Social choice theory studies how individual preferences can be aggregated into collective decisions (e.g., voting rules)
    • Condorcet paradox shows that majority voting can lead to intransitive social preferences
    • Arrow's theorem applies to social choice as well, limiting the scope for rational collective decision-making

Real-World Applications

  • Computable general equilibrium (CGE) models are used to simulate the effects of policy changes or other shocks on the economy
    • Based on calibrated parameters and functional forms, solved numerically
    • Examples: trade liberalization, tax reforms, environmental regulations
  • Input-output analysis studies the interdependence of industries in an economy and how changes in one sector affect others
    • Based on input-output tables showing flows of goods and services between sectors
    • Can be used to calculate multipliers and analyze supply chain disruptions
  • Urban economics applies general equilibrium concepts to the spatial structure of cities and the location decisions of firms and households
    • Monocentric city model explains land rent gradients and commuting patterns
    • Agglomeration economies and congestion externalities can lead to multiple equilibria and path dependence
  • International trade theory uses general equilibrium models to analyze the causes and consequences of trade between countries
    • Ricardian model explains trade based on differences in technology and opportunity costs
    • Heckscher-Ohlin model explains trade based on differences in factor endowments and intensities
    • Gains from trade, distributional effects, and optimal trade policies can be studied in a general equilibrium framework

Limitations and Critiques

  • Assumptions of perfect competition, complete markets, and no externalities are rarely satisfied in reality
    • Market power, asymmetric information, transaction costs, and missing markets are common
    • Public goods and externalities (e.g., pollution, congestion) create wedges between private and social costs/benefits
  • Behavioral economics challenges the assumption of rational, self-interested agents with stable preferences
    • Bounded rationality, cognitive biases, and social preferences can lead to deviations from standard model predictions
    • Nudges and choice architecture can be used to influence behavior and improve outcomes
  • Dynamic and stochastic aspects of the economy are often neglected in static, deterministic general equilibrium models
    • Intertemporal choices, uncertainty, and expectations formation can have important implications for equilibrium outcomes
    • Overlapping generations models and dynamic stochastic general equilibrium (DSGE) models try to address these issues
  • General equilibrium analysis is often criticized for being too abstract and unrealistic, and for neglecting important institutional and historical factors
    • Partial equilibrium analysis may be more appropriate for some research questions and policy issues
    • Comparative statics results may not hold in the presence of multiple equilibria or non-convexities
  • Distributional concerns and normative judgments are not fully captured by the Pareto criterion or competitive equilibrium
    • Equity-efficiency tradeoffs and interpersonal comparisons of well-being require additional value judgments
    • Social welfare functions and compensation principles have their own limitations and controversies


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© 2024 Fiveable Inc. All rights reserved.
AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.