Microeconomics

Eighth Edition

Chapter 10
General
Equilibrium and
Economic Welfare

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Learning Objectives
10.1 General Equilibrium.
10.2 Trading Between Two People.
10.3 Competitive Exchange.
10.4 Production and Trading.
10.5 Efficiency and Equity.

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Pareto Principle
• A narrow value criterion used in evaluating welfare in
general equilibrium.
• To rank different allocations of goods and services for
which no interpersonal comparisons need to be made.
• Pareto efficient - describing an allocation of goods or
services such that any reallocation harms at least one
person.

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General Equilibrium
• Partial-equilibrium analysis - an examination of
equilibrium and changes in equilibrium in one market
in isolation.
• General-equilibrium analysis - the study of how
equilibrium is determined in all markets
simultaneously.

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Figure 10.1 Relationship Between the Corn and
Soybean Markets

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Adjustment in the Corn and Soybean
Markets
• Table 10.1 Adjustment in the Corn and Soybean Markets
blank blank Corn blank Soybcans
Step Price Quantity Price Quantity
Initial (0) 2.15 8.44 4.12 2.07
1 1.9171 8.227 blank blank
2 blank blank 3.8325 2.0514
3 1,9057 8.2613 blank blank
4 blank blank 3.818 2.0505
5 1.90508 8.26308 blank blank
6 blank blank 3.81728 2.05043
. . . . .
. . . . .
. . . . .
Final 1.90505 8.26318 3.81724 2.05043
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Solved Problem 10.1
• The coffee and tea demand functions depend on both
prices. Suppose the demand curves for coffee and tea
are Qc = 120 − 2pc + pt and Qt = 90 − 2pt + pc, where Qc
is the quantity of coffee, Qt is the quantity of tea, pc is the
price of coffee, and pt is the price of tea. These crops are
grown in separate parts of the world, so their supply
curves are not interrelated. We assume that the short-run,
inelastic supply curves for coffee and tea are Qc = 45 and
Qt = 30. Solve for the equilibrium prices and quantities.
Now suppose that a freeze shifts the short-run supply
curve of coffee to Qc = 30. How does the freeze affect the
prices and quantities?

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Solved Problem 10.1: Answer
• Equate the quantity demanded and supplied for both
markets.
• Substitute the expression for pt from the coffee
equation into the tea equation and solve for the price
of coffee, then use that result to obtain pt
• Repeat the analysis for Qc = 30.

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Minimum Wages with Incomplete
Coverage (1 of 2)
• Result of partial-equilibrium analysis in Chapter 2:
– The minimum wage causes the quantity of labor
demanded to be less than the quantity of labor
supplied.
– Workers who lose their jobs cannot find work
elsewhere, so they become unemployed.

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Minimum Wages with Incomplete
Coverage (2 of 2)
• The story changes substantially if the minimum wage
law covers workers in only some sectors of the
economy.
• When the U.S. minimum wage law was first passed in
1938, it drove workers out of manufacturing and other
covered industries into agriculture, which the law did
not cover.

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Figure 10.2 Minimum Wage with
Incomplete Coverage
(a) Covered Sector (b) Uncovered Sector (c) Total Labor Market

w, Wage per hour

S
w
–
S u

w1 w1 w1
w2

Dc Du D

L c2 L c1 L u1 L u2 L 1 = L c1 + L u1
L c , Annual hours L u , Annual hours L , Annual hours

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Solved Problem 10.2
• Initially, all workers are paid a wage of w1 per hour.
The government taxes the cost of labor by t per hour
only in a covered sector of the economy. If workers
receive a wage of w2 per hour, firms in the covered
sector pay w2 + t. Show how the wages in both sectors
are determined in the post-tax equilibrium. What effect
does the tax have on total employment, and
employment in the covered and uncovered sectors of
the economy?

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Solved Problem 10.2: Answer

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Trading Between Two People:
Scenario
• Jane and Denise live near each other in the wilds of
Massachusetts when a snowstorm strikes, isolating
them from the rest of the world.
– They must either trade with each other or consume
only what they have at hand.
• Collectively, they have 50 piles of firewood and 80
bars of candy and no way of producing more of either
good.

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Trading Between Two People:
Endowments
• Endowment - an initial allocation of goods.
• Jane’s endowment is 30 piles of firewood and 20
candy bars.
• Denise’s endowment is 20 (= 50 − 30) piles of
firewood and 60 (= 80 − 20) candy bars.
– So Jane has relatively more firewood, and Denise has
relatively more candy.

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Figure 10.3(a) Endowments in an
Edgeworth Box

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Figure 10.3(b) Endowments in an
Edgeworth Box

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Figure 10.3(c) Endowments in an
Edgeworth Box

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Mutually Beneficial Trades (1 of 2)
• Three assumptions about their tastes and behavior:
– Utility maximization
– Usual-shaped indifference curves
– No interdependence

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Figure 10.4 Contract Curve

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Mutually Beneficial Trades (2 of 2)
• We can make four equivalent statements about
allocation f:
1. The indifference curves of the two parties are tangent
at f.
2. The parties’ marginal rates of substitution are equal
at f.
3. No further mutually beneficial trades are possible at f.
4. The allocation at f is Pareto efficient: One party
cannot be made better off without harming the other.

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Contract Curve
• Contract curve - the set of all Pareto-efficient
bundles.
• Only at these bundles are the parties unwilling to
engage in further trades or contracts – these
allocations are the final contracts.
• A move from any bundle on the contract curve would
harm at least one person.

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Solved Problem 10.3
• Are allocations a and g in Figure 10.4 part of the
contract curve?
• Answer:
– By showing that no mutually beneficial trades are
possible at those points, demonstrate that those
bundles are Pareto efficient.

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Competitive Exchange
• Two desirable properties:
– First Theorem of Welfare Economics
▪ The competitive equilibrium is efficient.
– Second Theorem of Welfare Economics
▪ Any efficient allocations can be achieved by competition.

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Competitive Equilibrium
• If there were a large number of people with tastes and
endowments like Jane’s and a large number of people
with tastes and endowments like Denise’s, each
person would be a price taker in the markets for the
two goods.
• In a competitive market, prices adjust until the quantity
supplied equals the quantity demanded.

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Figure 10.5(a) Competitive
Equilibrium

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Figure 10.5(b) Competitive
Equilibrium
(b) Prices That Do Not Lead to a Competitive Equilibrium
Denise’s candy
80 60 43 0d
50

Denise’s wood
45

I d1
30 20
I d2 e
j
22
d
32
I 2j
Jane’s wood

I 1j

a Price line
50
0j 20 30 60 80
Jane’s candy

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The Efficiency of Competition
• In a competitive equilibrium:
Pc
MRS j = − = MRSd
Pw
– Thus, we have demonstrated the First Theorem of
Welfare Economics:
– Any competitive equilibrium is Pareto efficient.

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Obtaining Any Efficient Allocation
Using Competition (1 of 2)
• Any Pareto-efficient bundle x can be obtained as a
competitive equilibrium if the initial endowment is x.
• That allocation can also be obtained as a competitive
equilibrium if the endowment lies on a price line
through x, where the slope of the price line equals the
marginal rate of substitution of the indifference curves
that are tangent at x.

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Obtaining Any Efficient Allocation
Using Competition (2 of 2)
• We’ve demonstrated the Second Theorem of Welfare
Economics:
Any Pareto-efficient equilibrium can be obtained by
competition, given an appropriate endowment.

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Production and Trading
• Scenario: Jane and Denise can produce candy or
chop firewood using their own labor. They differ,
however, in how much of each good they produce
from a day’s work.

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Production Possibility Frontier (1 of 3)
• Jane can produce either 3 candy bars or 6 piles of
firewood in a day.
• Denise can produce up to 3 piles of wood or 6 candy
bars in a day.

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Production Possibility Frontier (2 of 3)
• Production Possibility Frontier - shows the
maximum combinations of two goods that can be
produced from a given amount of input.
– The slope of the production possibility frontier is the
marginal rate of transformation (MRT).

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Figure 10.6 Comparative Advantage
and Production Possibility Frontiers

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Production Possibility Frontier (3 of 3)
• Comparative advantage - the ability to produce a
good at a lower opportunity cost than someone else.
• Because of the difference in their marginal rates of
transformation, Jane and Denise can benefit from a
trade.

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Solved Problem 10.4
• How does the joint production possibility frontier in
panel c of Figure 10.6 change if Jane and Denise can
also trade with Harvey, who can produce 5 piles of
wood, 5 candy bars, or any linear combination of
wood and candy in a day?

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Solved Problem 10.4: Answer

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The Number of Producers
• With many producers the PPF is a smooth concave
curve.
• Because the PPF is concave, the marginal rate of
transformation decreases (in absolute value) as we
move up the PPF.
• Also,
MCc
MRT = −
MCw
– where MCc and MCw are the marginal costs of
producing candy and wood respectively.

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Figure 10.7 Optimal Product Mix

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Efficient Product Mix
• If a single person were to decide on the product mix,
that person would pick the allocation of wood and
candy along the PPF that maximized his or her utility.
– For each consumer:
MRS = MRT ,
– if the economy is to produce the optimal mix of goods
for each consumer.

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Competition (1 of 3)
• Each consumer picks a bundle of goods so,

Pc
MRS = −
Pw

• Consumption efficiency - we can’t redistribute goods

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Competition (2 of 3)
• If candy and wood are sold by competitive firms,
Pc = MCc
Pw = MCw
– Therefore,
Pc MCc
=
Pw MCw
Pc
MRT = −
Pw
Pc
MRT = − = MRS
Pw
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Competition (3 of 3)
• Since,
Pc
MRT = − = MRS
Pw
• A competitive equilibrium achieves an:
– efficient product mix - the rate at which firms can
transform one good into another equals the rate at
which consumers are willing to substitute between the
goods, as reflected by their willingness to pay for the
two goods.

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Figure 10.8 Competitive Equilibrium

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Efficiency and Equity
• How well various members of society live depends on
how society deals with efficiency (the size of the pie)
and equity (how the pie is divided).
• The actual outcome depends on choices by
individuals and on government actions.

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Role of the Government
• By altering the efficiency with which goods are
produced and distributed and the endowment of
resources, governments help determine how much is
produced and how goods are allocated.

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Application: The Wealth and Income
of the 1% (1 of 2)

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Application: The Wealth and Income
of the 1% (2 of 2)

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Efficiency
• The Pareto criterion ranks allocation x over allocation
y if some people are better off at x and no one else is
harmed.
– x is Pareto superior to y.
• Any policy change that leads to a Pareto-superior
allocation must increase W (welfare).
– However, some policy changes that increase W are not
Pareto superior: There produce both winners and
losers.

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Equity
• Social welfare function - combines various
consumers’ utilities to provide a collective ranking of
allocations.
– Sort of like a utility function for society.
• Utility possibility frontier (UPF) - the set of utility
levels corresponding to the Pareto efficient allocations
along the contract curve.

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Figure 10.9 Welfare Maximization

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Voting
• Sometimes voting does not work well, and the
resulting social ordering of allocations is not transitive.

blank Individual 1 Individual 2 Individual 3

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Arrow’s Impossibility Theorem (1 of 2)
• A social welfare function should satisfy the following
criteria:
– Social preferences should be complete and transitive,
like individual preferences.
– If everyone prefers Allocation a to Allocation b, a
should be socially preferred to b.
– Society’s ranking of a and b should depend only on
individuals’ ordering of these two allocations, not on
how they rank other alternatives.
– Dictatorship is not allowed; social preferences must not
reflect the preferences of only a single individual.

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Arrow’s Impossibility Theorem (2 of 2)
• It is impossible to find a social decision-making rule
that always satisfies all of these criteria.
– Result indicates that democratic decision making may
fail—not that democracy must fail.

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Social Welfare Functions (1 of 2)
• Utilitarian philosophers: suggested that society should
maximize the sum of the utilities of all members of
society.
– Their social welfare function is the sum of the utilities of
every member of society.
• If Ui is the utility of Individual i and there are n people,
the utilitarian welfare function is:

W = U1 + U2 + ... + U n .

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Social Welfare Functions (2 of 2)
• The Rawlsian welfare function is:

W = min U1,U 2 ,...,U n .

– Rawls’ rule leads to a relatively egalitarian distribution

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Efficiency versus Equity
• Given a particular social welfare function, society
might prefer an inefficient allocation to an efficient
one.
• By most of the well-known social welfare functions,
but not all, there is an efficient allocation that is
socially preferred to an inefficient allocation.
• Competitive equilibrium may not be very equitable
even though it is Pareto efficient.

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Anti-Price Gouging Law

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