Ch11

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
CHAPTERCHAPTER 1111
Prepared by: Fernando QuijanoPrepared by: Fernando Quijano
and Yvonn Quijanoand Yvonn Quijano
General Equilibrium and theGeneral Equilibrium and the
Efficiency of PerfectEfficiency of Perfect
CompetitionCompetition

Firm and Household DecisionsFirm and Household Decisions
• Input and outputInput and output
markets cannot bemarkets cannot be
considered separatelyconsidered separately
or as if they operatedor as if they operated
independently.independently.

Partial Equilibrium AnalysisPartial Equilibrium Analysis
• Partial equilibrium analysisPartial equilibrium analysis isis
the process of examining thethe process of examining the
equilibrium conditions inequilibrium conditions in
individual markets, and forindividual markets, and for
households and firms,households and firms,
separately.separately.

General EquilibriumGeneral Equilibrium
• General equilibriumGeneral equilibrium is theis the
condition that exists when allcondition that exists when all
markets in an economy are inmarkets in an economy are in
simultaneous equilibrium.simultaneous equilibrium.

EfficiencyEfficiency
• In judging the performance of anIn judging the performance of an
economic system, two criteria usedeconomic system, two criteria used
are efficiency and equity (fairness).are efficiency and equity (fairness).
• EfficiencyEfficiency is the condition inis the condition in
which the economy is producingwhich the economy is producing
what people want at the leastwhat people want at the least
possible cost.possible cost.

General Equilibrium AnalysisGeneral Equilibrium Analysis
• To examine the move from partial toTo examine the move from partial to
general equilibrium analysis we willgeneral equilibrium analysis we will
consider the impact of:consider the impact of:
• a major technological advance, anda major technological advance, and
• a shift in consumer preferences.a shift in consumer preferences.

Cost-Saving Technological ChangeCost-Saving Technological Change
• Technology improvements made it possible toTechnology improvements made it possible to
produce at lower costs in the calculator industry.produce at lower costs in the calculator industry.

• As new firms entered the industry and existing firmsAs new firms entered the industry and existing firms
expanded, output rose and market prices dropped.expanded, output rose and market prices dropped.

• A significant technological change inA significant technological change in
a single market affects manya single market affects many
markets:markets:
• Households must adjust to changingHouseholds must adjust to changing
pricesprices
• Labor reacts to new skill requirementsLabor reacts to new skill requirements
and is reallocated across marketsand is reallocated across markets
• Capital is also reallocatedCapital is also reallocated

A Shift in Consumer PreferencesA Shift in Consumer Preferences
• To examine the effects of a change in one market on otherTo examine the effects of a change in one market on other
markets, we will consider the wine industry in the 1970s.markets, we will consider the wine industry in the 1970s.
Production and Consumption of Wine in the United States, 1965–1980Production and Consumption of Wine in the United States, 1965–1980
YEARYEAR
U.S.U.S.
PRODUCTIONPRODUCTION
(MILLIONS OF(MILLIONS OF
GALLONS)GALLONS)
IMPORTSIMPORTS
GALLONS)GALLONS)
TOTALTOTAL
GALLONS)GALLONS)
CONSUMPTIONCONSUMPTION
PER CAPITAPER CAPITA
(GALLONS)(GALLONS)
19651965 565565 1010 575575 1.321.32
19701970 713713 2222 735735 1.521.52
19751975 782782 4040 822822 1.961.96
19801980 983983 9191 10731073 2.022.02
Percent change,Percent change,
1965–19801965–1980
++ 74.074.0 ++810.0810.0 ++ 86.686.6 ++53.053.0
SourceSource: U.S. Department of Commerce, Bureau of the Census,: U.S. Department of Commerce, Bureau of the Census, Statistical Abstract of the United StatesStatistical Abstract of the United States, 1985, Table 1364, p. 765., 1985, Table 1364, p. 765.

Adjustment in an EconomyAdjustment in an Economy
with Two Sectorswith Two Sectors
• This graph shows theThis graph shows the
initial equilibrium in aninitial equilibrium in an
economy with twoeconomy with two
sectors—wine (sectors—wine (XX) and) and
other goods (other goods (YY)—prior)—prior
to a change into a change in
consumer preferences.consumer preferences.

• A change in consumerA change in consumer
preferences causes anpreferences causes an
increase in the demandincrease in the demand
for wine, and,for wine, and,
consequently, aconsequently, a
decrease in the demanddecrease in the demand
for other goods.for other goods.

• A higher price creates aA higher price creates a
profit opportunity inprofit opportunity in
sectorsector XX..
• Simultaneously, lowerSimultaneously, lower
prices result in losses inprices result in losses in
industryindustry YY..

• As new firms enterAs new firms enter
industryindustry XX and existingand existing
firms expand, outputfirms expand, output
rises and market pricesrises and market prices
drop. Excess profits aredrop. Excess profits are
eliminated.eliminated.

• As new firms exitAs new firms exit
industryindustry Y,Y, market pricemarket price
rises and losses arerises and losses are
eliminated.eliminated.

Wine Production is anWine Production is an
Increasing-Cost IndustryIncreasing-Cost Industry
Land in Grape Production in the United States and in California Alone,Land in Grape Production in the United States and in California Alone,
1974 and 19821974 and 1982
NUMBER OF VINEYARDSNUMBER OF VINEYARDS NUMBER OF ACRESNUMBER OF ACRES
United StatesUnited States
19741974 14,20814,208 712,804712,804
19821982 24,98224,982 874,996874,996
Percent changePercent change +75.8+75.8 +22.8+22.8
CaliforniaCalifornia
19741974 8,3338,333 607,011607,011
19821982 10,48110,481 756,720756,720
Percent changePercent change +25.8+25.8 +24.7+24.7
SourceSource: U.S. Department of Commerce, Bureau of the Census,: U.S. Department of Commerce, Bureau of the Census, Census of AgricultureCensus of Agriculture (1974 and 1982), 1, part 51.(1974 and 1982), 1, part 51.

Formal Proof of aFormal Proof of a
General Competitive EquilibriumGeneral Competitive Equilibrium
• This section explains why perfectThis section explains why perfect
competition is efficient in dividingcompetition is efficient in dividing
scarce resources among alternativescarce resources among alternative
uses.uses.
• If the assumptions of a perfectlyIf the assumptions of a perfectly
competitive economic system hold, thecompetitive economic system hold, the
economy will produce an efficienteconomy will produce an efficient
allocation of resources.allocation of resources.

The Efficiency of Perfect CompetitionThe Efficiency of Perfect Competition
• The three basic questions in aThe three basic questions in a
competitive economy are:competitive economy are:
1.1. What will be produced?What will be produced? WhatWhat
determines the final mix of output?determines the final mix of output?
2.2. How will it be produced?How will it be produced? How doHow do
capital, labor, and land get divided upcapital, labor, and land get divided up
among firms?among firms?
3.3. Who will get what is produced?Who will get what is produced? WhatWhat
is the distribution of output amongis the distribution of output among
consuming households?consuming households?

• As we will see, in a perfectlyAs we will see, in a perfectly
competitive economic system:competitive economic system:
1.1. resources are allocated among firmsresources are allocated among firms
efficiently,efficiently,
2.2. final products are distributed amongfinal products are distributed among
households efficiently, andhouseholds efficiently, and
3.3. the system produces the things thatthe system produces the things that
people want.people want.

Pareto EfficiencyPareto Efficiency
• Pareto efficiency,Pareto efficiency, oror ParetoPareto
optimality,optimality, is a condition in which nois a condition in which no
change is possible that will make somechange is possible that will make some
members of society better off withoutmembers of society better off without
making some other members of societymaking some other members of society
worse off.worse off.
• This very precise concept of efficiencyThis very precise concept of efficiency
is known asis known as allocative efficiency.allocative efficiency.

Efficient Allocation of Resources:Efficient Allocation of Resources:
• Perfectly competitive firms have incentives toPerfectly competitive firms have incentives to
use the best available technology.use the best available technology.
• With a full knowledge of existingWith a full knowledge of existing
technologies, firms will choose thetechnologies, firms will choose the
technology that produces the output theytechnology that produces the output they
want at the least cost.want at the least cost.
• Each firm uses inputs such thatEach firm uses inputs such that MRPMRPLL == PPLL..
The marginal value of each input to eachThe marginal value of each input to each
firm is just equal to its market price.firm is just equal to its market price.

• Within the constraints imposed by incomeWithin the constraints imposed by income
and wealth, households are free to chooseand wealth, households are free to choose
among all the goods and services availableamong all the goods and services available
in output markets. Utility value is revealed inin output markets. Utility value is revealed in
market behavior.market behavior.
• As long as everyone shops freely in theAs long as everyone shops freely in the
same markets, no redistribution of finalsame markets, no redistribution of final
outputs among people will make them betteroutputs among people will make them better
off.off.
Efficient Distribution of Outputs AmongEfficient Distribution of Outputs Among
Households:Households:

• Society will produce theSociety will produce the
efficient mix of output if allefficient mix of output if all
firms equate price andfirms equate price and
marginal cost.marginal cost.
Producing What People WantProducing What People Want
—the Efficient Mix of Output:—the Efficient Mix of Output:

The Key Efficiency Condition: PriceThe Key Efficiency Condition: Price
Equals Marginal CostEquals Marginal Cost
IfIf PPXX >> MCMCXX, society gains value by producing more, society gains value by producing more XX
IfIf PPXX << MCMCXX, society gains value by producing less, society gains value by producing less XX
The value placed on
good X by society
through the market, or
the social value of a
marginal unit of X.
Market-determined value of
resources needed to produce a
marginal unit of X. MCX is equal
to the opportunity cost of those
resources: lost production of other
goods or the value of the resources
left unemployed (leisure, vacant
land, etc).

Efficiency in Perfect CompetitionEfficiency in Perfect Competition
• Efficiency in perfect competition follows from a weighing of values byEfficiency in perfect competition follows from a weighing of values by
both households and firms.both households and firms.

The Sources of Market FailureThe Sources of Market Failure
• Market failureMarket failure occurs when resourcesoccurs when resources
are misallocated, or allocatedare misallocated, or allocated
inefficiently. The result is waste or lostinefficiently. The result is waste or lost
value. Evidence of market failure isvalue. Evidence of market failure is
revealed by the existence of:revealed by the existence of:
• Imperfect marketsImperfect markets
• Public goodsPublic goods
• ExternalitiesExternalities
• Imperfect informationImperfect information

Imperfect MarketsImperfect Markets
• Imperfect competitionImperfect competition is an industry inis an industry in
which single firms have some controlwhich single firms have some control
over price and competition.over price and competition.
• Imperfectly competitive industries giveImperfectly competitive industries give
rise to an inefficient allocation ofrise to an inefficient allocation of
resources.resources.

• MonopolyMonopoly is an industry composedis an industry composed
of only one firm that produces aof only one firm that produces a
product for which there are no closeproduct for which there are no close
substitutes and in which significantsubstitutes and in which significant
barriers exist to prevent new firmsbarriers exist to prevent new firms
from entering the industry.from entering the industry.

• In all imperfectly competitive industries,In all imperfectly competitive industries,
output is lower—the product isoutput is lower—the product is
underproduced—and price is higherunderproduced—and price is higher
than it would be under perfectthan it would be under perfect
competition.competition.
• The equilibrium conditionThe equilibrium condition P = MCP = MC does notdoes not
hold, and the system does not produce thehold, and the system does not produce the
most efficient product mix.most efficient product mix.

Public GoodsPublic Goods
• Public goodsPublic goods, or, or social goodssocial goods areare
goods and services that bestowgoods and services that bestow
collective benefits on members ofcollective benefits on members of
society.society.
• Generally, no one can be excluded fromGenerally, no one can be excluded from
enjoying their benefits. The classicenjoying their benefits. The classic
example is national defense.example is national defense.

Public GoodsPublic Goods
• Private goodsPrivate goods are products producedare products produced
by firms for sale to individualby firms for sale to individual
households.households.
• Private provision of public goods fails. APrivate provision of public goods fails. A
completely laissez-faire market will notcompletely laissez-faire market will not
produce everything that all members of aproduce everything that all members of a
society might want. Citizens must bandsociety might want. Citizens must band
together to ensure that desired publictogether to ensure that desired public
goods are produced, and this is generallygoods are produced, and this is generally
accomplished through governmentaccomplished through government
spending financed by taxes.spending financed by taxes.

ExternalitiesExternalities
• AnAn externalityexternality is a cost or benefitis a cost or benefit
resulting from some activity orresulting from some activity or
transaction that is imposed or bestowedtransaction that is imposed or bestowed
on parties outside the activity oron parties outside the activity or
transaction.transaction.
• The market does not always forceThe market does not always force
consideration of all the costs and benefits ofconsideration of all the costs and benefits of
decisions. Yet for an economy to achievedecisions. Yet for an economy to achieve
an efficient allocation of resources, all costsan efficient allocation of resources, all costs
and benefits must be weighed.and benefits must be weighed.

Imperfect InformationImperfect Information
• Imperfect informationImperfect information is the absenceis the absence
of full knowledge concerning productof full knowledge concerning product
characteristics, available prices, and socharacteristics, available prices, and so
forth.forth.
• The absence of full information can lead toThe absence of full information can lead to
transactions that are ultimatelytransactions that are ultimately
disadvantageous.disadvantageous.

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