V. General equilibrium with competitive markets

    We've looked at consumers and how they allocate their budgets.
    We've looked at producers and how they choose their inputs to cut costs.
    We've looked at competitive firms and how they choose how much to produce.

    Now time to put the pieces together

    Keep in mind the importance of comparing.
    Because of scarcity, we never have as much as we want. We must always value what we've got relative to what else we might have.

    An economist's most common response to a question: "Compared to what?"

    This is microeconomics at its most elegant

    Economic efficiency
    The goal we have the most to say about

    First, what is economic efficiency?
    Layperson: no waste.
    More formally: economic efficiency  => Pareto optimal
    An allocation is Pareto optimal when it is impossible to make anyone better off without making someone else worse off.

    To achieve a Pareto optimal allocation requires satisfying
    3 efficiency conditions:
    (1) Output efficiency (OE): What to produce?
    (2) Input efficiency (IE): How to produce?
    (3) Exchange efficiency (EE): For whom to produce?

    We'll address the efficiency questions in a general equilibrium context.

    Recall what that means: Partial equilibrium analysis looks at one market at a time, using S&D, measuring welfare with CS and PS.
    Ex: fat-free cookies.

    Limitations of partial equilibrium:

    (1) What if the fat-free market equilibrium we see is because of a tax on regular cookies?
    Can't see that distortion with partial equil.

    (2) also, partial equilibrium only shows output. Doesn'‘t get behind S&D. How do we know that minimum costs have been achieved?

    General equilibrium analysis considers the relationship between markets.
    >1 market at a time--most broadly, for all markets together

    Here, we'll move to a 2x2x2 market. 2 goods; 2 inputs, 2 consumers

    3 key relationships

    One from each part of course so far: X-rays (X) and Yogurt (Y)

    Utility maximizing by consumers -->
        (1) MUx/MUy = MRS = Px/Py
    Relative relative of X = relative cost of X

    Cost minimizing by firms -->
        (2) MPL/MPK = MRTS = PL/PK
    Relative productivity of L = relative cost of L

    Profit maximizing by firms under perfect competition -->
        Px=MCx and Py=MCy =>
        (3) Px/Py = MCx/MCy
Relative price of X = relative cost of X.

    These relationships turn out to capture the 3 conditions for efficiency, with the order reversed:
    (1) addresses for whom to produce?
    (2) addresses how to produce?
    (3) addresses what to produce?

    A. Exchange efficiency   (EE)

    This deals with the efficient way to distribute to the members of society any given set of goods.
    Assumes that the actual bundle available to divide up is given--production is over.
    The goal is to get the goods to their highest-valued uses and users

    Exchange occurs between consumers
    A distribution of output is efficient if it is impossible for an exchange between consumers to make some consumer better off without making some other consumer worse off.

    1. Geometry: the Edgeworth box for exchange

    Example: Halloween
    2 consumers: Machiko (M) and Cami (C)
    2 goods: X=candy bars (B)
        Y=other sweets (S)
    Each has some initial bundle = their endowment of B and S.
        Um = U(Bm, Sm)
        Uc = U(Bc, Sc)

        Bm + Bc = Bt (total)
        Sm + Sc = St

    Indifference maps--the trick: measure Cami upside down:

    Make (Bt,St) the origin for Cami.

    Edgeworth box: measures M from the lower left corner and C from the upper right corner

Consider the set of allocations which would be efficient in exchange:     Step 1: Choose U1c     All along U1c, pts. --> consumption bundles which yield equal U.     ? Given U1c, what consumption bundles are available to Machiko?     So points inside the box and on U1c are Machiko's consumption possibilities.     ? How do we figure out which bundle is most satisfying to Machiko?     Step 2: Find the highest attainable Um, given Uc (=> Um tangent to U1c)

    Repeat steps 1 and 2 forever. Result =
    Contract curve (CC): the set of all Pareto optimal consumption bundles
    All the points on CC are efficient in distribution.

    Note: all along CC: MRSm = MRSc
    Example: At point 1, suppose MRSm = MRSc = 4.
    => both are willing to trade 4s for 1c.
    Both place the same relative marginal value on  chocolates compared to other sweets.

    Note 1: A Pareto optimal distribution is not unique. All points on CC are Pareto optimal.

    Note 2: Pareto optimality says nothing about equity:
    The origins are Pareto optimal despite one consumer being completely destitute.

    Suppose instead we are off the contract curve.

    Do "Achieving exchange efficiency" worksheet
    Example: At a, MRSm < MRSc

    The shaded area represents consumption bundles which both consumers prefer to point a.
    Called a lens: = bundles attainable through exchange which raise the utility of at least one consumer without reducing the utility of the other.
    = Pareto superior allocations.

    2. Exchange efficiency and competitive markets

    In practice, consumers don't bargain much; they just go to the market and buy.

    However, unrestricted competitive markets promote exchange efficiency since consumers face equal market-clearing prices for equivalent products.

    => MRSyou = Px/Py = MRSme

    Frank: An equilibrium produced by competitive markets will exhaust all possible gains from exchange

    --Careful: must be identical goods.
    Gas costs more in the mountains because of extra transport costs--consumers can't gain from exchange in this case.

    Counterexamples: usually show up with
    --price controls
    --price discrimination

Example: faculty discounts at the bookstore     s = students     f = faculty     goodX = books (B)     MRSs > MRSf     ? Can you think of how we can both end up better off?

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