09/11/2017

EC204 - Topic 4

General Equilibrium
And Welfare
Varian Chapter 31

Topics

 General Equilibrium
 Edgeworth Boxes
 Pareto optimality
 The Welfare Theorems

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Partial Equilibrium (V31)

 Most of the theory so far has focused on

partial equilibrium analysis
 Analysis that focuses on a single market
− Demand and supply depend on a good’s
price
 It ignores the idea that different markets are
inter-related
− Changes in one market will spill over to
others through changes in input prices,
substitution effects and welfare effects 3

Partial Equilibrium
 2017: duty on wine to increase
 Prior to the tax, assume all markets were in
equilibrium
− Wine tax rise shifts supply curve up by say
4p, so we have a new equilibrium price
 Under Partial equilibrium analysis, we have
reached a new equilibrium
− But under General Equilibrium, we need to
analyse the effects in other, related markets
− Consider the market for spirits (a substitute) 4

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Increase in taxation on wine

General Equilibrium
 We now view the economy as a system of
related markets
− It endogenizes prices and incomes
− Analysis of the interactions of demand and
supply in several markets to determine the
market prices of several goods
 GE models can be developed showing
production, exchange and consumption
 The importance for policy analysis

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Pure Exchange
 ‘2 x 2’ Economy
− The simplest possible world
− 2 consumers and 2 goods
− No production, only exchange
− Consumers have an initial endowment of
goods (a bundle of the 2 goods) and try to
maximise utility
− We represent preferences using a utility
function and thus indifference curves
− For each good in the economy, there is a
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competitive market

‘2 x 2’ Pure Exchange Economy

Jill’s preferences give us her

indifference curve.
Her initial endowment is
given by E2 with 10 oranges
and 4 bananas.

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‘2 x 2’ Pure Exchange Economy

Jack’s initial endowment is E1, where he has 3 oranges

and 6 bananas.
Combining Jack and Jill’s indifference curves on one
diagram gives us the Edgeworth Box.

The benefits of trade

Jack and Jill will keep trading from point E to A etc. until no further
mutually beneficial trades can be made. This occurs at point B,
which is an efficient division of the economy’s endowments.

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Pareto Efficiency and the contract

curve
 Pareto efficiency occurred at point B
 Are Pareto efficient points unique?
 The contract curve
 We want to be on the contract curve, but is
every point achievable?
− Those allocations that we can achieve through
voluntary trade, given the endowments ‘E’ are
part of the ‘Core’

The Contract Curve and the Core

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Competitive Equilibrium
 A trading process that mimics competition to
find equilibrium prices
− If we are in a disequilibrium with excess
supply/demand, what will happen to prices?
 By adjusting prices, we can find a vector of
prices which allows the exchange economy to
reach a competitive equilibrium (CE)

Competitive Equilibrium

By changing the prices, Jack

and Jill will optimise at the
same point (C). Demand
equals supply in both markets.

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The Welfare Theorems

 We try to combine the market solution of

competitive equilibrium …
 With the social ideology of Pareto efficiency
 This leads us to 2 key fundamental theorems
of welfare economics
− The First Welfare Theorem
− The Second Welfare Theorem

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The First Welfare Theorem

 If the competitive equilibria in an economy are
Pareto efficient (under certain assumptions), the
First Welfare Theorem will hold

Does this theorem

tell us anything
about equity?

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The Second Welfare Theorem

 This can be seen as the inverse of the first
 Given a Pareto efficient allocation of goods,
can it also be a market equilibrium?
− The First Theorem says that competitive
equilibria are efficient
− The Second Theorem says any efficient
allocation can be a competitive equilibrium
allocation, so long as the government can
redistribute endowments without shrinking
the economy in the process 17

The Second Welfare Theorem

For D to be an
equilibrium, the
endowment point must
be redistributed to
somewhere on the
budget line, such as E’.
The market mechanism
will then lead to the
new equilibrium at D.

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The Second Welfare Theorem

 If both agent’s preferences are convex, then the
budget line will not intersect either indifference
curve more than once
− A Pareto efficient allocation will be a
competitive equilibrium
 If preferences are not convex…
− The Second Welfare Theorem will not hold
− An allocation may be Pareto efficient, but there
may not be any prices at which both agents will
want to consume at that point
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Government’s role
 Pick a ‘societally preferred’ Pareto optimal
outcome and redistribute initial resources
− Tax endowments and redistribute - The First
Theorem guarantees Pareto optimality!
− The Second Theorem says that taxing an
agent’s endowment is non-distortionary
− The role of prices
 The trade-off between efficiency and equity
− The problem of deadweight losses
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− Evidence of this trade-off

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Conclusion
 Analysing GE is crucial from a policy point of
view
 Economists have shown that the GE effects from
a policy change are frequently more important
than the initial partial equilibrium effects that a
policy-maker intended to make
− The market for schools and the impact on
house prices of a school voucher
− If GE effects are ignored, incorrect predictions
will be made about who will benefit and suffer
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from such a policy

Self-study questions
 What is the difference between partial equilibrium
analysis and general equilibrium analysis? Use an
example to explain the importance of GE.
 If two consumers have DVDs and books to consume,
illustrate their indifference curves in an Edgeworth box.
 Show a situation in this Edgeworth box of an excess
demand/supply for the goods.
 How can a competitive equilibrium emerge?
 At which point is consumption Pareto optimal?
 What does the contract curve show?
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 Explain why Pareto optimal allocations are not unique.

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Self-study questions
 Why does a Pareto optimal allocation occur where the
2 consumers’ indifference curves are at a tangent?
 A Pareto optimal allocation is equitable. True or False?
 What is the role of the budget constraint within the
Edgeworth Box?
 Explain the First Fundamental Welfare Theorem.
 Using the Edgeworth Box explain the principle behind
the Second Fundamental Welfare Theorem.
 Why do the consumers’ initial endowments have to be
on the budget constraint?
 What does the Second Welfare Theorem suggest 23

about the role of government?

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