CHAPTER FIVE

GENERAL EQUILIBRIUM ANALYSIS AND WELFARE ECONOMICS

6.1. Introduction

Dear learners: do you remember the basic concepts you learned at the beginning of the
first part of Microeconomics? If you remember, you learned about the types of economic
systems and how they attain equilibrium.
The analysis of equilibrium you made there was partial in nature i.e. you kept many
variables constant and analyze the relationship between two variables. Here, it is time to
relax all assumptions and look for what will happen to the market equilibrium. In this
chapter, you will learn about the general equilibrium, but before that let us rehearse what
you learned earlier.

6.2. Partial versus General Equilibrium Analysis

6.2.1. Partial equilibrium Analysis
 Partial equilibrium analysis studies the behaviour of individual decision-making units and
individual markets, viewed in isolation.
 It analyzes the equilibrium for a particular element in the economy.
 For example, it may be equilibrium for certain commodity consumed or produced by assuming ceteris
paribus i.e. it assumes that there is no link between the subject matter of analysis and the economy
outside the model. It imposes several restrictions and limitations on the selected variable. Example:
when you analyze the functional relation ship between quantity demanded and price of a particular
commodity, we assume that there are no changes or ceteris paribus in income, taste, price of other
commodities (substitute and complements etc.).
 It deals about:
 How an individual maximizes satisfaction subject to his income,
 How a firm minimizes its costs of production and maximizes profits under various market
structures,
 How the price and employment of each type of input is determined.

 In short, the basic characteristic of a partial equilibrium approach is the determination of

the price and quantity in each market by demand and supply curves drawn on the ceteris
paribus assumption.
 However, a fundamental feature of any economic system is the interdependence among
its constituent parts. The markets of all commodities and all productive factors are
interrelated, and the prices in all markets are simultaneously determined.

For example, consumers’ demands for various goods and services depend on their tastes and
incomes.  In turn, consumers' incomes depend on the amounts of resources they own and
factor prices.  Factor prices depend on the demand and supply of the various inputs.  The
demand for factors by firms depends not only on the state of technology but also on the demands
for the final goods they produce.  The demands for these goods depend on consumers' income.
 There is circular interdependence of activities within an economic system.

 These effects are studied by general equilibrium analysis.

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 6.2.2. General Equilibrium Analysis

 Leon Walras introduced the first and simplest general equilibrium model in 1874. In the Walrasian
system, all prices and quantities in all markets are determined simultaneously through their
interaction with one another (by the solution of the system of equations).
 General equilibrium analysis show how prices and output are simultaneous determined in all
segments of the economy
 General equilibrium studies the interdependence or interconnections that exist among
all markets and prices in the economy and attempts to give a complete, explicit, and
simultaneous answer to the questions of what, how and for whom to produce. General
equilibrium analysis is not used all the time because dealing with each and all industries
in the economy at the same time by its very nature is very difficult, time consuming and
expensive.
 General equilibrium is a state in which all markets and all decision - making units are in
simultaneous equilibrium.
 There are different markets and decision makers in consideration. All decision makers make
decisions independently. But all markets and decision making units are simultaneously in
equilibrium in the general equilibrium analysis.
 A general equilibrium exists if each market is cleared at a positive price, with each
consumer maximizing satisfaction and each firm maximizing profit.
 The first and simplest general equilibrium model was introduced in 1874 by Leon
Walras.

 General Equilibrium in a Two-Factor, Two-Commodity, Two-

Consumer (2x2x2) Economy

Assumptions of the 2x2x2 model

1. There are two factors of production (Land K) whose quantities are given exogenously.
These factors are perfectly divisible and homogeneous.
2. Only two commodities (X and Y) are produced. Technology is given).
3. The goal of each firm is profit maximization and that of each consumer is utility maximization.
4. The factors of production are owned by the consumers.
5. There is full employment of factors of production, and all incomes received by their owners
(A&B) are spent.
6. There is perfect competition in both commodity and factor markets. Consumers and firms face
the same set of prices (Px, Py, w, r).
 In this model a general equilibrium is reached when the four markets (two commodity and two
factor markets) are cleared at a set of equilibrium prices (Px, Py, w, r) and each participant
economic agent (two firms and two consumers) is simultaneously in equilibrium.

 Three static properties are observed in a general equilibrium solution, reached

with a free competitive market:
a.Efficient allocation of resources among firms (equilibrium of production)
b. Efficient distribution of commodities between the consumers (equilibrium of
consumption)

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 c.Efficient combination of products (simultaneous equilibrium of production and
consumption)
6.1.2.1. Equilibrium of Consumption (Efficiency in Distribution)
Here, we show how each consumer, faced with the market prices P x and Py reaches
equilibrium, that is, maximizes his satisfaction.
From the theory of consumer behavior we know that the consumer maximizes his utility by
equating the marginal rate of substitution of the two commodities (slope of his indifference
curves) to the price ratio of the commodities. Thus the condition for consumer equilibrium is
MRS x,y = Px/Py
Since both consumers in perfectly competitive markets are faced with the
same prices the condition for general equilibrium of both consumers is
MRS x,y A = MRS x,y B = Px/Py

 Given the total quantities of X and Y to be distributed between A&B, there will be an infinite number
of Pareto optimal equilibria of distribution. Any point on the Edgeworth contract curve of
consumption is Pareto optimal. An analytical device known as the Edgeworth Box that depicts the
distribution of X and Y leaves between A and B.

X B

Y
X B1
Edge worth box of consumption G
However, not all distributions are Pareto-optimal.
A Pareto - efficient distribution of commodities isZone such that it is impossible to increase the A
utility of one consumer with out reducing the utility of the other.
B2 F
In another word it is at which the only way to make one person better off is 5

to make anotherB3 person worse off.

Only points of tangency of the indifference curves of the two A consumers
4
represent Pareto
B4 - efficient distributions.
E the contract curve.
The locus of all the Pareto efficient points is called
At Beach point on this curve MRSxy D=MRSxy.B. Point Z (or any point off
A
5
the Edge worth contractCcurve of consumption)A3 is a point of inefficient
A2
consumption because itA1is possible to increase the utility of at least one
Y consumer without making the other worse off called Pareto improvement
A
(consider movement to E, to F or to any point between E and F on the
contract curve).
Of the infinite number of points where the condition MRSxyA =MRSxy.B holds, only one point is
realized in perfect competition. This point is where MRSxyA = MRSxy.B = .
6.1.2.2 Equilibrium of Production (Efficiency in Factor Allocation)

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 Equilibrium of production requires the determination of the efficient
distribution of the available productive factors among the existing firms
(efficiency in factor substitution).
In the theory of producer behavior we know that the firm is in equilibrium if
it chooses the factor combination which minimizes its cost. Thus the
equilibrium of the firm requires that

 The joint equilibrium of production of the two firms in our simple model can be derived
by the use of the Edgeworth box of production

L OY

K
Y1
Q

Edge worth box of production

R
X
The size of the box refers to the total amountY2
of L and K available to the
P
economy. Any point
inside the box indicates how the total amount of the two inputs is utilized in the production of the4
two commodities. If this economyYwas 3
initially at point R, it would not be maximizing its output
of commodities X and Y because, at point R, MRTS LKX  MRTSLKY. The economy Xcan 3
move
from point R to point N and increase
B4 its output of Y without reducing its out put of X.
N
Alternatively, it can move to point P increasing its output of X without reducing its output of Y.
K
At points M, N, P and Q, an X isoquant is tangent to a Y isoquant so that the MRTS LKX =
MRTSLKY. Y4
M X2
X1

OX Page 4
L
Curve OXMNPQOY is the Edge worth contract curve of production. It is the locus of tangency
points of the isoquants for X and Y at which MRTSLKX = MRTSLKY .
 The general equilibrium of production occurs at a point which satisfies this Pareto
optimality criterion of efficiency in factor substitution.
 Since this occurs at any point along the Edge worth contract curve of production, there is
an infinite number of possible Pareto-optimal production equilibrium.
 However, with perfect competition, one of these equilibrium will be realized, the one at
which the MRTSLKX = MRTSLKY = .
In a general equilibrium, the amounts of X and Y which maximize the profits of firms must be
equal to those which consumers want to buy in order to maximize their utility. Consumers
decide their purchases on the basis of commodity prices, P X & PY. Thus, in order to bring
together the production side of the system with the demand side, we must define the equilibrium
of the firms in the product space.
 From each point of the Edge worth contract curve of production, we can read off the
maximum obtainable quantity of one commodity, given the quantity of the other.
 The locus of all the Pareto-efficient outputs (or of all the minimum attainable
combinations of the two commodities) given the resource endowment and ) and the
state of technology is the Production possibility frontier (PPF/PPC.)

Y
OX’
Y4 M’

N’
Y3

Y2 P’

Q’
Y1 ÓY’

X1 X2 X3 X4 X

 At any point on the curve all factors are optimally (efficiently) employed.
 Any point inside the curve is technically inefficient, implying unemployed
resources.
 Points above the curve are unattainable, unless additional resources or a new technology
or both are found.
 The PPF is also called the product transformation curve because it shows how a
commodity is transformed into another, by transferring some factors from the production
of one commodity to the other.

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 The negative of the slope of the PPF is called the marginal rate of product transformation
(MRPTXY) and it shows the amount of Y that must be sacrificed in order to obtain an
additional unit of X.

MRPTXY= - by definition

MRPTXY = .

Proof: MCX= & MCY=

=( ). ……………..(1)

Because TCx = w.LX + r.KX and TCY= w.LY + r.KY and w&r are given,
d(TCX) = w.(dLX)+ r.(dKX) ........................(2)
d(TCY) = w.(dLY)+ r.(dKY) ........................(3)
Substituting (2) & (3) into (1) gives,

=( ). = ………………(4)

Movement on a given PPF (or full employment of resources requires that the factors released
from the decrease in commodity Y must be equal to the factors absorbed by the increase in the
production of X, i.e.,
dLX = - dLY and dKX = - dKY…………………..(5)
Substituting (5) into (4) yields,

= = -1. =- = MRPTXY

In perfect competition the profit maximizing producer equates the price of the commodity
produced to the marginal cost of production: MCX=PX and MCY=PY.
MRPTXY= =
Assuming that the market prices of the commodities define the slope of line AB (in figure
below), the general equilibrium of production is given by point T. The two firms are in
equilibrium producing the levels of output Ye and Xe.

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 Y
A

F
T
Ye
Slope = -

Xe F’ B X

*Equilibrium of Production
6.1.2.3 Simultaneous Equilibrium of Production and Consumption (Efficiency in Product-
Mix)

The general equilibrium of the system as a whole requires the fulfillment of the condition:
MRPTXY = MRSXYA = MRSXYB.
In perfect competition, this condition is satisfied since MRPT XY= (equilibrium of

production), MRSXYA = MRSXYB = (equilibrium of consumption) and it follows that, MRPT XY

= MRSXYA = MRSXYB = .
Only when the rate at which the consumers are willing to exchange one good for another
(MRSXY) equals the rate at which a good can be transformed into another in production
(MRPTXY) the production sectors’ plans are consistent with the household sectors’ plans, and the
two are in equilibrium.

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 Y
A

F
T OB
Ye
Slope = -

H C

OA
G Xe F’ B X

*Equilibrium of Production
The economy is in equilibrium (of production) producing Xe units of X and Ye units of Y where
the slope of PPF (=MRPTXY) equals the commodity price ratio (P X/PY} at point T. Given the Xe
and Ye amounts of the commodities, we can draw the Edgeworth box of consumption with the
dimensions OAYe and OAXe. Then, the consumers will have an efficient distribution of X and Y
between them along the contract curve. The unique equilibrium (of consumption) will be at a
point of tangency of the X and Y isoquants with the common slope equal to the slope of the PPF
at point T. If this happens to be at point C, A maximizes his/her utility by consuming O AG units
of X and OAH units of Y. Individual B maximizes his/her utility, consuming GXe units of X and
HYe units of Y.
Divergence between MRSXY and MRPTXY implies disequilibrium of the economy.
Suppose that the MRPTXY= while MRSXY= . This conveys that the economy
can produce two units of Y by sacrificing one unit of X, while the consumers are
willing to exchange one unit of X for one unit of Y. This means firms produce a
larger quantity of X and a smaller quantity of Y relative to the preferences of the
consumers.
Firms must reduce X and increase the production of Y for the attainment of general
equilibrium (see the figure below).

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 Y

MRPTXY = -
d

O
X

After determining the equilibrium quantities of the inputs and the commodities, the next step is
to determine the prices (PX, PY, w and r].
From the Walrasian general equilibrium framework, we have the following equations
MRTSLKX = w/r = MRTSLKY --------------------------------------------1
w = MPPLX.PX = MPPLY.PY----------------------------------------------2
r = MPPKX.PX = MPPKY.PY----------------------------------------------3
MRSYXA=MRSYXB=PY/PX----------------------------------------------- 4

Dividing (2) by (3) gives = =

Which is identical to equation (1). There are only 3 independent equations with four
unknowns. There will be no unique solution. We choose one of the prices as a numeraire
(unit of account) and express the other prices in terms of (relative to) the numeraire. Let the
numeraire be PX.
From (1), w = r.MRTSLK------------------- (5)
From (3), r = MPPKX.PX -------------------(6)
Substituting (6) in to (5), w = MPPKX.PX. MRTSLK----------------- (7)
From (4), PY = PX. MRSYX--------------- (8)
We can derive the relative prices from (6), (7) and (8):
i. =

ii. =

iii. =
Note that the change of numeraire leaves the relative prices unaffected.

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At its present stage, general equilibrium theory is largely non-operational and unrealistic. But,
by viewing the economy as a vast system of mutually interdependent markets, it makes the
student aware of the complexity of the real world. Moreover, the solution which exists under
certain assumptions and its optimality properties can be used as a norm to judge the significance
and implications of deviations of the various markets from this ideal state of equilibrium.

6.2 WELFARE ECONOMICS

6.2.1 Definition of Welfare Economics

 Welfare economics is a branch of economics that uses microeconomic techniques to
evaluate well-being (welfare) at the aggregate (economy-wide) level.
 Welfare economics is the economic study of the definition and the measure of the social
welfare; it offers the theoretical framework used in public economics to help collective
decision making, to design public policies, and to make social evaluations.
 Welfare Economics studies the conditions under which the solution to the general
equilibrium model can be said to be optimal.
 It examines the conditions for economic efficiency in the production of output and the
exchange of commodities and equity in the distribution of income.
 Note that the above definition points out that the maximization of society’s well – being
requires not only efficiency in production and exchange but also equity in the distribution
of income.
 There are different criteria forwarded by different economists so as to judge about welfare.
Among these, the main criteria are discussed below.

i) Adam Smith’s criterion

According to him the main determinant of welfare is the growth of national product. That is,
increase in production leads to increase in consumption and satisfaction. However, there are
some limitations of this criterion.

a) He assumed the existing income distribution as fair and just.

b) The growth in national income can reduce social welfare if accompanied by
greater income inequalities.

ii) Bentham’s criterion

According to him, the main determinant of welfare is the summation of individual utilities. That

is, if Ui is very large or if change in social welfare is greater than zero, there is just

distribution of income. However, there are some limitations of this criterion.

a) Difficulty of adding individual utilities to obtain the social welfare.

b) The welfare of most individuals may be negatively affected while change in social
welfare is greater than zero.

iii) Pareto’s criterion

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According to him an allocation which makes at least one individual better off and no other worse
off is an improvement in social welfare.

iv) Hicks-Kaldor criterion

According to them the person who benefited from an economic policy or reallocation of
resources must be able to compensate the person who becomes worse off due to this policy.
However, the compensations should not exceed the benefits gained.


6.2.2 Utility Possibility Frontier/Curve (UPF/UPC) and Grand Utility Possibility Frontier
(GUPF)

 The UPF shows the various combinations of utilities received by individuals A and B
(i.e., UA and UB) when our simple economy is in general equilibrium or Pareto optimum
in exchange;
 it is the locus of maximum utility for one individual for any given level of utility for the
other individual.

UB
UM’

UPF

UM’ UA

UPF UM’UM’ shows the various combinations of utilities received by individuals A and B (i.e.,
UA and UB) when the economy composed of individuals A and B is in general equilibrium or
Pareto optimum in exchange. The frontier is obtained by mapping consumption contract (OC) in
the Edgworth box of consumption from output or commodity space to utility space.
Note that UPF is associated with Pareto efficient allocations given equilibrium of production
(i.e., given a point on PPF where MRPT X, Y = ). This means we have another UPF for any
other point on PPF. In general we can have as many UPFs as there are points on PPF.
GUPF is the envelope of these UPFs associated with Pareto optimum points of production
and exchange.

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 UB G

E’
UM
’
GUPF
UN
’
H’

UN G
UM’ ’

UA

UM’UM’ is UPF drawn when the economy is in production equilibrium at point e as shown on
page 9. UN’UN’ is another UPF drawn on the assumption that the economy is in equilibrium of
production at point d on its PPF. By joining points E’, H’, and other points of equilibrium
similarly obtained, we can derive GUPF which is curve GE’H’G in the above diagram.
The GUPF indicates that no reorganization of the production – exchange process is possible
that makes someone better off without, at the same time, making someone else worse off.
Given GUPF of the above sort, in order to determine the Pareto optimum point in production
and exchange at which social welfare is maximized, we need a social welfare function.

6.2.4 Social Welfare Function

 A social welfare function is just some function of individual utility functions:

W (U1 (X), …,Un (X))
It gives a way to rank different allocations that depends on the individual preferences.

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