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Economic Systems An economic system is a set of institutional arrangements for the exchange of goods and services between people and productive units (…rms). Welfare Economics Examples of economic systems: the command system; the dictatorial system; the capitalist system. Philip A. Viton An economic system results in an allocation: basically a list of who ends up with what. For an individual, we can speak of his or her individual allocation under a particular economic system. May 17, 2012 Of course, di¤erent economic systems will typically result in di¤erent allocations. Fundamental question: how can we compare the allocations delivered by di¤erent systems? Philip A. Viton CRP 781 ()— Welfare May 17, 2012 1 / 19 Pareto Optimality Philip A. Viton CRP 781 ()— Welfare May 17, 2012 2 / 19 General Equilibrium The standard approach to the fundamental question of comparing allocations is as follows: 1. We say that an allocation A is Pareto-Preferred to an allocation B if At least one person prefers his/her individual allocation in A Everyone else is indi¤erent between what he/she receives in A and B 2. We say that an allocation A is Pareto-Optimal if there is no feasible and Pareto-Preferred alternative allocation to it. Equivalently: An economic system is in (general) equilibrium if demands and supplies for all goods, services and inputs balance everywhere. That is, the total demand for each good/service/input equals total supply for that good/service/input. If an allocation A is Pareto-Optimal, then there is no feasible allocation B such that (i) at least one person prefers B and (ii) everyone else is indi¤erent. If A is Pareto-Optimal, and B is Pareto-Preferred to A, then B is infeasible. Philip A. Viton CRP 781 ()— Welfare May 17, 2012 3 / 19 Philip A. Viton CRP 781 ()— Welfare May 17, 2012 4 / 19 The Competitive Economy Competitive Equilibrium We turn now to the construction of a equilibrium for the Competitive Economy. We now describe a particular economic system, called the Competitive Economy (the competitive economic system). It is characterized by: This is called a Competitive Equilibrium. All individuals are price-takers and maximize utility subject to their budget constraints. Recall that this involves Supply = Demand for each good (including inputs) and service. So we need to construct aggregate (total) supply and demand functions for each good or service. All …rms are pro…t-maximizing price-takers in input and output markets. Philip A. Viton CRP 781 ()— Welfare We can arrive at aggregate demand and supply functions via horizontal addition of individual demand and supply functions. May 17, 2012 5 / 19 Aggregate Demand in an Industry I Philip A. Viton CRP 781 ()— Welfare May 17, 2012 6 / 19 Aggregate Demand in an Industry II p1 D11 We generate aggregate demand functions via horizontal addition of the individual demand functions. D21 In the …gure opposite, we consider the demand for a good x1 by two utility-maximzing price-taking individuals, whose individual demand functions are D11 and D21 . p1 At price p1 individual 1 demands x11 and individual 2 demands x21 . So at price p1 aggregate demand (by these two individuals) is x11 + x21 . D1 We can do this for any price and any number of individuals, and thus generate the aggregate demand function D1 for good x1 . x11 Philip A. Viton x21 x11+x21 CRP 781 ()— Welfare x1 May 17, 2012 7 / 19 Philip A. Viton CRP 781 ()— Welfare May 17, 2012 8 / 19 Aggregate Supply in an Industry I Aggregate Supply in an Industry II p1 S11 We generate aggregate supply functions in the same way, via horizontal addition. S1 S21 In the …gure opposite, we consider the supply for a good x1 by two competitive (price-taking, pro…t-maximizing) …rms, whose individual supply functions (the relevant portions of their MC curves) are S11 and S21 . p1 At price p1 …rm 1 supplies x11 and …rm 2 supplies x21 . So at price p1 aggregate supply (by these two …rms) is x11 + x21 . We can do this for any price and any number of …rms, and so generate the aggregate supply function S1 for good x1 . x11 Philip A. Viton x21 x1 x11+x21 CRP 781 ()— Welfare May 17, 2012 9 / 19 Industry Equilibrium and Individual Demand I Philip A. Viton CRP 781 ()— Welfare May 17, 2012 10 / 19 Industry Equilibrium and Individual Demand II p1 D11 D21 In a monetary economy, the feature that brings demand and supply into conformity is prices. An economy is in equilibrium relative to a set of prices — in this case the equilibrium prices. S1 The (competitive) equilibrium price in this industry is where aggregate demand equals aggregate supply. p*1 In the …gure opposite, p1 is the equilibrium price in this industry. D1 x*11 x*21 Philip A. Viton Corresponding to the equilibrium price, the individual equilibrium demands are x11 (for individual 1) and x21 (for individual 2). x1 x*1 CRP 781 ()— Welfare May 17, 2012 11 / 19 Philip A. Viton CRP 781 ()— Welfare May 17, 2012 12 / 19 Industry Equilibrium and Firm Supply I Industry Equilibrium and Firm Supply II p1 S11 S21 S1 Corresponding to the equilibrium price p1 , …rm 1 supplies x11 and …rm 2 supplies x21 p*1 We can carry out these constructions for each (privately produced) good or service in the economy. D1 x*11 Philip A. Viton x*21 x1 x* 1 CRP 781 ()— Welfare May 17, 2012 13 / 19 Philip A. Viton CRP 781 ()— Welfare May 17, 2012 Equilibrium in the Competitive Economy Optimality in a Competitive Economy In the competitive economy, a competitive equilibrium consists of a set of market and input (factor) prices such that at those prices, demand equals supply for each good or input. Second question: does a competitive equilibrium have any attractive properties? First question: does an equilibrium necessarily exist for our competitive economy? Condition C : all indi¤erence curves and isoquants are convex-inwards (ie have the bowed-in shapes that we’ve always drawn them, except for indi¤erence curve for addictive goods). Theorem (Debreu: First Theorem of Welfare Economics): If condition C holds, then a competitive equilibrium exists. Philip A. Viton CRP 781 ()— Welfare May 17, 2012 15 / 19 14 / 19 Condition M : (existence of markets). Each good or service that enters into someone’s indi¤erence curve or into a production function has a market price. Theorem (Arrow and Debreu: Second Theorem of Welfare Economics): If Condition M holds, then a Competitive Equilibrium is Pareto Optimal. Philip A. Viton CRP 781 ()— Welfare May 17, 2012 16 / 19 Commentary on These Results The Third Theorem It is important to note that there will generally be many possible Pareto-Optimal allocations. Let A be your preferred Pareto-Optimal allocation. Just because an allocation is Pareto-Optimal does not mean that it is ethically desirable (think of the dictatorial allocation). Note that when we try to rank Pareto-Optimal allocations using ethical criteria, we are going beyond the notion of Pareto-Optimality. We cannot guarantee that competition (ie the outcome of the competitive economic system) will result in your ethically preferred Pareto-Optimal allocation, though (if condition M holds) it will result in some Pareto-Optimal allocation. Philip A. Viton CRP 781 ()— Welfare May 17, 2012 17 / 19 Considerations for Planning Note that our de…nition of the competitive economy contained no mention of planning, at least as we city planners think of it. We are not saying that the competitive economy could exist with no government at all — it probably needs a minimal government, if only to enforce contracts freely entered into (cf Nozick’s Night-Watchman State). But it certainly does not include the interventions typically envisioned by planners. So don’t these results imply that planning cannot make things better? We know that under competition we arrive at a Pareto Optimal allocation (if M holds); and if we can redistribute income, we can end up with any Pareto-Optimal allocation we like. Can planning improve on that? That is, can we …nd a role for planning that results in an improvement over what we could achieve with a no-planning competitive economy? Philip A. Viton CRP 781 ()— Welfare May 17, 2012 19 / 19 Theorem (Third Theorem of Welfare Economics). If it is possible to redistribute initial resources (incomes), then we can do so in such a way that A is realized as the result of a competitive economy. In other words, redistribute incomes and let the competitive economy evolve with no further intervention. If we have done the redistribution “correctly”, the end result will be the pre-selected allocation A . Philip A. Viton CRP 781 ()— Welfare May 17, 2012 18 / 19