Download General Competitive Equilibrium

General
Competitive
Equilibrium
Chapter 11
Slides by Pamela L. Hall
Western Washington University
©2005, Southwestern
Introduction


In general, changes in one market will affect demand and
supply in other markets
General-equilibrium analysis
 Study of how demand and supply conditions interact in a number of
markets and determine prices of many commodities

Economy is viewed as a closed and interrelated system
 Where interactions of all markets determine equilibrium market
prices and quantities
• Disturbance in one market generates ripples that spread through many
other markets

A (general) equilibrium model of all markets will result in
necessary conditions for economic efficiency
 Achieved by agents (households and firms) trading commodities
• Agents will engage in trade until all gains from trade are exhausted
2
Introduction

This chapter no longer restricts supply of commodities to sum of
individual agents’ initial endowments
 Allows firms to employ these endowments as inputs into production and


produce some outputs that will increase supply of those commodities
With introduction of production, conditions yielding production efficiency are
now required for economic efficiency
Allocation conditions for production efficiency
 Allocation Condition 1 (opportunity cost condition)
• Obtained by deriving production possibilities frontier

Where production must occur for efficiency
 Allocation Condition 2, (marginal product condition)
• For efficiency inputs should be allocated so that marginal products in production
of a particular commodity are equal
 Allocation Condition 3 (comparative advantage condition)
• For efficient production a firm with comparative advantage in producing a
commodity should produce that commodity
3
Introduction

Conditions for overall economic efficiency
 Must link producers’ efficient production decisions with consumers’
preferences
• An economy may be production efficient


But if it is not producing commodities consumers desire, it is inefficient
Aim in this chapter
 Demonstrate how a perfectly competitive market will result in an efficient
allocation of a society’s resources

Based on link between economic efficiency and competitive markets
 Applied economists are able to investigate effects that various policies have
• On directly affected market
• On related markets
 With this general analysis of markets throughout economy, economists can
determine complete impact of policies on an economy
• Failure to consider all effects across all markets may result in erroneous analysis

Wrong prescriptions for curing market imperfections
4
Efficiency in Production


Can extend concept of Pareto efficiency and Edgeworth box
to production efficiency
Efficiency in production deals with allocation of resources
(inputs) within a specific firm
 As well as how resources and outputs should be allocated among
firms

Generally, an allocation of resources is production efficient
 When no reallocation of resources will yield an increase in one
commodity without a sacrifice in output from other commodities

Necessary conditions for such an efficiency are stated in
three allocation conditions
 Opportunity cost condition
 Marginal product condition
 Comparative advantage condition
5
Allocation Condition 1
(Opportunity Cost Condition)



For production efficiency no more of one commodity can be
produced without having to cut back on production of other
commodities
Requires that MRTS for each output be equal
Consider optimal choice of inputs for a single firm producing
two outputs (fish, F, and bread, B)
 With two inputs (capital, K, and labor, L)
 Assuming limited resources and holding total quantities of K and L
fixed
• Problem is how to efficiently allocate these fixed resources to production
of F and B

Firm will operate efficiently if it is not possible to reallocate its inputs in such
a way that output of F can be increased without cutting back on B
6
Allocation Condition 1
(Opportunity Cost Condition)

Firm with fixed resources has allocated its
resources efficiently if it has them fully employed
and
 MRTS between inputs is same for every output firm
produces

Suppose firm has 100 units of L and 100 units of K
 Uses half of each input to produce fish and bread
• If firm employs 50 units of K and 50 units of L to produce fish and
MRTSF (K for L) = 2

Same amount of fish could be produced by employing 48 units of K
and 51 units of L (See Table 11.1)
7
Table 11.1 Allocation Condition 1
(Opportunity Cost Condition)
8
Allocation Condition 1
(Opportunity Cost Condition)

Represented graphically in Figure 11.1
 Edgeworth box is analogous to box representing pure-exchange
model in Chapter 6

Compares various output levels for fish and bread with
isoquants
 Illustrates that every point inside box represents a feasible allocation
• Origin 0F


Allocation where no resources are allocated to fish production (0, 0) and all
resources are devoted to bread production (100, 100) is a feasible allocation
represented by the
Output of bread is maximized and no fish is produced
• At 0B, allocation is (0, 0) toward production of bread and (100, 100) for
•
fish
For a movement toward 0F, more of K and L are being allocated toward
bread production and less toward fish


Every feasible combination of K and L in production of fish and bread is
represented inside Edgeworth box
Points outside the box are not feasible
9
Figure 11.1 Allocation Condition 1
10
Allocation Condition 1
(Opportunity Cost Condition)

Size of box is determined by amount of fixed
resources, K and L
 An increase in amount of resources will enlarge box
• A change in technology for combining resources to produce
outputs may also expand output potential but not size of box

Production-efficient allocations are characterized by
efficiency locus in Figure 11.1
 Called production contract curve
• Represents set of efficient allocations

At every point on production contract curve MRTSF = MRTSB
11
Allocation Condition 1
(Opportunity Cost Condition)

In Figure 11.1, point C is not Pareto efficient
 Possible to reallocate inputs in such a manner that one
product can be increased without reducing other product
• For example, moving along bread isoquant curve toward point P3


Bread production remains unchanged but fish production increases
Mathematically, efficiency condition MRTSF =
MRTSB is determined by maximizing one output
while holding other output constant
12
Production Possibilities Frontier

In U.S., over 40% of all scientists, engineers, and technical
professionals work in military defense sector
 Allocation of talent and intellectual resources could be used for other
production possibilities

Based on efficiency locus in Figure 11.1, these alternative
production possibilities for commodities (guns and butter or
fish and bread) can be illustrated by production
possibilities frontier (See Figure 11.2)
 A mapping of efficient output levels, F and B, for each point on
production contract curve
• Corresponding output levels for fish (F1, F2, F3, and F4) and bread (B1,
B2, B3, and B4) are plotted on horizontal and vertical axes in Figure 11.2
13
Figure 11.2 Production
possibilities frontier
14
Production Possibilities Frontier

Points on production possibilities frontier correspond to tangency of
isoquants along production contract curve in Figure 11.1
 Output combinations (F1,B1), (F2,B2), (F3,B3 ), and (F4,B4) associated with
(P1, P2, P3, and P4) are same for both figures

Every point inside production possibilities frontier is a feasible allocation
 Corresponding to points inside Edgeworth box in Figure 11.1

Boundary of production possibilities frontier represents efficiency locus
(production contract curve) in Figure 11.1
 For given amounts of K and L, production possibilities frontier indicates
combinations of F and B that can be produced

An increase in amount of K and L or an improvement in technology will
result in production possibilities frontier shifting outward
15
Marginal Rate of Product
Transformation

Slope of production possibilities frontier measures how output F can be
substituted for output B
 When total level of inputs (resources) is held constant

Negative of this slope is called marginal rate of product transformation
(MRPT)
 MRPT (B for F) = -slope of production possibilities frontier
 MRPT (B for F) = -dB/dF|holding input constant
• Slope of production possibilities frontier is negative

Given production efficiency, an increase in one output will require a sacrifice in
other output
 Taking negative of this negative slope yields a positive MRPT

MRPT measures how much one commodity is sacrificed to produce an
additional amount of another commodity
 At point P1 in Figure 11.2, MRPT is a relatively small number
• Sacrifice in B for an additional unit of F is small
 At point P4 MRPT is a relatively large number
• Sacrifice in B for an additional unit of F is large
 Increase in MRPT as F increases is due to concave nature of production possibility
frontier
16
Concave Production Possibilities
Frontier



Concave shape of production possibilities frontier is
characteristic of most production situations
 Based on technical relationship exhibited by two outputs
Can represent total cost of producing F and B by total cost
function TC(F, B)
Given fixed level of input supply, cost is constant along
production possibilities frontier
 Total differential of this cost function is
• dTC = (∂TC/∂F)dF + (∂TC/∂B)dB = 0

dTC is equal to zero because cost is constant along production possibilities
frontier
• Rearranging terms results in

MRPT(B for F) = -dB/dF|dTC=0 = (∂TC/∂F)/( (∂TC/∂B) = MCF/MCB
• In general MRPT(q2 for q1) = MC1/MC2
17
Concave Production Possibilities
Frontier

Can compare relationship of MRPT equaling ratio of marginal costs to
allocation of inputs for production of F and B
 Recall that for one variable input—say, labor
• MCF = w/MPL|F
• MCB = w/MPL|B

MPL|F (MPL|B) is marginal product of labor in production of fish (bread)
 Assume it takes 1 unit of L to produce 2 units of F, MPF = 2; if wage rate is 1
• MCF = ½
 For a concave production possibilities frontier (as illustrated in Figure 11.2)
• Ratio of MCF to MCB increases as output of F increases and B decreases

In short run, this is result of Law of Diminishing Marginal Returns
 An increase in F results in an increase in its SMC

• Decrease in B results in a decrease in its SMC
In long run, a concave production possibilities frontier will also result if
decreasing returns to scale exists for both outputs
 LMC curves have a positive slope
18
Concave Production Possibilities
Frontier

Specialized inputs exist when some inputs are relatively more suited for
production of a particular output
 Have a comparative advantage in production of one output versus another

In Figure 11.2, concave nature of production possibilities curve implies that
increases in F production requires taking inputs out of B production
 Where they are more suitable
 Allocating them to F production
• Where they are progressively less suitable
 As production of F increases and that of B declines
• Marginal cost for F production increases and marginal cost for B production decreases


Yields a relatively larger MRPT
Specialized inputs assume heterogeneous inputs
 Even if inputs are homogeneous, production possibilities frontier will be concave if
production of F and B use inputs in different proportions
• Different input intensities are represented by nonlinear production contract curves
19
Concave Production Possibilities
Frontier

In Figure 11.3 production contract curve is bowed above main diagonal
 Indicates that production of F is relatively more capital intensive than that of B

If curve were bowed below main diagonal
 B would be relatively more capital intensive


Production possibilities frontier will be concave if production contract curve
is not linear through origin of both F and B
Consider Figure 11.3, where F is using a high proportion of capital relative
to B
 Weighted average of points P1 and P2 is represented by linear cord connecting
points
• Points on this cord result in a lower level of output for both F and B


Compared to points on production contract curve
In terms of corresponding production possibilities frontier, Figure 11.4
 Cord lies in interior of mapping that establishes concave nature of frontier
20
Figure 11.3 Production contract curve
with weighted average of outputs
21
Figure 11.4 Production possibilities
frontier with differing factor intensities
22
Opportunity Costs


Production possibilities frontier illustrates a fundamental condition in economic
theory
Assuming resources are fully employed in most efficient way
 Any increase in production of one commodity will require shifting of resources out of other
commodity and vice versa
• Opportunity cost of producing more of the one commodity



MRPT measures degree of opportunity cost
A relatively large MRPT = -dB/dF|dTC=0
 Illustrates a large opportunity cost of increasing F
Concave production possibilities frontier is associated with increasing opportunity
cost
 The more concave the frontier
• The greater the increase in opportunity cost as one commodity is sacrificed for production of
another


Constant MRPT implies a linear production possibilities frontier and constant
opportunity cost
Theoretically, if factor intensities are the same and production functions exhibit
increasing returns to scale
 Production possibilities frontier will be convex
• Represents decreasing opportunity cost as one commodity is substituted for another
23
Economies of Scope




Increasing opportunity cost results in lowest opportunity cost
for increasing fish corresponding to point A
 At point A, production of fish is zero
Lowest opportunity cost for producing bread is at point B
 Production of bread is zero
Low levels of opportunity cost result from joint production of
fish and bread
In general, a firm incurs production advantages when it
produces two or more products
 Can use inputs and technologies common to producing a set of
products
• May be advantages in joint use of inputs, marketing programs, or
administration
24
Economies of Scope


Unless there are some constraints firms will almost always
produce more than one product
Technologies resulting in joint production advantages are
called economies of scope or increasing returns to
scope
 Exist when one firm jointly producing a set of products results in a
higher level of output than a set of separate firms each uniquely
producing one of the products
 Results in concave production possibilities curves

Without these production advantages associated with joint
production
 Joint production would generate same output as the two specialized
firms
• Production possibilities frontier would be linear

Representing constant opportunity cost or constant returns to scope
25
Diseconomies of Scope

Decreasing opportunity cost associated with convex production possibilities frontiers
characterize diseconomies of scope (decreasing returns to scope)
 Illustrated in Figure 11.5


Opportunity cost of specialization is lower than cost of joint production
Production possibilities frontier is below cord connecting points A and B
 At point A in Figure 11.5, increasing fish production
• Results in MRPT on convex production possibilities frontier being greater than MRPT on cord between points
A and B
 Opportunity cost of producing fish and bread jointly is greater than opportunity cost of specialized
production

There is no direct relationship between economies to scale and economies of scope
 Economies of scale is concerned with output effect of expanding production through increasing all

inputs
Economies of scope is concerned with output effect of expanding production through increasing
number of different products produced
• Both are related to increasing output


But differ in how output is increased
Returns to scale increases output through input usage
 Returns to scope increases output through product diversification
26
Figure 11.5 Decreasing returns to scope,
decreasing opportunity cost, and …
27
Allocation Condition 2 (Marginal
Product Condition)


If production is to be efficient, resources should be allocated
to point where marginal product of any resource in production
of a particular commodity is the same
 No matter which firm produces the commodity
For example, consider two firms (1 and 2) producing the
same commodity, Q
 An objective of society is to determine efficient allocation of K and L
between the two firms that will maximize output, Q
28
Allocation Condition 2 (Marginal
Product Condition)

Incorporating constraints into objective function
yields
29
Allocation Condition 2 (Marginal
Product Condition)


In general, for N firms, F.O.C.s result in Allocation Condition
2 (marginal product condition)
 MPK|firm 1 = MPK|firm 2 = … = MPK|firm n
 MPL|firm 1 = MPL|firm 2 = … = MPL|firm n
For labor input with two firms this allocation condition is
illustrated in Figure 11.6
 If MPL|firm 1 > MPL|firm 2
• Can increase combined output for both firms by reallocating labor inputs

Area under a marginal product curve is total amount of output produced
 Shaded areas represent change in output
• Shaded area associated with firm 1 is larger than shaded area for firm 2


Net gain in output represents increase in output by reallocating input
Can continue to increase output by shifting input allocation until level of the
input used by each firm results in equivalent marginal products
30
Figure 11.6 Allocation
Condition 2
31
Allocation Condition 2 (Marginal
Product Condition)

Alternative illustration of Allocation Condition 2 for
production functions of two firms producing the same
commodity, Q, with one variable input, L
 Shown in Figure 11.7
• Can increase total output of Q with given amount of labor, L



By reallocating labor between two firms
Taking labor away from less productive firm 1
 Allocate it to relatively more productive firm, firm 2
 Will enlarge box vertically
Output will continue to increase for given level of labor
 Until production functions are tangent
• At this tangency, marginal products for these two firms will be equal

Results in an efficient allocation of labor for production of Q
 Indicated in Figure 11.8
 Q* in Figure 11.8 is greater than Q' in Figure 11.7
32
Figure 11.7 Inefficient allocation
of labor between two firms
33
Figure 11.8 Allocation Condition
2 with an Edgeworth box
34
Allocation Condition 3 (Comparative
Advantage Condition)

If two or more firms produce same outputs
 They must operate at points on their respective production possibility
frontiers
• At which marginal rates of product transformation are equal

Figure 11.9 illustrates this Pareto-efficient condition
 At point A MRPT for firm 1 is greater than MRPT for firm 2
• By reallocating production of outputs between the two firms


Can reduce total amount of resources employed for producing given amount
of fish and bread
Only where MRPTs for two firms are equal is it impossible to
reallocate production in such a way as to reduce resource
requirements for given level of production
35
Figure 11.9 Allocation Condition 3
36
Comparative Advantage

Related to Allocation Condition 3 is theory of comparative advantage in
international trade
 First developed by David Ricardo



A country has a comparative advantage in commodities that it is
relatively more efficient in producing
Efficiency is measured in the sacrifice of other commodities for
production of an additional unit of a commodity
Comparative advantage is in contrast to absolute advantage
 A country’s cost in terms of input usage is used as measure of advantage

Countries will specialize in producing products for which they have a
comparative advantage until their MRPTs are equilibrated
 Will then trade with other countries to satisfy consumer demand
37
Comparative Advantage

As countries specialize in production of
commodity for which they have a
comparative advantage
 Gains from improved efficiency are realized
• Ability to either produce more of both commodities or


Maintain their current production levels and allocate excess
resources to other activities
 Total world production will increase
Improved efficiency through comparative
advantage and trade is basis for supporting
idea of reducing trade barriers
38
Economic Efficiency

If all three allocation conditions for production and equality of MRS
exchange condition hold
 Provides for a Pareto-efficient production and exchange of commodities

However, they are not sufficient for achieving economic efficiency
 Also require output efficiency
• What firms produce is what households want

For example, an economy that concentrates on efficient production of military
commodities at expense of household items during relative peace is inefficient
 Requires that MRS = MRPT
• MRS measures how much a household is willing to substitute one commodity for
•
another, holding utility constant
MRPT measures opportunity cost (sacrifice of another commodity) of producing
one more unit of a commodity

If MRS > MRPT, household’s willingness to substitute one commodity for another is
greater than opportunity cost
 Efficiency can be improved by a reallocation of resources until a household’s
willingness-to-pay is equal to cost of producing any additional unit of a commodity
39
One-household Or Homogeneous
Preferences Economy


Concept of equating MRS to MRPT is illustrated in
Figure 11.10 for case of a one-household economy
 Or case where all households have same utility function
Assume this household (or set of households acting
as one) produces and consumes two commodities
with a given level of inputs
 Household’s preferences for two commodities are
represented by indifference curves superimposed on
household’s production possibilities frontier
• Household attempts to maximize utility subject to production
possibilities constraint
40
Figure 11.10 Economic efficiency
for a one-household economy
41
One-household or Homogeneous
Preferences Economy

At commodity bundle A, MRS(x2 for x1) > MRPT(x2 for x1)
 The one household can increase its utility by moving down along
production possibilities frontier from A to B
• At bundle B, household is maximizing its utility for this production
possibilities frontier



Corresponds to where MRS(x2 for x1) = MRPT(x2 for x1)
Economically efficient commodity bundle (Pareto-efficient allocation) for the
economy
 Point where society maximizes social welfare, local bliss
 Because there is only one household in this economy
Bundle B is only point on production possibilities frontier
where there is no other commodity bundle preferred to it
 For example, bundle A is Pareto efficient in terms of production
• But there are commodity bundles, such as C, within production
possibilities frontier that are preferred to A

Bundle C is inefficient in terms of production
 Because it is in interior of production possibilities frontier
42
Pareto Efficiency With More Than
One Type Of Household Preferences


In Chapter 6, general-equilibrium condition for a pure-exchange
economy with n households equated MRS across all households
By combining this pure-exchange condition with equilibrium solution
when considering a one-household production economy, MRS = MRPT
 Get necessary conditions for a Pareto-efficient allocation

When there are more than one type of household preferences, a Paretoefficient allocation requires that
 MRS1 = MRS2 = … = MRSn = MRPT

If all n households have the same preferences for the commodities
 Their MRSs will be the same and a Pareto-efficient allocation for more than
one type of household preferences reduces to one-household production
economy solution
• MRS = MRPT
43
Two-Household Economy with
Heterogeneous Preferences


Assuming Friday and Robinson have different preferences, we must
examine economic efficiency associated with more than one type of
household preferences
Pareto-efficient allocation is where MRS for Robinson equals MRS for
Friday and both are equal to MRPT
 Illustrated in Figure 11.11

Production-efficient commodities, Q1* and Q2*, from production
possibilities frontier, forms an Edgeworth box
 Robinson’s indifference map originates from production possibilities frontier

point of origin, 0R
Friday’s indifference map is rotated 180 with its origin placed on production
possibilities frontier associated with Q1* and Q2*
• At point where Robinson’s and Friday’s MRSs are equal and MRPT is also equal
to their MRSs

Pareto-efficient allocation exists
44
Figure 11.11 Economic efficiency
for a two-household economy
45
Figure 11.12 Economic efficiency for
alternative utility levels
46
Two-Household Economy with
Heterogeneous Preferences

Mathematically, we derive the condition MRSR = MRSF = MRPT by
maximizing Robinson’s utility subject to
 Friday’s utility
 Production possibilities constraint
 And condition that what is being produced (supply) must equal demand

If all commodities are desirable, then an efficient allocation would have
no excess demand
 Supply would equal demand

This Pareto-efficiency allocation, illustrated in Figure 11.11, is based on
a given level of utility for Friday
 Changing this level of utility for Friday will result in alternative combinations
of Q1 and Q2 produced and allocated between Robinson and Friday

Maximizing Robinson’s utility results in Pareto-efficient allocation
 Illustrated in Figure 11.12
47
Two-Household Economy with
Heterogeneous Preferences

In general, considering all possible Pareto-efficient allocations, MRSR =
MRSF = MRPT
 By varying Friday’s utility from consuming zero units of Q1 and Q2 to Friday
consuming all of Q1 and Q2
• Obtain a collection of all economically efficient utility levels (contract curve) for
both Robinson and Friday

Initial endowment of resources held by Robinson and Friday will
determine which of these economically efficient allocations are feasible
 For example, if Friday initially has a relatively large share of resources
• An economically efficient allocation resulting in Robinson consuming most of the
commodities would not be feasible

Competitive-price system will yield an economically efficient allocation
 However, initial allocation of endowments or access to these endowments
(equal opportunity) has social-welfare implications
• Redistribution of initial endowments may enhance social welfare and thus be
socially desirable
48
General Equilibrium in a
Competitive Economy


A perfectly competitive economy assumes agents
(households and producers) take all prices as given
No agent has control over some of the markets
and, thus, no agent can influence market prices
 In this economy, a general competitive equilibrium is a
set of prices for both inputs and outputs
• Where quantity demanded equals quantity supplied in all input
and output markets, simultaneously
 At this set of prices, households maximize utility subject
to their initial endowments and firms maximize profit
49
Efficiency In Production



Can establish a relationship between this competitive-equilibrium set of
prices and efficiency in production by examining three allocation
conditions
Perfectly competitive pricing provides necessary conditions for these
allocation conditions to hold
Recall Allocation Condition 1
 MRTS1 = MRTS2 = … = MRTSk = w*/v*, for all k commodities
• Where the two inputs are labor and capital with a wage rate of w and a rental rate
of v
 Given perfect competition in input markets, firms producing these k
commodities will equate their MRTS(K for L) to common input price ratio,
w*/v*, which results in Allocation Condition 1
• Thus, in a decentralized tâtonnement process, without any market intervention,
firms will adopt least-cost combination of inputs for a given level of output
50
Efficiency In Production

Allocation Condition 2 (Figure 11.8)
 MPs of an input are equal for all firms producing same output, Q
• MPL|firm 1 = MPL|firm 2 = MPL|firm 3 = … = MPL|firm n = w*/p*

Where p is price per unit for output Q
• Multiplying both sides by p* yields VMPL = p1*MPL = w*


Where VMPL is value of marginal product for labor
 Profit-maximizing condition for a perfectly competitive market
 Where marginal revenue from hiring an additional worker (VMPL) is
equal to wage rate w*
 Fixed prices (w*, p*) ensure MPL will be same across all firms
producing Q
Free market results in a Pareto-efficient allocation of all
inputs among firms producing same product
 A decentralized decision process yields an efficient resource
allocation
51
Efficiency In Production

Allocation Condition 3
 MRPT(q2 for q1)firm 1 = MRPT(q2 for q1)firm 2 = … = MRPT(q2 for q1)firm n =
MC1/MC2 = p*1/p*2
• Where p1 and p2 denote per-unit price of outputs q1 and q2, respectively
 Given perfect competition, all firms face same set of output prices
• Which for maximizing profits are set equal to each respective marginal cost of
production
 Thus, ratio of marginal cost, MRPT, will be same for all firms in a perfectly
competitive market
• Indicates that no firm has a lower sacrifice in additional production of a
commodity than any other firm
 Market intervention could not alter production mix among firms and increase
efficiency
• Production is Pareto efficient under perfect competition without any central
decision making
52
Output Efficiency

If price ratios associated with households are same as price ratios for
producers, then
 MRS1 = MRS2 = … = MRSn = MRPT = p*1/p*2

• Will be true for any pair of commodities
Tâtonnement process assures supply and demand will be equalized for
all commodities
 Results in market-clearing price, where no excess supply or demand exists
(Walrasian equilibrium)
• First Fundamental Theorem of Welfare Economics

When assumptions of perfectly competitive equilibrium hold, every general perfectly
competitive equilibrium is efficient in production
 Results in a Pareto-efficient allocation (output efficiency)
 Second Fundamental Theorem of Welfare Economics also holds, given
assumptions of a perfectly competitive equilibrium
• Every allocation that is efficient in production and could potentially be a Paretoefficient allocation can be obtained with a general perfectly competitive
equilibrium

By reallocating initial endowments
53
Output Efficiency

Figure 11.12 illustrates duality of these welfare theorems in a twohousehold, two-product productive economy
 Perfectly competitive prices p1* and p2* correspond to a Pareto-efficient

allocation
Given a change in initial endowments, a new Pareto-efficient allocation is
obtainable with perfectly competitive prices p'1 and p'2
• These dual results provide support for laissez-faire position taken by many
economists


Adam Smith’s invisible hand will provide production efficiency and output efficiency
Society’s problem of achieving an economically efficient allocation of
resources is decentralized and solved at individual agent level
 Each household and firm only has to be concerned with its own
maximization problem
• Only information communicated among agents is market prices

Market prices act as signals in determining relative scarcity of commodities
 Tâtonnement process results in efficient resource allocation
54
Optimal Reallocation Of
Endowments

Free markets take distribution of initial endowments as given
 Unless some optimal initial distribution of endowments is mated with
competitive markets, social welfare may not be maximized

To achieve an optimal initial distribution of endowments, some
government authority must be able to identify individual household
preferences and endowments
 This government authority is some policymaker, social planner, or decision


maker with objective of maximizing social welfare
Decision maker will not undertake actions counter to households’
preferences
So that decision makers can properly identify individual preferences and
endowments and thus reallocate endowments to improve social welfare
 Many government agencies will require some type of needs evaluation
• For example, welfare, college financial aid, and many other public-assistance
programs require a completed application

Designed to reveal an applicant’s preferences and endowments
55
Imperfect Markets


Free markets will fail to achieve efficiency due to
 Imperfect competition
 Externalities
 Supply of public goods
 Asymmetric information
Inability of free markets alone to maximize social
welfare opens way for government programs
 A sound understanding of economic theory can guide
development and implementation of effective government
programs
56
Imperfect Markets

Opposite of a free market is a centrally planned economy
 All aspects of production, distribution, and consumption are based on
a government plan
• Efficient outcome requires knowledge of individual household
preferences and production possibilities



Such knowledge is difficult and costly to obtain
 Unless individual preferences and production plans are dictated by
some party
 Such dictation is at the expense of individual freedom of expression
Thus, even in centrally planned economies there still exists
a free market, either legally or illegally
The question is
 What degree of government intervention into the free activities of
markets is required for improving social welfare?
57
Imperfect Markets


General failure of centrally planned socialism in determining efficient
resource allocation led to a system of decentralized socialism
Prior to World War II, O. Lange and F. Taylor demonstrated how
decentralized socialism can result in a Pareto-efficient allocation of
resources
 State would own all capital and rent it out to state-owned, bureaucratically
managed firms
• These firms would then be free to maximize profits in a competitively determined
labor market
 State would receive all profits and distribute them to households—in the


form of public goods and subsidies—in some equitable form
As in perfect competition, prices would be determined in free markets
A problem with decentralized socialism is determining optimal supply of
capital
• State would have to make this determination

There is no invisible hand to reflect households’ preferences
58
Imperfect Markets

Decentralized socialism was adopted in a limited form after World War II
in Eastern Europe
 System was abandoned in late 1980s due to

• Major problems of allocating capital among firms
• Political appointment of firm managers
• Limited individual incentives to work
Socialist societies generally attempt to replace individual incentives to
work and invest with social responsibility
 Put great weight on common welfare of whole society
 Such a system can work well during national emergencies (for example,
during wars)
• Becomes a social responsibility for all households to work toward ensuring their
•
joint preservation
However, without some common menace, social responsibility wanes as a
motivation to work

Thus, some socialist states will manufacture threats
 Such as Cultural Revolution in China
59
Imperfect Markets


A general problem with relying on centralized
control
 Complete system failure occurs when control unit fails
In an economic system, free market, with its
emphasis on decentralized control, mimics
decentralization found in nature
 Human agents are all basically identical

• Each take on specialized tasks
Failure or exit of any one household or firm will not result
in complete failure of economic system
• Those agents exiting will be replaced by other agents

Without a perceptible disruption in economy
60