Microeconomics

General
Equilibrium
 Introduction
• Markets are interdependent. Hence, the analysis of a
single market considered in isolation is often incomplete.
• General equilibrium analysis studies competitive
equilibrium in two or more markets at the same time
• Competitive markets allocate consumption goods
efficiently among consumers and also assure efficient
production.
• Efficiency-equity trade-off: Good economic institutions
avoid waste while treating all members of society fairly,
two goals that can come into conflict.

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The Nature of General Equilibrium
• Partial equilibrium analysis focuses on a single
competitive market, considered in isolation
• General equilibrium analysis is the study of
competitive equilibrium in many markets at
the same time
– Factors that affect supply and demand in one
market can have significant ripple effects in other
markets, creating unintended consequences
– The interdependence of markets can produce
feedback on the original market.

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 General Equilibrium in Two Markets
(a) Ice cream market (b) Pie market
Ice cream price ($/gal.)

Pie price ($/pie)

𝐷𝐷𝐼𝐼 𝑆𝑆 𝐼𝐼 Ice Cream: $6

Pie: $12
𝑆𝑆 𝑃𝑃
12
6 𝐷𝐷𝑃𝑃

25 26
Ice cream (million gallons) Pies (millions)
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 Market-Clearing Curves
• The market-clearing curve relates outcomes
across markets
• It shows, for some good, the combinations of
prices (both for that good and for other
related goods) that bring supply and demand
for the good into balance.
• Its slope depends on whether the goods
considered are complements or substitutes.

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 Market-Clearing Curve for Ice Cream
(a) Ice cream market
(b) Market-clearing curve

Market-
Ice cream price ($/gal.)

Ice cream price ($/gal.)

Pie: $6
clearing
curve for ice
S1 cream

Pie: $12 A1 B1
8 8
A2 B2
6 6
A3 B3
Pie: $18
4 4

15 25 35 6 12 18
Ice cream (million gallons) Pie price ($/gal.)

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A General Equilibrium in Two Markets

General equilibrium
price combination

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 Effects of a Sales Tax
• $3 tax on ice cream
shifts the market-
clearing curve for
ice cream upward
• The vertical
distance is the
partial equilibrium
effect of the tax

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 Effects of a Sales Tax
(a) Ice cream market (a) Pie market
1. The tax shifts supply up (from
the consumers’ perspective).
2. The rise in the price of ice
Ice cream price ($/gal.)

3. The fall in the price of pie raises

cream reduces demand for pie if
demand for ice cream. 𝑆𝑆 𝐼𝐼
𝑇𝑇

Pie price ($/pie)

the two goods are complements.

𝐷𝐷𝐼𝐼Pie: $11 𝑆𝑆 𝑃𝑃
𝐼𝐼 T
𝐷𝐷Pie: $12
8 𝑆𝑆 𝐼𝐼 12 𝑃𝑃
11 𝐷𝐷Ice Cream: $6
𝑃𝑃
6 𝐷𝐷Ice Cream: $8

20 25 23 26
Ice cream (million gallons) Pies (millions)
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 General Equilibrium
in an Exchange Economy
To focus on the role of prices in goods’ allocation,
we consider a pure exchange economy
• In an exchange economy, people own and trade
goods, but no production takes place
• An endowment is the bundle of goods an
individual starts out with before trading
• A general equilibrium in this environment
requires a set of prices at which the markets for
all goods clear.
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 General Equilibrium
in an Exchange Economy
(a) Humphrey (b) Lauren
At prices PW=1 and PF=1, demand for
PW=1, PF=2 food (water) exceeds (is less than) the
endowment. At prices PW=1 and PF=2,
markets clear.
Endowment
Equilibrium

Water (gal.)
Water (gal.)

PW=1, PF=2

AL
CH 7
7 Equilibrium
Endowment
6
BH
BL
3 3
AH CL
PW=1, PF=1 PW=1, PF=1

5 6 8 2 4 6
Food (lb.) Food (lb.)
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 Equilibrium in an Edgeworth Box
Lauren’s food (lb.)
4 2
Since prices ratios are PW=1, PF=2
the same for all
2
individuals, we can PW=1, PF=1

Lauren’s water (gal.)

7 3
plot budget lines and BL C

Humphrey’s water (gal.)

indifference curves for BH
4
both individuals in the
same diagram to 3 7
A
more directly analyze
the conditions for an
equilibrium.
6 8
Humphrey’s food (lb.)
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 Example: General Equilibrium
Two individuals with identical preferences 𝑈𝑈 𝑋𝑋, 𝑌𝑌 = 𝑋𝑋 𝛼𝛼 𝑌𝑌𝛽𝛽 , who are
endowed with 𝑋𝑋1 , 𝑌𝑌1 and 𝑋𝑋2 , 𝑌𝑌2 , respectively.
• At prices (𝑃𝑃𝑋𝑋 , 𝑃𝑃𝑌𝑌 ), individual 1 has
• wealth 𝑋𝑋1 𝑃𝑃𝑋𝑋 + 𝑌𝑌1 𝑃𝑃𝑌𝑌
𝛼𝛼 𝑋𝑋1 𝑃𝑃𝑋𝑋 +𝑌𝑌1 𝑃𝑃𝑌𝑌 𝛽𝛽 𝑋𝑋1 𝑃𝑃𝑋𝑋 +𝑌𝑌1 𝑃𝑃𝑌𝑌
• demand functions 𝐷𝐷1𝑋𝑋 = and 𝐷𝐷1𝑌𝑌 = .
(𝛼𝛼+𝛽𝛽)𝑃𝑃𝑋𝑋 (𝛼𝛼+𝛽𝛽)𝑃𝑃𝑌𝑌
• At prices (𝑃𝑃𝑋𝑋 , 𝑃𝑃𝑌𝑌 ), individual 2 has
• wealth 𝑋𝑋2 𝑃𝑃𝑋𝑋 + 𝑌𝑌2 𝑃𝑃𝑌𝑌
𝛼𝛼 𝑋𝑋2 𝑃𝑃𝑋𝑋 +𝑌𝑌2 𝑃𝑃𝑌𝑌 𝛽𝛽 𝑋𝑋2 𝑃𝑃𝑋𝑋 +𝑌𝑌2 𝑃𝑃𝑌𝑌
• demand functions 𝐷𝐷2𝑋𝑋 = and 𝐷𝐷2𝑌𝑌 = .
(𝛼𝛼+𝛽𝛽)𝑃𝑃𝑋𝑋 (𝛼𝛼+𝛽𝛽)𝑃𝑃𝑌𝑌
Total demand must equal total supply of 𝑋𝑋 (and same for good 𝑌𝑌):
𝛼𝛼 𝑋𝑋1 𝑃𝑃𝑋𝑋 +𝑌𝑌1 𝑃𝑃𝑌𝑌 𝛼𝛼 𝑋𝑋2 𝑃𝑃𝑋𝑋 +𝑌𝑌2 𝑃𝑃𝑌𝑌
+ = 𝑋𝑋1 + 𝑋𝑋2
(𝛼𝛼+𝛽𝛽)𝑃𝑃𝑋𝑋 (𝛼𝛼+𝛽𝛽)𝑃𝑃𝑋𝑋
∗
𝑃𝑃𝑋𝑋 𝛼𝛼 𝑌𝑌 +𝑌𝑌
⇒ The equilibrium price ratio is ∗ = ⋅ 1 2 .
𝑃𝑃𝑌𝑌 𝛽𝛽 𝑋𝑋1 +𝑋𝑋2

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 First Welfare Theorem
• First welfare theorem: in a general
equilibrium with perfect competition, the
allocation of resources is Pareto efficient.

• Pareto efficient: an economic outcome at

which it is impossible to make anyone better
off without making someone else worse off.

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 First Welfare Theorem
If point C is a competitive
equilibrium allocation, then
• Humphrey must like point
C better than all points to
the left of the budget line,
like D
• Lauren must like point C
better than all points to
the right of the budget
line, like E
• both must like point C at
least as well as all other
points on the budget line.
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 Efficiency in Exchange
So which allocations are
Pareto efficient?
• Point G is inefficient
(Lauren and Humphrey
both like H better)
• Point J makes
Humphrey better off
without hurting Lauren
• Point J is Pareto
efficient.

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 Contract Curve
The contract curve
shows every
efficient allocation
of consumption
goods in an
Edgeworth box.

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 Exchange Efficiency Condition
• The exchange efficiency condition requires that
in every pair of individuals the same marginal
rate of substitution is shared for every pair of
goods.
• If two consumers’ marginal rates of substitution
differ, they can both gain by trading.
• The resulting price ratio equals the common
marginal rate of substitution.

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 Normative Criteria for Evaluating
Economic Performance
• Much of economics is concerned with positive
analysis
– e.g., by how much does a tax on ice cream change
the demand for pie?
• Nevertheless, economic tools can be used for
normative analysis, using criteria such as
– Efficiency
– Equity
– Social welfare functions.
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 Efficiency
• An economy is wasteful Efficient
(or inefficient) if we can
reallocate resources in a
way that will make at
Inefficient
least one consumer
better off without
hurting anyone else
• Utility possibility
frontier: shows utility
levels associated with
all efficient allocations
of resources.
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 Equity
• Equity of chances vs. distributive equity

• Process-oriented notions of equity focus on

the procedures used to arrive at an allocation
of resources (equal opportunity)
• Outcome-oriented notions of equity instead
focus on the allocation itself (equal
distribution).

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 Equity
Outcome-oriented notions of equity focus on whether
the process used to allocate resources yields fair results
– but what is fair?
• According to utilitarianism, society should place
equal weight on the well-being of every individual
• According to Rawlsianism, society should place all
weight on the well-being of its worst-off member
• According to egalitarianism, equal division of
society’s resources among all members of the
population is the most equitable outcome.
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 Social Welfare Functions
A social welfare function summarizes judgments
about resource allocations. For each possible
allocation, the function assigns a number that
indicates the overall level of social welfare:
𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 = 𝐹𝐹 𝑈𝑈1 , 𝑈𝑈2 , … , 𝑈𝑈𝑀𝑀 ,
for 𝑀𝑀 members of society.
For instance,
• Utilitarian 𝐹𝐹 𝑈𝑈1 , 𝑈𝑈2 , … , 𝑈𝑈𝑀𝑀 = 𝑈𝑈1 +…+𝑈𝑈𝑀𝑀
• Rawlsian 𝐹𝐹 𝑈𝑈1 , 𝑈𝑈2 , … , 𝑈𝑈𝑀𝑀 = min{𝑈𝑈1 , … , 𝑈𝑈𝑀𝑀 }.
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Applying Social Welfare Functions

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 Contract Curve and
Utility Possibility Frontier
Every allocation on the contract curve corresponds to a point on the
utility possibility frontier.

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 Second Welfare Theorem
• Second welfare theorem: every Pareto efficient
allocation is a competitive equilibrium for some
initial allocation of resources.

• Efficiency is still achieved after resources are re-

allocated by lump-sum transfers.

• A lump-sum transfer is a re-allocation that does

not depend on consumers’ choices.
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Second Welfare Theorem

Individual 2’s endowment/consumption of good Y

Individual 1’s endowment/consumption of good Y
Individual 2’s endowment/consumption of good X

initial
redistribution
endowment

trade

−𝑃𝑃𝑋𝑋 /𝑃𝑃𝑌𝑌
contract curve

Individual 1’s endowment/consumption of good X

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 Equity vs. Efficiency
• The second welfare theorem suggests that
societies can use competitive markets in
combination with lump-sum transfers to achieve
both efficiency and equity.
• Since wealth is observable, an equitable outcome
may be achieved by redistributing resources.
• But wealth is not only an endowment: it depends
on a variety of choices (education, employment,
saving).
• Pure lump-sum transfers are difficult to find.
• Equity and efficiency are still in conflict.

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 Second Welfare Theorem
Example:
• Endowment A favors Humphrey
• Equilibrium B is efficient but
arguably unfair to Lauren
• Government can tax
Humphrey’s food purchases
(his price line becomes steeper)
and give the food to Lauren
(endowment moves to point E)
• The resulting point D is more
equitable, but inefficient.

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