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0 views29 pagesThis document offers a very interesting insight into the walrasian & marshallian equilibrium functions in economics.

Jun 10, 2019

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This document offers a very interesting insight into the walrasian & marshallian equilibrium functions in economics.

© All Rights Reserved

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This document offers a very interesting insight into the walrasian & marshallian equilibrium functions in economics.

© All Rights Reserved

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determination of commodity, keeping the prices of other commodities

constant and also assuming that the various commodities are not

interdependent.

• Thus in Marshallian explanation of pricing under perfect competition,

demand function for a commodity is drawn with the assumption that

prices of other commodities, tastes and incomes of the consumers

remain constant.

• Similarly, supply curve of commodity is constructed by assuming that

prices of other commodities, prices of resources or factors and

production function remain the same.

• Then Marshall’s partial equilibrium analysis seeks to explain the price

determination of a single commodity through the intersection of

demand and supply curves, with prices of other goods, resource

prices etc., remaining the same.

• Prices of other goods, resource prices, incomes, etc., are the data of

the system which are taken as given to explain the determination of

price-output equilibrium of a single commodity.

• Given the assumption of ceteris paribus it explains the

determination of a price of a goods, say X,

independently of the prices of all other goods. With the

change in the data, new demand and supply curves will

be formed and, corresponding to these, new price of

the commodity will be determined.

• Thus partial equilibrium analysis of price determination

also studies how the equilibrium price changes as a

result of change in the data.

• But given the independent data the partial equilibrium

analysis explains only the price determination of a

commodity in isolation and does not analyse how the

prices of various goods are interdependent and inter-

related and how they are simultaneously determined.

• It should be noted that partial equilibrium analysis is

based on the assumption that the changes in a single

sector do not significantly affect the rest of the sectors.

Thus, in partial equilibrium analysis, if the price of a

good changes, it will not affect the demand for other

goods.

• Prof. Lipsey rightly writes: “All partial

equilibrium analyses are based on

the assumption of ceteris paribus.

Strictly interpreted, the assumption

is that all other things in the

economy are unaffected by any

changes in the sector under

consideration (say sector A).

• This assumption is always violated to

some extent, for anything that

happens in one sector must cause

changes in some other sectors.

• What matters is that the changes

induced throughout the rest of the

economy are sufficiently small and

diffuse so that the effect they in turn

have on the sector A can be safely

ignored”.

Marshallian Approach to Price Determination

• Marshall prices are determined

in a static framework keeping

other things constant.

• Marshall asked "what

determines the price" and

answered that Qd and Qs

determine the price. Thus he

uses supply and demand curves

for price determination and

assumes perfect competition.

We can arrive at Marshal stability of an equilibrium by disturbing the quantity. Let

initial equilibrium be (P0, Q0). Let us disturb it to produce Q1. But at Q1, the price

offered by consumers is much less than the price demanded by suppliers.

Suppliers are disappointed and they produce less in the next cycle such that the price

demanded is same as price offered in the last cycle. Hence it is Marshal stable

In figure 1, e1 is Marshal unstable. In figure 2, e1 is Marshal unstable, e2 is Marshal

stable and e3 is Marshal unstable. In figure 3, e1 is Marshal unstable and e2 is @

equilibrium @ P < P2 and Marshal stable for P > P2.

Walras General Equilibrium Analysis

• In general equilibrium analysis, put forward by French Economist Walras

the price of a good is not explained to be determined independently of

the prices of other goods.

• Since the changes in price of good X affect the prices and quantities

demanded of other goods and in turn the changes in prices and quantities

of other goods will affect the quantity demanded of the good X, the

general equilibrium approach explains the simultaneous determination of

prices of all goods and factors.

• As stated above, partial equilibrium approach assumes that the effect of

the change in price of a good A” will be so diffused in the rest of the

economy (i.e., over all other goods) so as to have negligible effect on the

prices and quantities of other individual goods.

• Therefore, where the effect of a change in the price of a good on the prices and

quantities of some other goods is significant, as is there in the case of inter-

related goods, that is, substitutes and complementary goods, the partial

equilibrium approach cannot be validly applied in such cases and therefore there

is need for applying general equilibrium analysis which should explain the mutual

and simultaneous determination of their prices and quantities.

• General equilibrium analysis deals with inter-relationship and inter-dependence

between equilibrium adjustments with each other. General equilibrium exists

when at the going prices, the quantities demanded of each product and each

factor are equal to their respective quantities supplied.

• A change in the demand or supply of any good, or factor would cause changes in

prices and quantities of all other goods and factors and there will begin the

process of adjustment and readjustment in demand, supply and prices of other

goods and factors till the new general equilibrium is established. Indeed, the

general equilibrium analysis is solving a system of simultaneous equations.

• In a general equilibrium system, the quantity demanded of each good is

described by an equation in which its quantity demanded is a function of

prices of all goods. Likewise, in general equilibrium analysis, quantity supplied

of each good is considered to be the function of price of all factors of

production.

• In a general equilibrium system the prices of all goods affect the quantity

demanded of each good. Further, the prices of the all factors affect the

quantity supplied of each good. Besides these crucial equations, there will be

equations determining the price of each of the factors of production. As noted

above, a change in any of the demand or supply equations would cause

changes in all prices and quantities and as a result the system will tend to

move to the new general equilibrium.

• To explain the inter-relationship and interdependence among the prices and

quantities of goods and factors and ultimately to explain the determination of

the relative prices of all goods and factors, the proportion in which different

goods are being produced and different factors are being used for the

production of different goods is the essence of general equilibrium analysis.

Walrasian Approach to Price Determination

vector i.e. all prices together in

a general equilibrium

framework.

• Walras asked "what determines

the quantity demanded" and his

answer was relative price.

• This can be inferred from law of

equimarginal utilities i.e. a

person consumes till

(MUx/MUy) = (Px/Py).

• He assumes all markets to be

perfectly competitive.

Assumptions For Solution Of The General

Equilibrium Model

• All markets are perfectly competitive. All factors are

completely mobile. All inputs and outputs are perfectly

divisible. All production functions and demand functions are

continuous and twice differentiable.

• There are no externalities. Closed economy.

• There are constant returns to scale.

Industry

The Theory of Demand

Cardinal Utility Theory Ordinal Utility Theory

• Assumptions • Assumptions

1. Rationality: Utility maximizer 1. Completeness: Consumer can rank

consumer. all items.

2. Cardinal Utility: Utility can be 2. Transitivity: If U(x) > U(y) and U(y)

measured in monetary units. > U(z) => U(x) > U(z).

3. Constant Marginal Utility of 3. Non Satiation: The more a good,

Money: This is to make sure the better.

measuring scale doesn't change. 4. Continuity: All goods can be

4. Diminishing Marginal Utility: Used divided into infinitely small units.

in deriving demand curve. 5. Strict Convexity: MRSx,y and

5. Additive Utility: U(a, b, c) = U(a) + MRSy,x should both decline

U(b) + U(c). throughout the indifference curve.

6. Differentiability: Twice

differentiable.

Cardinal Utility Theory Ordinal Utility Theory

• Critique • Critique

1. Cardinal Utility: This is extremely 1. Assumption of existence and

doubtful. convexity of ICs.

2. Constant Marginal Utility of 2. It is also doubtful if the

consumer can order his

Money: Money is a good like preferences as precisely as the

others, so its marginal utility theory assumes. His orderings

can't be same. also keep on changing, so at

3. Diminishing Marginal Utility: best, any ordering can be for a

This has been established from very short run.

'introspection' or psychology. 3. The concept of Marginal Utility

is still implicit in MRTSx,y.

Advantages over Cardinal Utility Theory

1. Assumption of cardinality dropped.

2. Assumption of constant marginal utility of money dropped.

3. It breaks down the price effect into substitution effect and income

effect. Thus gives a better understanding of substitutability of goods.

Hicks said that goods are substitute if after adjusting for the change in

real income, a decrease in Px leads to decrease in quantity demanded

for y.

Demand Curve and Distribution Channels

1. Final Consumers: Some argue that in the long run demand curve should be

flat as demand would be infinitely elastic and consumers will buy only on

basis of price. But this ignores the product differentiation. A consumer

buying an identical product from a trendy store is not irrational.

2. Other manufacturing firms: If the product is an investment good i.e.

machine then it involves substantial sum and brand awareness. So demand

curve will be downward sloping. For intermediate goods, flat curve.

3. Wholesalers: It is argued he will only buy products where his profit margin is

highest or he is price sensitive. But this overemphasizes his ability to control

the final demand and he may buy a low margin product if total profit is

maximized. Hence again demand curve downward sloping.

4. Retailers: If retailers buy for their own brand, then more price conscious and

flat curve. If for end consumers, then downward sloping curve.

The Theory of Production

• Marginal Revenue and Price Elasticity

To prove: MR = p. (1 - 1/ηd)

Proof 1. We know

total revenue (TR) = price (P) * quantity (q)

=> TR = p.q.

Now differentiating it to get MR,

MR = p + q. (∂p/∂q)

We can write

∂p/∂q = [(∂p/p) / (∂q/q)] . (p/q)

But 1/ηd = - (∂p/p) / (∂q/q)

so => MR = p - 1/ηd . p or MR = p. (1 - 1/ηd).

Production Function

Homogeneous production function

1. A production function is homogenous when if each input is multiplied by &,

then & can be factored out of the function. The power of & thus factored out

is the degree of homogeneity. Thus Q = A. (K˚å) . (Lˆß) is a homogenous

function of degree (å+ß). If degree of homogeneity is 1 it implies CRS

prevails. 1% change in both K & L together leads to 1% jump in output.

2. If a ƒ is homogenous of degree å then its marginal productivity function will

be homogenous of degree (å-1). This means for CRS functions, MPPL and

MPPK don't change with changing input values i.e. in CRS, MPPL and MPPK

are constant.

3. Homogenous functions of degree 1 satisfy Euler's theorem i.e. Q = L . MPPL +

K . MPPK. This ensures that

(a) Each input is paid the value of its marginal product.

(b) Total output is just exhausted. L.(p.MPPL) + K.(p.MPPK) = p.q. But p.MPPL = w

and p.MPPK = r, this means L.w + K.r = TR. This means in long run, TR = TC or a

firm can only earn normal profits in such a case.

Productivity Curves

• Given a constant K,

variation of output as a

function of L. Q = ƒ(L)|K0.

Such a curve should

demonstrate law of

diminishing marginal

productivity.

• Also higher the level of K

employed, lower the level

of L needed for a given

output

Iso-quants & Iso-costs

• MRTSL,K = -(Slope of Iso-quant) = MPPL / MPPK. At equilibrium, MRTSL,K =

w/r. Assumption: Perfect factor markets. 1. If MPPL is -ve => slope of iso-

quant is positive. At such a point, reduction in both L and K will lead to

increase in production. No one would operate on such a point. This defines

the rational zone i.e. a zone where both the marginal products are positive.

• The profit maximizing behavior dictates: π = p.Q - C should me maximized. Q

= ƒ(L,K) and C = a + w.L + r.K. This means ∂π/∂L = 0 and ∂π/∂K = 0. This

means p.MPPL = w and p.MPPK = r are 2 conditions. This actually represents

the point where his MR = MC.

Long Run Cost Curves

• To get the LR total cost curve, @

every output level q, draw the

SR total cost curves for every K

level. Choose the minimum cost

point. Repeat this process for all

levels of q and get the LR total

cost curve. LTC curve can also be

seen as the envelope of STC

curves.

• To get the LR average cost curve,

just divide the total cost curve

by q. LAC curve can also be seen

as the envelope of SAC curves.

• for LMC curve, take the partial

derivative of LTC wrt q.

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