DEPARTMENT OF ECONOMICS

ALICE CAMPUS

ECO 211

Instructor: Dr. D. Hompashe

TOPIC 2: EXCHANGE
GENERAL EQUILIBRIUM ANALYSIS AND RESOURCE ALLOCATION (Mansfield
& Yohe, Chapter 16)
1. Introduction
So far we have examined the response of CONSUMERS to the economic
problem of scarcity; that is, we have examined how consumers allocate their
limited income to maximize utility. The ALLOCATION OF RESOURCES was
therefore implicit in much of our analysis, even though it may not have been
explicitly discussed. In addition, the analyses in our previous chapter were of
a partial equilibrium nature. Changes taking place in one particular market
were limited to the effects they had upon that specific market. No attempt was
made to examine the repercussions and effects that might have filtered
through to other markets. In the present topic you will be introduced to
general-equilibrium analysis, a theoretical paradigm (model) which attempts to
consider the implications of a change in one market on all other markets in the
economy.

Here we will make use of a general-equilibrium approach in order to explicitly

address the question of the EFFICIENT ALLOCATION OF RESOURCES.
This facet of economic theory is known as welfare economics.

It would be easy for you to go through chapter 16 of your textbook (Mansfield

and Yohe) and arrive at the last page without really knowing what exactly you
have been reading. Let us therefore start out with a survey; it should help you
understand this topic.
2. General-Equilibrium Efficiency

A general-equilibrium model is one that explicitly examines the relationships

between different sectors of the economy. Assuming a simple two-input, two-
output, two-consumer economy, we must first consider the condition for
production efficiency: only when the MRTS (marginal rate of technical
substitution) between the two inputs is the same for both industries is there
production efficiency - a situation in which it is impossible to increase the
output of one industry without reducing the output of the other. Many different

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 input allocations, all of which lie on the relevant contract curve, satisfy the
production-efficiency requirement.

Next, we have to look at consumption efficiency. Once an output combination

is produced, consumption efficiency requires that it be distributed among
consumers in such a way that the MRS (marginal rate of substation) of one
good for the other good is equal for all consumers. Only when this condition is
met is it impossible to increase the utility of one consumer without reducing
the utility of another. Many different distributions, all lying along the consumer
contract curve, satisfy this efficiency condition.

The third condition necessary to achieve efficiency requires that the proper
combination of goods must be produced. This requires that the MRS of one
good for the other good be equal to the MRTS of that good for the other good.

In addition to providing a means of exhibiting these efficiency conditions, the

framework of the general-equilibrium model brings out the economic inter-
dependencies existing between production and consumption. It is not enough
to simply satisfy one of the conditions of economic efficiency; these conditions
must be satisfied at a position or point at which the interrelated production and
consumption decisions are consistent with each other.

3. Welfare Economics

So far we have not indulged in value judgments; but in this topic they become
important. We will develop criteria which can be used to evaluate the
desirability of resource allocation decisions. This branch of microeconomics is
called welfare economics. Welfare economics is the study of the conditions
under which the solution to a general equilibrium model may be said to be
optimal.

In the study of welfare economics a number of difficulties crop up. One is the
fact that there exists no scientific basis for making interpersonal utility
comparisons. This problems not only makes it difficult to determine whether or
not a given economic change results in a net increase in social well-being, but
also makes it extremely difficult to conclude that one income distribution is
more desirable than another. And since it is impossible to conclude that one

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income distribution is better than another, we will not be able to say that the
efficient allocation associated with one income distribution is more desirable
than the efficient (or even inefficient) allocation of resources associated with
another income distribution. We can see that it is impossible to say that one
position in the economy or one allocation of resources is better than other
positions or allocations without resorting to value judgments. However, it
might be possible to compare alternative resource allocations with minimal
reliance on value judgments. An example of the criterion central to welfare
economics that any change which improves the well-being of one person
without reducing the well-being of anyone else is a desirable change. Any
change that satisfies this condition is referred to as a Pareto-efficient change.
When all opportunities to take advantage of Pareto-efficient changes have
been exhausted, a Pareto-efficient allocation of resources is said to have
been reached.

There is, however, one fact of which we should be aware. The Pareto criteria
can say nothing about a change that makes some individuals better off and
others worse off, and since most policy changes are of this more complex
kind, the Pareto criteria have shortcomings. Other more explicit welfare
judgment methods have, therefore, been suggested to supplement the Pareto
criterion - for example the Kaldor-Hicks criterion. Nevertheless, although the
Pareto criterion has its shortcomings, it is the common core of all social
welfare functions. It provides the fundamental criterion against which the
desirability of a particular allocation of resources is judged, and it can be
shown that competitive markets satisfy all the marginal conditions for the
attainment of a Pareto optimum.

It should be pointed out that not every allocation that satisfy the Pareto
condition is a social welfare optimum, because the social welfare optimum
depends on the social welfare function. Many different resource allocations
satisfy all three marginal conditions for efficiency, and we have no objective
basis for considering one Pareto-efficient allocation superior to another. It
might in fact happen that all the efficiency conditions may be satisfied at a
point where one of the consumers is receiving most, if not all, of the economic
benefits. This can be shown by constructing the grand utility possibilities

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 curve, which indicates the maximum utility that one consumer can receive at
each possible utility level for the other consumer. The only way to select the
most desirable Pareto-efficient position is to be willing to make a value
judgment regarding the value of one consumer’s utility relative to another’s.
Having done this, we shall find that it is possible to determine a social welfare
function and the corresponding social indifference curve that can be used in
conjunction with the grand utility possibility curve to select the “superior”
Pareto-efficient position. This is called the constrained bliss point because it
represents the one organisation of exchange production and distribution
that corresponds to maximum attainable social welfare.

In the following sections of this lecture note, we will attempt to illustrate how
the different analytical tools you have encountered - indifferent curves,
isoquants, production possibility curves, equilibrium, perfect competition,
allocation of resources and a few others can be integrated into a model which
uses a general equilibrium approach to the problem of welfare economics.

4. A summary of the interrelationship of certain basic concepts

encountered in a study of general equilibrium and welfare analysis
4.1. Basic Definitions
(a) A general equilibrium is a simultaneous, consistent, long-run equilibrium
for all markets and all decision units in an economic system. General
equilibrium theory can demonstrate that the production and consumption
sectors can adjust themselves to levels which are mutually consistent with
each other.
(b) Welfare economics is concerned with maximizing social welfare, that is,
the welfare of all members of a society. The criteria used to evaluate the
concept of efficiency are those of Pareto. We assume a given social
welfare function.
4.2. The analysis

In our analysis we look at (1) consumption and (2) production. Then we bring
consumption and production together and (3) look at how maximum social
welfare is determined. Our economy (society) has 2 consumers consuming 2
goods and there are 2 factors of production with which the goods are produced.

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(1) Consumption

We start off with the Edgeworth box displayed in Figure 16.3 with the indifference
curves for Harry and Tom. We already know an indifference curve represents a
constant level of utility (satisfaction). Higher indifference curves represent higher
levels of utility.

The dimensions of the box are determined by the quantity of each good available
in the system. Assume point P represents the initial endowment of goods. From
the viewpoint of society as a whole, is it possible to improve on point P? How?
How does our knowledge of indifference curves help us? What does Pareto say
about this? What can we say about the MRS at a point like P0 where
consumption is efficient? (First Pareto condition.)

Each consumer has many indifference curves, so many points like P0 will exist -
they form the contract curve for consumption, that is, the set of consumption-
efficient allocations - Figure 16.3. Utility-maximising behaviour will lead
consumers to the consumption contract curve.

Microeconomics 11th Edition

Copyright © 2004 W. W. Norton & Company

(2) Production
In Figure 16.5 we construct the Edgeworth box diagram for production. The
dimensions of the box are determined by the quantities of inputs (L,K) available in
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the economy. Assume point Z represents the initial endowment of inputs for the
two producers. From the viewpoint of society as a whole, can the two producers
improve on point Z? How? How does our knowledge of isoquants help us? What
does Pareto say in this respect? What can we say about the MRTS at point like
U? (Second Pareto condition.)

Each producer has many isoquants, therefore many points like U will exist: they
form the contract curve for production, which is the set of production-efficient
input combinations.

The output levels represented by the production-efficient points on the contract

curve can be replotted in the next figure to give us the PPC (production
possibilities curve) showing the maximum combinations of goods that society can
produce - Figure 16.6. a production possibility curve, PPC is constructed
assuming that all inputs are used fully and efficiently and that resource
endowments and technology are fixed. (The slope of the PPC is called the MRT,
that is the marginal rate of transformation - do you know exactly what the
meaning of this is?)

Can you see how points U and V from Figure 16.5 are transferred to Figure 16.6?

Fig. 16.5

Microeconomics 11th Edition

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 Fig. 16.6

Microeconomics 11th Edition

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(3) Linking production and consumption

The PPC links the production and consumption sectors. There is an Edgeworth
consumption box consistent with each point on the PPC such as point Al in
Figure 16.7. Each point on the consumption contract curve within a consumption
box, such as point B, represents a consumption-efficient allocation of goods
between the 2 consumers.

If the dimensions of the consumption box lie on the PPC and consumption
choices are restricted to the box, then production and consumption decisions will
be consistent.

For equilibrium in production and consumption a further condition is necessary:

consumers must be willing to substitute the goods in their commodity baskets in
the same ratio as the economy can transform one good into the other. This
means that for Harry and Tom, purchasing food and medicine must equal the
MRT between food and clothing, (third Pareto condition.) Therefore, the slope of
the indifference curves for Harry and Tom, if equilibrium is achieved, must equal
the slope of the PPC - Figure 16.7 (third Pareto condition.)

(What happens of the MRT is not equal to the MRS? Since this will sidetrack our
discussion somewhat, it will be explained in the Appendix).

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The utility levels from a consumption contract curve may be replotted to yield a
utility possibility frontier (curve). In Figure 16.7, point Al lies on the production
possibility curve P Pl. At each point on the contract curve 0 Al identify the utility
levels of Harry and Tom - then use this information to plot the thick orange utility
possibility curve UU’ in Figure 16.13. To achieve this we reproduce the Figure
16.7 into Figure 16.12 below. At any point on the PP’ curve in Figure 16.12,
inputs are allocated so that the second condition for economic efficiency is
satisfied - that is, the MRTS of labour for capital are identical in both sectors for
any point on PP’. We could construct an Edgeworth box within the boundary of
PP’ if we knew the amount of food and the amount of medicine that would be
produced. If, for example, the total quantity of food produced were F, then the
maximum amount of medicine that could be produced would be M. Figure 16.12
also show the three indifference curves for Tom and Harry and the contract
curve, CC’.

Fig. 16.12

Microeconomics 11th Edition

Copyright © 2004 W. W. Norton & Company

Assuming that F units of food and M units of medicine are produced, then the
third condition for economic efficiency dictates that the commodities be
distributed between the consumers so that they are at point G. Why? Because
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the third condition requires that the common MRS of food for medicine match the
MRT at the point selected on the production possibilities frontier.

This condition is satisfied in Figure 16.12 only at point G. There, the common
slopes of the indifference curves (the negative MRS) equal the slope of the PPC
at point N (the negative MRT). This distribution of commodities at point G
between Tom and Harry means that Tom achieves a certain level of utility and
Harry achieves a certain level of utility. Suppose that this pair of utility levels
corresponds to point R in Figure 16.13.

Now suppose that we had taken a different point on the PPC in Figure 16.12,
say, N’. We could then have drawn a new Edgeworth box diagram with F’ and
height M’ (see Figure 16.12). Drawing from Tom’s and Harry’s indifference curves
in this new Edgeworth box diagram, we could have found a different contract
curve. And so we could have found a different point on this new contract curve for
which the common slopes of the indifference curves would be equal the slope of
the PPC at point N’. The MRS for Tom and Harry would then equal a new and
slightly higher MRT. Let point R’ in Figure 16.13 depict the utility levels for Tom
and Harry that correspond to this point.

Fig. 16.13

Microeconomics 11th Edition

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Review Questions
1. Sipho and Siphokazi go to a Chinese restaurant. They order lemon
chicken and sweet-and-sour pork. When the food arrives, they divide each
portion completely between themselves. Indicate how the Edgeworth box
diagram might be used to analyse the way in which they divided the food,
and how they should have divided the food. Is it reasonable to assume
that Siphokazi’s satisfaction depends only on the amount of food she
consumes and not on the amount Sipho consumes too? And vice versa?
2. Suppose that you have 6 bottles of beer and no potato chips and your
roommate has 4 bags of potato chips and no beer. Your university has no
policy prohibiting beer in the dorm (right?). It is late at night, and the stores
are closed. You decide to swap some of your beer for some of her potato
chips. The accompanying figure displays the relevant Edgeworth box
diagram. Your indifference curves are labelled I and II; note that they
favour beer. Hers are labelled 1 and 2; they favour chips, but beer is OK.
Label the point on the diagram that represents your pre-trade situation.
Suppose that you decide to swap 3 bottles of your beer for 1 bag of your
roommate’s potato chips. Is this a rational offer? That is, would her
acceptance of this offer make you better off? Explain. Suppose that you
offer to exchange 2 bottles of your beer for 1.5 bags of your roommate’s
potato chips. Would your roommate agree to this? Would this be a rational
offer on your part?

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 Prob. 16.4

Microeconomics 11th Edition

Copyright © 2004 W. W. Norton & Company

3. Suppose that there are only two goods, green jellybeans and red jellybeans,
consumed by two individuals, Ronnie and Nancy. Assume also that there
are 50 jellybeans of each color which are evenly divided between these two
consumers. Ronnie’s marginal rate of substitution of red for green jellybeans
is 2. That is, Ronnie would be willing to exchange 2 greens for a red. Nancy’s
marginal rate of substitution is 1. Does the initial equal allocation of
jellybeans imply that both individuals are at a point on the contract curve?

4. There are two individuals on the island of St. Croy, Jebb and Billy Bob. The
Edgeworth box depicting their initial situation (point A) is shown below.

Rum Billy Bob

10

Jebb Mangoes
1 2 3 4

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 If Jebb is willing to trade 2 bottles of rum for 11/2 mangos, will Billy Bob
accept the offer? Why or why not?

5. Assume that there are two individuals, Norton and Ralph, who live in a
world where they consume only fish and cabbage.
a. Given their initial endowment, Norton’s MRS of fish for cabbages is 4
and Ralph’s is 2. Show how both could gain from trading with each
other. Will Nor- ton trade fish for cabbages or cabbages for fish? In
the context of this two-person pure exchange model, define and
illustrate the concept of economic efficiency.
b. Does efficiency imply equity? Explain.
6. Assume that there are two goods in society, bread and wine, and two
factors of production, capital and labour. Given the current allocation of
resources, the marginal product of labour in bread production is 6, while in
wine production it is 2, and the marginal product of capital in bread
production is 4 while in wine production it is 8. Illustrate how you could get
more of both bread and wine by reallocating labour and capital between
the two goods. Would you transfer labour from bread production to wine
production, moving capital the other way, or capital from bread to wine
production in exchange for labour? Explain.

7. Explain the meaning of the term “Pareto optimality” and the reason it might
be useful in making decisions regarding allocation of resources.

8. It has been argued that with economic growth, all groups in society are
guaranteed to be better off. Is this necessarily true? Explain using
production possibility curves and Edgeworth boxes.

9. Without the use of diagram(s), discuss what is meant by “Pareto efficiency”.

10. Illustrate and explain what is meant by Pareto efficiency in consumption.

11. Illustrate and explain what is meant by Pareto efficiency in exchange.

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