L10 GenEQ

EC2066 MICROECONOMICS
Topic 10: General Equilibrium and Welfare Economics
Learning Outcomes
By the end of this chapter, and having completed the Essential reading and activities, you should
be able to:
 define the competitive general equilibrium
 analyse the competitive equilibrium in the case of a pure exchange economy
 define Pareto efficiency and apply it to a general equilibrium setting
 find the contract curve
 explain the welfare theorems
 discuss the theory of second best.
Essential Reading
 Morgan, Katz and Rosen, Microeconomics, Chapter 12.

 Perloff, J.M. Microeconomics: theory and applications with calculus. Chapter 10
1. Introduction to General Equilibrium

 In the past chapters, we analysed markets on the assumption that these markets are in
partial equilibrium.
 As defined by George Stigler, “a partial equilibrium is one which is based on only a

restricted range of data, a standard example is price of a single product, the prices of
all other products being held fixed during the analysis.” In partial equilibrium analysis, we
analyse one particular market while keeping other markets unchanged.
 In general equilibrium analysis, we examine how the interactions of individual economic

agents in the economy as a whole in order to determine the allocation of resources and
whether the allocation of resources is efficient or not. The theory seeks to prove that
there exists a set of prices which will result in an overall (or "general") equilibrium in the
economy.
 We will begin with the analysis of the pure exchange economy between consumers.
Copyright: Singapore Institute of Management Page |1

2. Pure Exchange Economy with Consumers

 Suppose we have two consumers, A and B. Suppose also we have two goods, X and Y.
Consumer A is endowed with 4 units of X and 2 units of Y. We can depict them as
follows. Notice that the consumer will have initial indifference curves passing through
the endowment point.
YA
2 U0
4 XA
 Suppose Consumer B is endowed with 1 unit of X and 3 units of Y. We can depict them
as follows.
YB
U0
1 XB
 In an exchange economy, we simply draw both the consumers on one diagram.

 We invert Consumer B’s indifference curve diagram and draw it on top of Consumer A’s
diagram. This is the construction of the Edgeworth’s Box.
 We begin with Consumer A. Consumer A’s diagram will look like what we have just seen.
YA
4 XA
 We add in Consumer B’s utility curve. The curve will be represented by UB and can
only be viewed upside-down.
5 XB 1
YA
UB
UA
2 3
YB
4 XA 5

 We notice that A is endowed with 4 units of X and B is endowed with 1 unit of X.

Hence, the total amount of X is 5. At the end of the Edgeworth Box, on the axis XA
and XB, the maximum number of X the individual can hold is 5.
 We notice that A is endowed with 2 units of Y and B is endowed with 3 units of Y.

Hence, the total amount of Y is 5. At the end of the Edgeworth Box, on the axis YA
and YB, the maximum number of Y the individual can hold is 5.
 The sum of endowments for X or Y is also the supply of X or Y. The sum of both
individuals’ holdings of X or Y is also the demand of X or Y. Both the demand and the
supply must be exactly 5 units of X and 5 units of Y. This is the equilibrium condition
whereby demand is equal to supply.
 The initial equilibrium is such that A holds 4 units of X and 2 units of Y and B holds 1
unit of X and 3 units of Y. We can begin analysing the pure-exchange economy.
5 XB 2.5 1
YA
UB
2.5 2.5
D UA2
UA1
2 3
C
YB
2.5 4 XA 5
 Initially we start off at Point C.
 Notice that A can trade with B such that A can have less units of X in exchange for more
units of Y. B will trade with A such that B can have more units of X and less units of Y.
 The trade occurs such that this is a movement along B’s indifference curve from Point
C to Point D. B’s utility remains the same after the trade.
 However, this trade is beneficial to A as the trade from Point C to D elevates A’s utility
from UA1 to UA2 without changing B’s utility which is UB.

 Individual A can trade up to Point D whereby his utility cannot go any higher and Individual
B’s utility is not lower. This is a Pareto improvement for the economy as A is better off
while B is not worse off.
 Given an initial allocation of goods among a set of individuals, a change to a different

allocation that makes at least one individual better off without making any other individual
worse off is called a Pareto improvement.
 Let us consider another scenario. Initially we start off at Point C.
5 XB 3 1
YA
UB1
UB2 D’
2.5 2.5
UA1
2 3
C
YB
2 4 XA 5
 We notice that Individual B can trade with Individual A such that Individual B can have
more units of X in return for less units of Y. In other words, Individual A will trade with
individual B such that Individual A can have less units of X and more units of Y.
 This trade occurs such that this is a movement along A’s indifference curve from point
C to point D’. A’s utility remains the same after the trade.
 However, this trade is beneficial for B as this trade from point C to D’ elevates B’s utility
from UB1 to UB2 without changing A’s utility which is UA.
 B can trade up to point D’ whereby his utility cannot go higher anymore and individual
A’s utility is not lower. This is a Pareto improvement for the economy as B is better off
while A is not worse off.

 Point D and Point D’ are Pareto Efficient points whereby it is not possible to make an
individual better off without making another individual worse off.
 At Point D and D’, MRSA = MRSB as both individuals’ indifference curves are tangent to
each other and thus have the same slopes.
 The two consumers will trade such that they maximise their utility subject to the
endowment constraints.
 The mutual gains from the trade is shown in the shaded area.
5 XB 1
YA
UB
Mutual Gains
From Trade
UA
2 3
YB
4 XA 5
 As pointed out earlier, at Point D or D’, the Pareto efficient point occurs when the two
indifference curves are tangent to one another. In the Edgeworth Box, there is more
than one Pareto Efficient point.

 Let us consider another situation where both individuals gain from trading with each
other.
5 XB 2.5 1
YA
UB1
UB2
3 2
D’’ UA2
2 3
C UA1
YB
2.5 4 XA 5
 Individual B can trade with Individual A such that Individual B can have more units of X in
return for less units of Y. In other words, Individual A will trade with Individual B such
that Individual A can have less units of X and more units of Y. The results from the trade
shifts both individuals’ indifference curves from point C to D’’.
 This trade is beneficial for both Individual A and B as this trade from Point C to D’’
elevates B’s utility from UB1 to UB2 and A’s utility from UA1 to UA2.
 Point D’’ is a Pareto efficient point whereby it is not possible to make an individual better
off without making another individual worse off.
 The Locus of all possible Pareto efficient points is called the contract curve. Thus, the
contract curve shows the set of points representing final allocations of two goods
between two people that could occur as a result of mutually beneficial trading between
those people given their initial allocations of the goods.
 In general, the contract curve will not be a straight line. Whether it is a straight line of
not depends on the nature of individuals’ utility functions and their relationship. Along
the contract curve, MRSA = MRSB. This is depicted below.

5 XB
YA
Contract
UB1 Curve
UA3
UB2
UA2
UB3
UA1
YB
XA 5


3. Competitive Equilibrium: A Mathematical Analysis

 A competitive equilibrium is an equilibrium condition where the interaction of profit-
maximising producers and utility-maximising consumers in competitive markets with
freely determined prices that gives rise to an equilibrium price. At this equilibrium price,
the quantity supplied is equal to the quantity demanded.
 A competitive equilibrium is reached when both individuals trade with each other such
that there will not be any more possible gains from the trade. Notice that a competitive
equilibrium is Pareto efficient.
Example:
. .
Individual A maximises utility 4 2 . At the
optimum consumption choice, MRS = Price Ratio.
We proceed to find the MRS:
. .
0.5
. .
0.5
. .
0.5
0.5 . .
When MRS = Price Ratio, we have
Substitute this into the budget constraint, we have
2 4 2
A’s Demand function for X.
A’s Demand function for Y.
. .
Individual B maximises utility subject to 1 3
. .
0.25
. .
0.75
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. .
0.25 1
0.75 . . 3
Substitute this into the budget constraint
4 1 3
B’s Demand function for X
B’s Demand function for Y
The next step is to find the competitive equilibrium. We will find the equilibrium amount
of X and Y in this economy.
To find the competitive equilibrium, we need to know either Px or Py. Let us suppose Px =
1.
In equilibrium, Supply of X = Demand of X
In terms of supply, the sum of endowments for Good X is 5.
In terms of demand, we sum up demand from both individuals, i.e.,
3 4 2 1 3 4 2
4 2 4 2
In equilibrium, we have:
1 3 8 4
5
4 4
20 1 3 8 4
11 7
11
7
Substituting this into A and B’s demand function for X and Y, we have:
A’s Demand for X

B’s Demand for X
We can check that 5
A’s Demand for Y
B’s Demand for Y.
We can also check that 5
Note that we could also use Supply of Y = Demand of Y and we should get exactly the
same results.
4. Contract Curve: A Mathematical Analysis

Pareto Optimality requires that MRS of A = MRS of B. Suppose there are a total of 5
units of X and 5 units of Y in the market.
. .
This implies that is the equation for Pareto Efficiency. Graphically, the contract
curve becomes a 45 degree straight line and the Edgeworth Box is a square since total
supply of X and Y are all 5 units each.
Since the total supply of X is 5 and the total supply of Y is also 5, then 5 and
5 .
Hence the contract curve lies on , ,5 ,5 .
As the contract curve becomes a 45 degree straight line and the Edgeworth Box is a
square, we can express the curve all in terms of a single variable, say . Then the
contract curve can be shown as , ,5 ,5
Likewise, we can also express the curve all in terms of . Hence, the contract curve will
lie on , ,5 ,5 .

5. Pure Exchange Economy with Producers

 This is almost identical to the Pure Exchange with consumers.
 Producers produce 2 goods, X and Y. They are endowed with 2 resources, capital and
labour.
 We assume that producers maximise profit subject to their resource endowment and
producers are price-takers.
 The initial output for Good X is QX and the initial output for Good Y is QY. This is shown as
the level of ISO-Quants in the Edgeworth Box below.
5 LY 1
KX
QY
2 3
QX
KY
4 LX 5
 We notice that the producer producing Good X is endowed with 4 units of L and the
producer producing Good Y is endowed with 1 unit of L. Hence, the total amount of L is
5. At the end of the axis LX and LY, the Edgeworth Box depicts the maximum number of
L the producers can employ.
 We notice that the producer producing Good X is endowed with 2 units of K and the
producer producing Good Y is endowed with 3 units of K. Hence, the total amount of K
is 5. At the end of the axis KX and KY, the Edgeworth Box depicts the maximum number
of K the producers can employ.
 The sum of endowments for K or L is also the supply of K or L. The sum of both
producers’ employment of K or L is also the demand of K or L. Both the demand and
the supply must be exactly 5 units of K and 5 units of L. This is the equilibrium condition
whereby demand is equal to supply.

 At the initial equilibrium, Point C, the production of QX requires 4 units of L and 2 units of K
and the production of QY requires 1 unit of L and 3 units of K. Now we can begin analysing
the pure exchange economy.
5 LY 2.5 1
KX
QY
D
2.5 2.5
QX2
2 3
QX1
C
KY
2.5 4 LX 5
 Notice that the economy can restructure the production of X and Y such that production
of Good X will require less L and more K. Likewise, the production of Good Y will require
more L and less K.
 This exchange occurs such that this is a movement from Point C to Point D along
isoquant QY.
 This restructuring of the production results in an improvement for the production of X.

From Point C to D, this increases the amount of X produced from QX1 to QX2 without
decreasing the amount of Y produced.
 Good X can be produced until Point D whereby the isoquant Qx2 cannot go any higher and
isoquant for good Y is not lower. This is a Pareto improvement for the economy as we
can produce more units of X without producing less units of Y.

5 LY 3 1
KX
QY1
D’
QY2
2.5 2.5
QX
2 3
C
KY
2 4 LX 5
 Similarly, the restructuring of the production can result in an improvement for the
production of Y without decreasing the amount of X produced. From point C to D’, this
increases the amount of Y produced from QY1 to QY2 without decreasing the amount of X
produced as the isoquant QX remains unchanged.
 Good Y can be produced until Point D’ whereby the isoquant QY2 cannot go any higher
and isoquant for Good X is not lower. This is a Pareto improvement for the economy as
we can produce more units of Y without producing less units of X.
 Both Point D and D’ are the Pareto efficient points whereby it is not possible to produce
more of a good without decreasing production of another good. On Point D and D’,
MRTSX = MRTSY.
 Therefore, to summarise, as long as there is the shaded grey area below, there will be
gains from restructuring of production.

5 LY 1
KX
QY
Mutual gains
from trade
2 3
QA
KY
4 LX 5
 In the Edgeworth Box, there is more than one Pareto Efficient point.
5 LB 2.5 1
KA
QY2
QY1
3 2
D’’
QX2
2 3
C QX1
KB
2.5 4 LA 5

 Notice that the economy can also restructure the production of X and Y such that there
is an improvement for the production of both X and Y. From Point C to D’’, this increases
the amount of X produced from QX1 to QX2 and the amount of Y produced from QY1 to QY2.
 The outcome at Point D’’ is Pareto efficient as the two isoquants of X and Y are tangent
to each other.
 The Locus of all possible Pareto efficient points is called production contract curve.
 In general, the production contract curve will not be a straight line. Whether it is a
straight line of not depends on the nature of production function and their relationship.
Along the contract curve, MRTSX = MRTSY. This is depicted below.
5 LB
KA
Contract
QY1 Curve
QX3
QY2
QX2
QY3
QX1
KB
LA 5

6. Welfare and Efficiency
4.1 Productive Efficiency

 Along the production contract curve, MRTSX = MRTSY. The production–possibility
frontier can be constructed from the contract curve in an Edgeworth production box
diagram.
 As the relationship between the isoquants of goods X and Y are plotted together in an
Edgeworth production box diagram, all Pareto efficient points (along the contract curve)
is given by the production possibility frontier (PPF) as shown below.
 All points along the PPF are said to be productive efficient because these points also
coincide with the contract curve and that they are Pareto efficient.
 Point B is productively inefficient as it does not lie on the frontier of the PPF. In an
Edgeworth production box diagram, B does not lie the contract curve.
 On Point B, more X can be produced without reducing the production of Y. Similarly,

more Y can be produced without reducing the production of X. Hence, the economy is
not productive efficient.

PPF
 The gradient or slope of the PPF is given by Marginal Rate of Transformation (MRT).
MRT shows the rate at which one good must be sacrificed in order to produce a single
extra unit of another good, assuming that both goods require the same inputs, i.e., K and
L.
 The slope of MRT is also defined as . This is derived below.
 Assuming labour is the only means of production and that wage rate is fixed at w. Take
one unit of labour away from production of Y and relocate the labour to produce X. The
loss of Y is dy which will be the marginal product of that unit of labour in the production
of Y ; the gain in X is dx which will be the marginal product of that unit of labour in the
production X. Hence,
dY  dL  MPLy
dX  dL  MPLx
dY
 Geometrically, the slope of the PPF is . As dL  1 ,
dX
dY dL  MPLy MPLy
 
dX dL  MPLx MPLx
 As labour is the only means of production, hence, TC ( x)  w  L( x) . Marginal cost of X is,
dTC dL w
MC  x   w 
dx dx MPLx
 Marginal cost of Y is,

dTC dL w
MC  y  
w 
dy dy MPLy
w
MC  x  MPLx MPLy dY
  
MC  y  w MPLx dX
MPLy
dY MC  x 
Hence, MRT   . So long as firms are maximising profits, this condition is
dX MC  y 

always satisfied. This applies to both perfect competitive markets as well as monopolistic
markets.
4.2 Consumption Efficiency

 The concept of consumption efficiency is similar to that of productive efficiency.
 Consumption efficiency refers to the allocations on the contract curve under the
consumer exchange economy.
 With two individuals A and B, it occurs when MRSA = MRSB that satisfies the requirement
of the contract curve. If this condition did not hold, the individuals could mutually gain by
trade.

4.3 Correct Product Mix
 Notice that when drawing the PPF, the axis is in terms of Good X and Good Y. As a
result, we can combine the PPF with indifference curves (also drawn in the axis of Good
X and Y).
 We say that the correct product mix is achieved if MRS = MRT as shown above.
 This means that as the two indifference curve is tangent to each other at a particular
slope (MRS). In addition, this slope where the two indifference curves are tangent must
also be equal to the slope of the PPF at a particular point of production allocation.
 An economy does not have the correct product mix if the slope of the indifference curves
does not equal to the slope of the PPF. This is shown below.

4.4 Allocative Efficiency

 The requirements for allocative efficiency is that the economy must have consumption
efficiency, productive efficiency and the correct product mix.
 Allocative Efficiency will only be obtainable under perfect competition because marginal
cost = price.
 First, when the economy is productive efficient, the output is on the PPF with the slope
= MRT .
 Second, when consumption is efficient, then individuals’ indifference curves are tangent
such that .
 Lastly, under correct product mix, .
 As under perfect competitive market, Hence
 A simultaneous satisfaction of all the three conditions is only possible under perfect
competitive market.
MC X
 Under monopoly, the output is productively efficient as MRT  . Even with a
MCY
monopolistic market, consumption is efficient as individuals’ indifference curves are
tangent such that .

 However, Price > Marginal cost. This implies

assuming that Market Y is perfectly competitive while Market X is regulated by a
monopolist.
 Hence, under a monopoly, the correct product mix is not achieved. Hence, a monopoly
is allocative inefficient.
 Even with allocative efficiency cannot be achieved, we could shorten the gap between
price and marginal cost as a second best alternative. This is shown in the theory of
second best.
5.1 First Welfare Theorem

 The First Welfare theorem states that if consumers and producers are price takers,
then any competitive equilibrium is Pareto Efficient.
 This means that under perfect competition, any allocation of resources under
competitive equilibrium will be Pareto Efficient.
 Essentially, we are ruling out distortions such as monopolies and monopsonies.
 This theorem implies consumption efficiency and productive efficiency.
5.2 Second Welfare Theorem

 The Second Welfare theorem states that each Pareto efficient allocation can be
implemented as a competitive equilibrium for a given initial resources.
 This means that in principle, efficiency and equity are issues that can be separated in
the analysis of equilibrium.

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EC2066 MICROECONOMICS

Topic 10: General Equilibrium and Welfare Economics

 define the competitive general equilibrium

 analyse the competitive equilibrium in the case of a pure exchange economy

 define Pareto efficiency and apply it to a general equilibrium setting

 find the contract curve

 explain the welfare theorems

 discuss the theory of second best.

 Morgan, Katz and Rosen, Microeconomics, Chapter 12.

1. Introduction to General Equilibrium

 As defined by George Stigler, “a partial equilibrium is one which is based on only a

 In general equilibrium analysis, we examine how the interactions of individual economic

Copyright: Singapore Institute of Management Page |1

2. Pure Exchange Economy with Consumers

 In an exchange economy, we simply draw both the consumers on one diagram.

Copyright: Singapore Institute of Management Page |2

Copyright: Singapore Institute of Management Page |3

 We notice that A is endowed with 4 units of X and B is endowed with 1 unit of X.

 We notice that A is endowed with 2 units of Y and B is endowed with 3 units of Y.

 Initially we start off at Point C.

Copyright: Singapore Institute of Management Page |4

 Given an initial allocation of goods among a set of individuals, a change to a different

 Let us consider another scenario. Initially we start off at Point C.

Copyright: Singapore Institute of Management Page |5

Copyright: Singapore Institute of Management Page |6

Copyright: Singapore Institute of Management Page |7

Copyright: Singapore Institute of Management Page |8

Copyright: Singapore Institute of Management Page |9

3. Competitive Equilibrium: A Mathematical Analysis

We proceed to find the MRS:

When MRS = Price Ratio, we have

Substitute this into the budget constraint, we have

A’s Demand function for X.

A’s Demand function for Y.

Copyright: Singapore Institute of Management P a g e | 10

Substitute this into the budget constraint

B’s Demand function for X

B’s Demand function for Y

In equilibrium, Supply of X = Demand of X

In terms of supply, the sum of endowments for Good X is 5.

In terms of demand, we sum up demand from both individuals, i.e.,

A’s Demand for X

Copyright: Singapore Institute of Management P a g e | 11

B’s Demand for X

We can check that 5

A’s Demand for Y

B’s Demand for Y.

We can also check that 5

4. Contract Curve: A Mathematical Analysis

Hence the contract curve lies on , ,5 ,5 .

Copyright: Singapore Institute of Management P a g e | 12

5. Pure Exchange Economy with Producers

Copyright: Singapore Institute of Management P a g e | 13

 This restructuring of the production results in an improvement for the production of X.

Copyright: Singapore Institute of Management P a g e | 14

Copyright: Singapore Institute of Management P a g e | 15

Copyright: Singapore Institute of Management P a g e | 16

Copyright: Singapore Institute of Management P a g e | 17

6. Welfare and Efficiency

4.1 Productive Efficiency

 On Point B, more X can be produced without reducing the production of Y. Similarly,

Copyright: Singapore Institute of Management P a g e | 18

 The slope of MRT is also defined as . This is derived below.