Microeconomics

Advanced Microeconomics II
Welfare Economics
Major Text
Hal R. Varian. -- 3rd edition
Andualem Begashaw 1
Contents
General equilibrium
Welfare function
Compensation criteria
Andualem Begashaw 2
General Equilibrium
 General equilibrium analysis is the study of the

processes by which equilibrium is achieved in
the markets for all commodities and
resources simultaneously.
 It is about the issue of allocating resources
efficiently in many competitive markets.
2 Andualem Begashaw 3
General Equilibrium Model
 It is an economic model of a complete system of
markets.
 General equilibrium model is in sharp contrast with
a partial equilibrium model, an economic model of a
single market.
 A decision to shift resources to one industry to meet
an increased demand for one commodity means a
reduced quantity of resources in other industries
and a reduced supply of other commodities.
General Equilibrium….
Unlike partial equilibrium analysis, general
equilibrium analysis determines the prices
and quantities in all markets simultaneously,
and it explicitly takes feedback effects into
account.
A feedback effect is a price or quantity
adjustment in one market caused by price and
quantity adjustments in related markets.
Andualem Begashaw 5
General Equilibrium Model
 The level of output of one industry cannot be

determined in isolation.
 There is interrelationship.
Figure 1: General Equilibrium Model
Food (tons)
The curve PP‘ is the
P F production possibility
frontier for food and cloth.
E CIC1 is the highest possible
community indifference curve.
G
CIC1
E is social welfare
maximizing point
CIC2
0 Cloth (meters) 7
5 Andualem Begashaw P’
An Illustration of General
Equilibrium
 Figure 2 shows the market for tomatoes and
three of the many other markets related to
it:
– The market for tomato pickers.
– The market for a related product --cucumbers.
– The market for cucumber pickers.
 The initial equilibrium is shown by the darker
demand and supply curves.
FIGURE 2: The Market for Tomatoes and
Several Related Markets
Price S Wages S
P1 W1
D
D
Tomatoe Tomato
0 s 0 pickersPickers
(b) Market for Tomato
(a)
Price Market Wages S
S for
Tomato W2
P2 es
D D
0 Cucumbers 0 Cucumber pickers

9 (c) Andualem
Market Begashaw (d) Market for
9
An Illustration of General
Equilibrium
The initial set of equilibrium prices are:
– P1 for tomatoes.
– W1 for tomato pickers.
– P2 for cucumbers.
– W2 for cucumber pickers.
Since the markets are in general equilibrium,
this will persist unless something happens to
change it.
Andualem Begashaw 10
Disturbing the Equilibrium
 Assume the government announces that
tomatoes cure the common cold, resulting in
an increase in demand.
Initially, this would shift the demand curve for
tomatoes outward to D’.
 The increase in tomatoes prices brought about by
the increase in demand stimulates the demand
for more tomato pickers which shifts outward to
D’.
Price S Wages S
P1 W1
D’ D’
D
D
Tomatoe Tomato
(a)
S for
Tomato W2
P2 es
D D

12 Andualem Begashaw
(c) Market for Cucumbers (d) Market for
12
Disturbing the Equilibrium
 The higher wages for tomato pickers increases
the costs for tomato growers, shifting the tomato
supply curve back to S’ (next slide).
 If the demand for cucumbers decreased because
of the increase in demand for tomatoes.
 This decreases the price of cucumbers and leads
to less produced.
 The demand for cucumber pickers falls, and their
wages also decrease.
S’
Price S Wages S
P1 W1
D’ D’
D
D
Tomatoes Tomato
0 (a) 0 pickersPickers
Market Wages S
Price
for
S Tomato
es W2
P2
D D
D’ D
0 Cucumbers 0 Cucumber
’ pickers
(c) Market for Cucumbers 14
(d) Market for Cucumber Pickers
Reestablishing Equilibrium
 Eventually we would expect each market to
eventually reach a new equilibrium.
 The new equilibrium in Figure 2 is shown by the
lighter colored demand and supply curves (next
page).
 There is a rise in tomato prices (to P3), an
increase in tomato picker wages (to w3), a fall in
cucumber prices (to P4), and a fall in cucumber
picker wages (to w4).
15
S’
Price S Wages S
P3
W3
P1 W1
D’ D’
D
D
Tomatoe Tomato
(a)
S for
Tomato W2
P2 es
P4 W4
D D
D’ D’
(c) Market for Cucumbers 16
(d) Market for Cucumber Pickers
Efficiency The condition in which the economy
is producing what people want at least possible
cost.
Pareto efficiency or Pareto optimality A
condition in which no change is possible that
will make some members of society better off
without making some other members of society
worse off.
An Efficient Mix of Outputs
 A technically efficient allocation of
resources in output combination also reflects
people’s preferences is an economically
efficient allocation of resources.
 Figure 3 illustrates the requirements for
economic efficiency in the mix of outputs.
The Efficiency Of Perfect
Competition
The three basic questions
1. What gets produced? What determines the final mix

of output?
2. 2. How is it produced? How do capital, labor, and
land get divided up among firms? In other words,
what is the allocation of resources among producers?
3. 3. Who gets what is produced? What determines
which households get how much? What is the
distribution of output among consuming households?
Cont…
To demonstrate that the perfectly
competitive system leads to an efficient,
or Pareto optimal, allocation of
resources, we need to show that no
changes are possible that will make
some people better off without making
others worse off.
Cont…
In a perfectly competitive economic
system:
1. resources are allocated among firms
efficiently,
2. final products are distributed among
households efficiently, and
3. the system produces the things that
people want.
FIGURE 3: Efficiency of Output Mix
Quantity
of Y per
week
P F
E
U3
G
U2
U1
0 Quantity of X per
18 Andualem Begashaw P’
week
22
A Simple General Equilibrium Model
The best use of resources is achieved at point E.
This point is the utility maximizing choice where
the person’s indifference curve is tangent to the
production possibility frontier.
Point E is defined as an economically efficient
allocation of resources.
Fundamental Theorem of Welfare
Economics
A perfectly competitive price system will bring
about an economically efficient allocation of
resources.
This “theorem” is simply a generalization of the

efficiency result.
First Fundamental Theorem of
Welfare Economics
Assume that
 All producers and consumers act as perfect competitors
(e.g., no market power)
 A market exists for each and every commodity
Under these assumptions, the first fundamental
theorem of welfare economics states that a
Pareto efficient allocation will emerge.
Implication: Competitive economy automatically
allocates resources efficiently, without central
planning.
Conclusion: Free enterprise systems are amazingly
productive.
25
The Edgeworth Box
Diagram
 The Edgeworth box diagram is a graphic
device for illustrating all of the possible
allocations of two goods (or two inputs) that are
in fixed supply.
 It can be used to show how the production
possibility frontier is constructed.
 It can also be adapted to illustrate voluntary
exchange between two individuals.
Edgeworth Box
Diagram
 Assume that there are only two goods, x and y
 All individuals are assumed to have identical
preferences represented by an indifference
map
 The production possibility curve can be used to
show how outputs and inputs are related
Edgeworth Box
Diagram
 Construction of the production possibility curve

for x and y starts with the assumption that the
amounts of k and l are fixed
 An Edgeworth box shows every possible way
the existing k and l might be used to produce x
and y
 any point in the box represents a fully employed
allocation of the available resources to x and y
Edgeworth Box
Diagram
Labor in y
production
Capital in
Labor for x Labor for y Oy y
production

A
Capital
in x
Prod.
Ox
34 Labor in x production Andualem Begashaw
Total 29
Edgeworth Box
Diagram
 Many of the allocations in the Edgeworth box are
technically inefficient
 it is possible to produce more x and more y by shifting
capital and labor around
 We will assume that competitive markets will not
exhibit inefficient input choices
 We want to find the efficient allocations
 they illustrate the actual production outcomes
Andualem Begashaw
30
Edgeworth Box
Diagram
 We will use isoquant maps for the two goods

 the isoquant map for good x uses Ox as the origin
 the isoquant map for good y uses Oy as the origin
 The efficient allocations will occur where the

isoquants are tangent to one another
Andualem Begashaw
31
Edgeworth Box
Diagram
Oy
Point A is
y1 inefficient
because,
by moving
y2
along y1,
we can
x2 increase
 x from x1
A x1
to x2 while
holding y
Ox constant
Total
Andualem Begashaw
32 Labor
Edgeworth Box
Diagram
Oy
y1 We could
also
y2
increase y
from y1 to
y2
x2 whil
 e
A x1
hold
ing
Ox x
Total
Andualem Begashaw
con
33 Labor stan
Edgeworth Box
Diagram
Oy
y1
At each
p4
y2
efficient
p3
point, the
x4 RTS (of k
y3
for l) is
p2
equal in
x3
y4 p1 both
x2
x and y
x1 production
Ox
Total
Andualem Begashaw
34 Labor
Production Possibility
Frontier
 The locus of efficient points shows the maximum
output of y that can be produced for any level of x
 we can use this information to construct a
production possibility frontier
 shows the alternative outputs of x and y that
can be produced with the fixed capital and
labor inputs that are employed efficiently
Andualem Begashaw
35
Production Possibility
Frontier
Quantit
y of y Each efficient point of production
Ox p1 becomes a point on the production
y4 p2
y3 possibility frontier
p3
y2
The negative of the slope of
the production possibility
y1
p4 frontier is the rate of
product transformation
(RPT)
Quantity of x
x1 x2 x3 x4 Oy
Andualem Begashaw
36
Rate of Product
Transformation
 The rate of product transformation (RPT)
between two outputs is the negative of the
slope of the production possibility frontier
RPT (of x for y )   slope of production

possibility frontier
dy
RPT (of x for y )   dx (along Ox Oy )
Andualem Begashaw
37
Rate of Product
Transformation
 The rate of product transformation shows how x
can be technically traded for y while continuing to
keep the available productive inputs efficiently
employed
Andualem Begashaw
38
Pareto Efficient
Allocation
 A Pareto efficient allocation is an allocation
of available resources in which no mutually
beneficial trading opportunities are unexploited.
That is, an allocation in which no one
person can be made better-off without
someone else being made worse off.
Three static properties are observed in a
general equilibrium solution, reached
with a free competitive market mechanism:
(a) Efficient allocation of resources among

firms (equilibrium of production).
(b) Efficient distribution of the commodities
produced between the two consumers
(equilibrium of consumption)
(c) Efficient combination of products
(simultaneous equilibrium of production
and consumption).
These properties are called marginal conditions
of Pareto optimality or Pareto
efficiency..
A situation is defined as Pareto optimal
(or efficient) if it is impossible to make
anyone better-of without making
someone worse-of
a. Equilibrium of production
(efficiency in factor substitution)
Equilibrium of production requires the
determination of the efficient distribution of the
available productive factors among the existing
firms (efficiency in factor substitution).
the firm is in equilibrium if it chooses the factor
combination (for producing the most lucrative level
of output) which minimises its cost.
Equilibrium of production
Thus the equilibrium of the firm
requires that
Or
Since the Edgeworth contract curve of
production is the locus of tangencies of the
X and Y isoquants, at each one of its points
the slopes of the isoquants are equal:
Or
Firms being profit maximizes in competitive
markets, will be in equilibrium only if they produce
somewhere on the Edgeworth contract curve.
This follows from the fact that the factor prices
facing the producers are the same, and their profit
maximization requires that each firm equates its
MRTSL,K with the ratio of factor prices w/r:
The production possibility curve is also called
the product transformation curve because it
shows how a commodity is 'transformed' into
another, by transferring some factors from
the production of one commodity to the
other.
The negative of the slope of the production
possibility curve is called the marginal rate of
(product) transformation, MRPTx,y and it shows
the amount of Y that must be sacrificed in order
to obtain an additional unit of X.
The economic meaning of the transformation
curve is the rate at which a commodity can be
transformed into another.
By definition
Since dY/dX is negative, the MRPT is a positive

number. It can be shown that the MRPTx,y is
equal to the ratio of the marginal costs of the
two products
Efficiency in Consumption
(equilibrium of consumption)
The consumer Maximizes his utility by

equating the marginal rate of
substitution of the two commodities
Slope of IC = Price ratio of commodities
Efficiency in Consumption
Since both consumers in perfectly
competitive market are faced with the
same price the condition for joint or
general equilibrium of both consumers
is:
Edgeworth Contract curve of
consumption
C. Efficient combination of products
(simultaneous equilibrium of production
and consumption).
This is the third condition of Pareto efficiency.

It refers the general equilibrium of the
system as a whole requires the fulfillment of
the marginal rate of product transformation
(slope of the PPF) be equal to the marginal
rate of substitution of the two commodities
b/n the consumers
Kaldor-Hicks Compensation Criteria
 There is a net improvement in the welfare of the

community if the gainers could hypothetically
compensate the losers and still have some gain
left over.
 This is an extensively used test.
Andualem Begashaw
55
Efficiency and
Equity
 Equity is the fairness of the distribution of
goods or utility.
 A primary problem with this concept is
developing an accepted definition of “fair” or
“unfair” allocations of resources.
 Opinions vary from, an allocation is fair if no
laws are broken in obtaining it to a fair
allocation requires all people share equally.
Andualem Begashaw
56
Equity Criteria
 Egalitarian standard: Equal worth of every
human being in society.
 Cares equally about every member.
 All citizens, regardless of income and wealth,
should have free access to state-provided
and tax-funded services, such as health and
education.
Equity Criteria
 Selectivity: social benefits are targeted on
particular groups, such as those on low income or
disabled people. This is common in many western
democracies. Example: Welfare-to-work
programs targeted at unemployed persons.
 ‘Inter-generation’ standard: taking into account
temporal changes in the distribution of income and
wealth. Because decisions of one generation may
adversely or favorably affect the welfare of future
generations.
The End

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Microeconomics

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Advanced Microeconomics II

 General equilibrium analysis is the study of the

 The level of output of one industry cannot be

0 Cucumbers 0 Cucumber pickers

0 Cucumbers 0 Cucumber pickers

1. What gets produced? What determines the final mix

This “theorem” is simply a generalization of the

 Construction of the production possibility curve

 We will use isoquant maps for the two goods

 The efficient allocations will occur where the

RPT (of x for y )   slope of production

(a) Efficient allocation of resources among

Since dY/dX is negative, the MRPT is a positive

The consumer Maximizes his utility by

This is the third condition of Pareto efficiency.

 There is a net improvement in the welfare of the

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