CHAPTER FIVE

5. GENERAL EQUILIBRIUM ANALYSIS AND WELFARE

ECONOMICS
5.1. Partial versus General Equilibrium analysis
Partial equilibrium analysis studies the behavior of an
individual decision-making unit and a particular market,
viewed in isolation. Examples of such an analysis include the
study of:
 How an individual maximizes satisfaction subject to his/her
income constraint,
 how a firm minimizes its costs of production and maximizes
profits under various market structures,
 how the price and employment of each type of input is
determined.
CONTI…
 By choosing to undertake a partial equilibrium analysis, one has
abstracted from all the interconnections that exist between the
market under study and the rest of the economy. In short, the basic
characteristic of a partial equilibrium approach is the
determination of the price and quantity in a market with the help
of demand and supply curves drawn on the ceteris paribus
assumption. Only when an industry (or a market) is small and has
few direct links with the rest of the economy is partial equilibrium
analysis appropriate..
 However, a fundamental feature of any economic system is the
interdependence among its constituent parts. The markets of all
commodities and all productive factors are interrelated, and the
prices in all markets are simultaneously determined. For example,
consumers’ demands for various goods and services depend on their
tastes and incomes. In turn, consumers' incomes depend on the
amounts of resources they own and factor prices.
CONTI…
 Factor prices depend on the demand and supply of the various
inputs. The demand of firms for factors depends not only on the
state of technology but also on the demands for the final goods
they produce. The demands for these goods depend on
consumers‘ income. The message is that there is circular
interdependence of activities within an economic system.
 Such interrelated economic variables and multi-directional
effects are studied in general equilibrium analysis. General
equilibrium studies the interdependence or interconnections that
exist among all markets and prices in the economy and attempts
to give a complete, explicit, and simultaneous answer to the basic
economic questions of what, how and for whom to produce.
Despite its coverage and comprehensiveness, general equilibrium
analysis is not used all the time (in all situations) because dealing
with each and all industries in the economy at the same time – by
its very nature – is very difficult, time consuming and expensive.
Conti..
 General equilibrium is a state in which all markets and all
decision-making units are in simultaneous equilibrium. A
general equilibrium exists if each market is cleared at a
positive price, with each consumer maximizing satisfaction
and each firm maximizing profit.
 The first and simplest general equilibrium model was
introduced in 1874 by Leon Walras. In the Walrasian system,
all prices and quantities in all markets are determined
simultaneously through their interaction with one another.
That is, a general equilibrium of an economy is given by the
solution to a system of equations. Thus, the first task in
establishing the existence of a general equilibrium is to
describe the economy by means of a system of equations, in
which the number of unknowns should be equal to the
number of independent equations.
CONTI..
5.1.2 General Equilibrium in a Two-Factor, Two-Commodity,
Two-Consumer (2x2x2) Economy
 To facilitate the discussion and understandability of a
general equilibrium analysis, let us construct a simple
model/abstraction. Examine each of the following
assumptions of (the 2x2x2 model) carefully.
1. There are two factors of production (L and K), whose
quantities are given exogenously. Both of these factors are
homogeneous and perfectly divisible. Homogeneity indicates
that all units of labor are identical, and so are the units of
capital. Perfect divisibility of factors means that any factor of
production could be supplied and used in whatever fraction
desired.
CONTI..
2. Only two commodities (X and Y) are produced. The
technology of production isMgiven. That is, production at the
currently existing technology is considered. The isoquant maps
have the usual properties (smooth and convex to the origin
implying diminishing marginal rate of technical substitution,
MRTS, between factors along any isoquant). Each production
function exhibits constant returns to scale. The two production
functions are independent (no externalities in production).
That is, the production process of good X does not influence
that of Y, and vice versa.
3. There are two consumers in the economy (A and B) whose
preferences are represented by ordinal indifference curves,
which are convex to the origin.
CONTI…
4. The goal of each firm is profit maximization and that of each
consumer is utility maximization.
5. There is full employment of factors of production, and all
incomes received by their owners (A and B) are spent. Note an
implicit assumption in this assumption: the factors of
production are owned by the consumers.
6. There is perfect competition in both commodity and factor
markets. Thus, both consumers and firms face the same set of
prices (PX, PY, w, r).
 In this model, a general equilibrium is reached when:
 the four markets (two commodity and two factor markets)
are cleared at a set of equilibrium prices (PX, PY, w, r); and
each economic agent (two firms and two consumers) is
simultaneously in equilibrium.
CONTI…
 Put differently, three static properties are observed in a
general equilibrium solution, reached with a freely
competitive market:
 efficient allocation of resources between firms or goods
(production equilibrium);
 efficient distribution of commodities between consumers
(consumption equilibrium); and
 efficient combination of products (simultaneous
equilibrium of production and consumption).
5.2 Welfare Economics
5.2.1 Definition of Welfare Economics
 Welfare economics studies the conditions under which the solution to
the general equilibrium model can be said to be socially optimal. It
examines the conditions for economic efficiency in the production of
output and the exchange of commodities and equity in the distribution
of income. This definition of welfare economics points out that the
maximization of the society’s well-being requires not only efficiency in
production and exchange but also equity in the distribution of income.
 The fact that perfect competition leads to economic efficiency (Pareto
optimality in production and exchange) proves Adam Smith’s famous
law of the invisible hand. Smith’s law postulates that in a free market
economy, each individual by pursuing his/her own selfish interests is
led, as if by an invisible hand, to promote the well-being of society more
so than he/she intends or even understands. This law leads to the first
theorem of welfare economics, which postulates that an equilibrium
produced by competitive markets exhausts all possible gains from
exchange, or that equilibrium in competitive markets is Pareto optimal.
CONTI…
 There is also a second theorem of welfare economics. This
theorem postulates that when indifference curves are
convex to their origins, every efficient allocation (every
point on the contract curve for exchange) is a competitive
equilibrium for some initial allocation of goods or
distribution of inputs (income).
 The significance of the second welfare theorem is that the
issue of equity in distribution is logically separable from the
issue of efficiency in allocation. This means that whatever
redistribution of income that society wants would lead to
the exhaustion of all possible gains from exchange under
perfect competition. Therefore, Pareto optimality does not
imply equity. Society can use taxes and subsidies to achieve
what it considers as a more equitable distribution of
income.
5.2.2 The Utility Possibilities Frontier (UPF) and the Grand
Utility Possibilities Frontier (GUPF)
 The utility possibilities frontier/curve shows the
various combinations of utilities received by
individuals A and B (i.e., UA and UB) when our simple
economy is in general equilibrium or Pareto optimum
in exchange. Alternatively, it is the locus of the
maximum utility for one individual for any given level
of utility for the other individual.
 This indicates that the utility levels of the two
consumers are inversely related: as the utility of A rises
that of B falls and vice versa. This yields a downward
sloping UPF in Figure 5.2 below
CONTI…

 The utility possibilities frontier OA'OB' in Figure 5.9 shows

the various combinations of utilities received by individuals
A and B (i.e., UA and UB) when the economy composed of
the two individuals is in general equilibrium of exchange.
CONTI…
 Grand Utility Possibilities Frontier (GUPF) is the envelope of
all the UPFs associated with points of Pareto efficiency
(optimality) in production and exchange. Figure 5.3 shows
two utility possibilities frontiers and the grand utility
possibilities frontier.