General Equilibrium and Economic Efficiency
Item 16: General Equilibrium and Economic Efficiency
General Equilibrium Analysis: Unlike partial equilibrium analysis, general equilibrium analysis determines prices and quantities simultaneously in all markets. It explicitly considers feedback effects. A feedback effect is a price or quantity adjustment in one market caused by price and quantity adjustments in related markets.
Efficiency in Exchange: In an exchange economy, two or more consumers trade two or more goods. An initial allocation of goods is economically inefficient if a reallocation can improve the well-being of at least one person without harming another. An efficient allocation is one where no one can be made better off without making someone else worse off. This concept is also known as Pareto efficiency, named after the Italian economist Vilfredo Pareto.
Contract Curve: The contract curve shows all efficient allocations of two goods between two consumers, or two inputs between two production functions. The contract curve has several properties that help understand the concept of efficiency in exchange. Once a point on the contract curve has been chosen, it is impossible to move to another point on the curve (e.g., point F) without reducing the well-being of at least one person.
Consumer Equilibrium in a Competitive Market: In a two-person exchange, the outcome can depend on the bargaining power of each party. However, competitive markets have many buyers and sellers. Therefore, if individuals do not like the terms of an exchange, they can find another seller who offers better terms.
Each buyer and seller takes the prices of the goods as fixed and decides how much to buy and sell at those prices. We can use an Edgeworth box to simulate the operation of a competitive market and show that competitive markets generate efficient exchange. Any imbalance should only be temporary. In a competitive market, prices adjust if there is excess demand in some markets and excess supply in others.
Equity and Efficiency: There are many possible efficient allocations of goods, and a perfectly competitive economy will result in one of these efficient allocations. However, some allocations may be more equitable than others.
The Utility Possibilities Frontier: The utility possibilities frontier represents all efficient allocations. It shows the levels of satisfaction achieved when two individuals have reached the contract curve. The problem lies in defining a fair allocation. Even if we restrict ourselves to all points on the utility possibilities frontier, we may ask which of these points is the most equitable. The answer depends on the value judgments we make about equity and, therefore, the interpersonal comparisons of utility we are willing to make.
Social Welfare Function: A social welfare function is widely used in economics to apply weights to each individual’s utility to determine what is socially desirable. An egalitarian social welfare function, for example, weights everyone’s utility equally and, therefore, maximizes the total utility of all members of society. Every social welfare function can be associated with a particular view about equity. However, some views do not explicitly weight individual utilities and, therefore, cannot be represented by a social welfare function.