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## PowerPoint Slideshow about 'General Equilibrium & Welfare' - lowell

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General Equilibrium &Welfare

- How should society organize the production and distribution of goods if the objective is to maximize social welfare?

General equilibrium & welfare

The Pedagogy

- The questions are answered by taking a hypothetical economy in which there are only two consumers, two goods, and two inputs.
- Once the answers to the questions are found in this special case, it will be apparent that these answers are generalizable.

General equilibrium & welfare

Question 1

- Suppose there are two consumers, Sally and Mike. Suppose also that there are two goods, Beer and Tacos, that are available in fixed quantities.
- What’s the best way to divide the Beer and Tacos between Sally and Mike?

General equilibrium & welfare

T* = Total tacos available

- B* = Total beer available
- TM = Mike’s taco consumption
- BM = Mike’s beer consumption
- TS = Sally’s taco consumption
- BS = Sally’s beer consumption

General equilibrium & welfare

So the following are assumed to be true:

- T* = TM + TS, and
- B* = BM + BS
- So Mike and Sally consume all the Beer and Tacos. Nothing goes to waste.

General equilibrium & welfare

The preceding diagram shows Mike’s starting amounts of consumption for Beer and Tacos, as well as the total amounts available.

- Three of Mike’s indifference curves are also shown. He starts off with utility level M1.

General equilibrium & welfare

Edgeworth Box

- Use the graphs showing the initial allocation to construct an Edgeworth Box diagram.
- The box diagram shows simultaneously the allocations of goods and the utility levels of Mike and Sally.

General equilibrium & welfare

And place the graph on top of Mike's indifference curve graph.

T

BS

OS

B

S0

S1

S2

M2

TS

(TM)'

M1

M0

B

OM

(BM)'

T

General equilibrium & welfare

So in the box diagram each point shows:

- Mike's consumption of both goods,
- Sally's consumption of both goods,
- Sally's utility level, and
- Mike's utility level.

General equilibrium & welfare

Is it possible to move away from the starting allocation and make at least one of the people better off without making the other one worse off?

- Yes, in this case. We can see all of the "better" allocations.

General equilibrium & welfare

"Better" allocations lie in the shaded area.

T

BS

OS

B

S0

S1

S2

M2

TS

(TM)'

M1

M0

OM

B

(BM)'

T

General equilibrium & welfare

So what must a "best" allocation of the goods look like?

- In the following diagram, the point Z is one best way to allocate the goods.
- [Any change from Z must make one of the two people worse off.]

General equilibrium & welfare

The distinguishing characteristic of Z is the indifference curves for the two people are tangent (have the same slope).

- At any optimal allocation the people will have equal Marginal Rates of Substitution (MRS) between the goods.

General equilibrium & welfare

Rule 1

- Allocate goods to consumers so that the consumers have equal marginal rates of substitution.
- MRS(B for T)Mike = MRS(B for T)Sally

General equilibrium & welfare

But many allocations are optimal!

- There are infinitely many optimal ways to allocate the goods between the two people.

General equilibrium & welfare

Contract Curve

- Points like X, Y, and Z fall on the "Contract Curve" in the box diagram.
- The Contract curve shows all of the Pareto Optimal ways to distribute the goods to Mike and Sally.

General equilibrium & welfare

Application of Rule 1

- Price discrimination will result in an inefficient (not Pareto Optimal) allocation of goods among consumers.
- Why?

General equilibrium & welfare

Question 2

- Suppose Tacos and Beer can be produced using two inputs, Labor (L) and Capital (K).
- What's the best way to allocate the labor and capital to the production of beer and tacos?

General equilibrium & welfare

L* = Total labor available

- K* = Total capital available
- LT = Labor used in taco production
- LB = Labor used in beer production
- KT = Capital used in taco production
- KB = Capital used in beer production

General equilibrium & welfare

So the following are assumed to be true:

- L* = LT + LB, and
- K* = KT + KB
- So all the labor and capital are used in production. No resources are unemployed.

General equilibrium & welfare

The preceding diagram shows an allocation of labor and capital to taco production, and the total amounts of L and K available.

- Three isoquants are also shown. We start off with production level T1.

General equilibrium & welfare

Is it possible to move away from the starting allocation and increase the production of one good without reducing the production of the other?

- Yes, in this case. We can see all of the "better" allocations.

General equilibrium & welfare

Edgeworth Box

- Use the graphs showing the initial allocation to construct another Edgeworth Box diagram.
- The box diagram shows simultaneously the allocations of inputs and the output levels of Tacos and Beer.

General equilibrium & welfare

And place it on top of the Taco isoquants.

- Each point in the box shows an allocation of the inputs to the outputs and the resulting levels of output of the two goods.

General equilibrium & welfare

"Better" allocations lie in the shaded area.

K

LB

OB

L

B0

B1

B2

T2

KB

(KT)'

T1

T0

OT

L

(LT)'

K

General equilibrium & welfare

So what must a "best" allocation of the inputs look like?

- In the following diagram, the point Q is one best way to allocate the inputs.
- [Any change from Q must reduce output of at least one of the goods.]

General equilibrium & welfare

The distinguishing characteristic of Q is the isoquants for the two goods are tangent (have the same slope).

- At any optimal allocation the people will have equal Marginal Rates of Technical Substitution (MRTS) between the goods.

General equilibrium & welfare

Rule 2

- Allocate inputs to goods so that the goods have equal marginal rates of substitution.
- MRTS(L for K)Tacos = MRTS(L for K)Beer

General equilibrium & welfare

But many allocations are optimal!

- There are infinitely many optimal ways to allocate the inputs between the goods.

General equilibrium & welfare

Production Contract Curve

- Points like P, Q, and R fall on the "Production Contract Curve" in the box diagram.
- The contract curve shows all of the Pareto Optimal ways to distribute the inputs between the outputs.

General equilibrium & welfare

Application of Rule 2

- Price discrimination in inputs will result in an inefficient (not Pareto Optimal) allocation of inputs across goods.
- Why?

General equilibrium & welfare

From PCC to PPC

- The next step in the exercise is to show how the analysis of productive efficiency can be used to derive the Production Possibilities Curve for our 2 by 2 economy.

General equilibrium & welfare

Notice that each point on the Production Contract Curve shows the maximum amount of one output that can be produced, given some amount of the other good to be produced.

General equilibrium & welfare

For example, when T2 tacos are produced, maximum

beer is B0. T2 and B0 are one point the PPC.

K

OB

L

B0

B*

R

B2

Q

T2

P

T*

T0

L

OT

K

General equilibrium & welfare

Each point on the Production Contract Curve "maps" to

a point on the Production Possibilities Curve.

T

r

T2

T*

q

T0

p

B0

B*

B2

B

General equilibrium & welfare

Alternative interpretation of Rule 2

- Efficiency requires that we be on the PPC. Point "inside" the PPC correspond to points off the Production Contract Curve.
- So Rule 2 says: "Get on the Production Possibilities Curve."

General equilibrium & welfare

Marginal Rate of Transformation

- The Marginal Rate of Transformation of Beer for Tacos is the amount of Tacos you must give up in order to get 1 more unit of Beer.
- It is the same as:
- Minus the slope of the PPC.
- The marginal (opportunity) cost of beer in terms of tacos.

General equilibrium & welfare

Notice that for the PPC we constructed, the MRT of Beer for Tacos rises as more Beer is produced.

- That is, marginal (opportunity) cost of beer rises as more beer is produced.

General equilibrium & welfare

Question 3

- Where on the Production Possibilities Curve should we produce?
- In other words, what should be the output mix?
- Are some points on the PPC better (in the sense of the Pareto Criterion) than others?

General equilibrium & welfare

If there were only one consumer (Robinson Crusoe?) the problem would be simple.

General equilibrium & welfare

B0, T2 is not a best point for a consumer with

indifference curves shown. T*, B* is optimal.

T

T2

T*

U1

U0

B0

B*

B

General equilibrium & welfare

Rule 3

- Produce amounts of goods so that the Marginal Rate of Transformation equals the Marginal Rate of Substitution in consumption.
- [MRT = MRS]

General equilibrium & welfare

Application of Rule 3

- If goods are not priced at marginal cost, then production will not be optimal.
- Why?

General equilibrium & welfare

If Rules 1 and 2 are satisfied, then Rule 3 implies that MC should equal P.

- 1) Suppose MRT = MRS [Rule 3].
- 2) If consumers maximize utility, and all face the same prices, then MRS(Beer for Tacos) = PB/PT. So MRT = (PB/PT)
- 3)MRT equals the marginal cost of beer in terms of tacos. So MCB = (PB/PT)
- 4) But since Tacos are the "unit of account", PT 1, so MCB = PB.

General equilibrium & welfare

Implications for markets

- Free trade.
- Competitive markets efficient.
- Monopoly inefficient.
- Price discrimination inefficient.

General equilibrium & welfare

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