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Firm and Household Decisions
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11
General Equilibrium and the Efficiency of Perfect Competition
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General Equilibrium and the Efficiency

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• Input and output markets cannot be considered separately or as if they operated independently.

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General Equilibrium and the Efficiency

• Partial equilibrium analysisis the process of examining the equilibrium conditions in individual markets and for households and firms separately. • General equilibrium is the condition that exists when all markets in an economy are in simultaneous equilibrium.

General Equilibrium and the Efficiency

General Equilibrium and the Efficiency of Perfect Competition

General Equilibrium and the Efficiency of Perfect Competition
• In judging the performance of an economic system, two criteria used are efficiency and equity (fairness). • Efficiency is the condition in which the economy is producing what people want at the least possible cost.

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General Equilibrium Analysis
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A Technological Advance: The Electronic Calculator

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• To examine the move from partial to general equilibrium analysis we will consider the impact of:
• a major technological advance, and • a shift in consumer preferences.

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Technology improvements made it possible to produce at lower costs in the calculator industry.
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General Equilibrium and the Efficiency

A Technological Advance: The Electronic Calculator

A Technological Advance: The Electronic Calculator
• A significant technological change in a single industry affects many markets:
• Households face a different structure of prices and must adjust their consumption of many products. • Labor reacts to new skill requirements and is reallocated across markets. • Capital is also reallocated.
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As new firms entered the industry and existing firms expanded, output rose and market prices dropped.
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General Equilibrium and the Efficiency

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To examine the effects of a change in one market on other markets, we will consider the wine industry in the 1970s.
U.S. PRODUCTION (MILLIONS OF GALLONS) 565 713 782 983 + 74.0

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A Shift in Consumer Preferences: The Wine Industry in the 1970s

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Adjustment in an Economy with Two Sectors
• This graph shows the initial equilibrium in an economy with two sectors—wine (X) and other goods (Y)—prior to a change in consumer preferences.

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Production and Consumption of Wine in the United States, 1965–1980
IMPORTS (MILLIONS OF GALLONS) 10 22 40 91 + 810.0 TOTAL (MILLIONS OF GALLONS) 575 735 822 1073 + 86.6 CONSUMPTION PER CAPITA (GALLONS) 1.32 1.52 1.96 2.02 + 53.0

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1965 1970 1975 1980 Percent change, 1965– 1980

Source: U.S. Department of Commerce, Bureau of the Census, Statistical Abstract of the United States, 1985, Table 1364, p. 765.

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General Equilibrium and the Efficiency

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Adjustment in an Economy with Two Sectors
• A change in consumer preferences causes an increase in the demand for wine, and, consequently, a decrease in the demand for other goods.

Adjustment in an Economy with Two Sectors
• A higher price creates a profit opportunity in sector X. • Simultaneously, lower prices result in losses in industry Y.

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• As new firms enter industry X and existing firms expand, output rises and market prices drop. Excess profits are eliminated.

General Equilibrium and the Efficiency

Adjustment in an Economy with Two Sectors

Adjustment in an Economy with Two Sectors
• As new firms exit industry Y, market price rises and losses are eliminated.

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General Equilibrium and the Efficiency

Land in Grape Production in the United States and in California Alone, 1974 and 1982
NUMBER OF VINEYARDS United States 1974 1982 Percent change California 1974 1982 Percent change 8,333 10,481 + 25.8 607,011 756,720 + 24.7 14,208 24,982 + 75.8 712,804 874,996 + 22.8 NUMBER OF ACRES

General Equilibrium and the Efficiency

A Shift in Consumer Preferences: The Wine Industry in the 1970s

Formal Proof of a General Competitive Equilibrium
• This section explains why perfect competition is efficient in dividing scarce resources among alternative uses. • If the assumptions of a perfectly competitive economic system hold, the economy will produce an efficient allocation of resources.

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Source: U.S. Department of Commerce, Bureau of the Census, Census of Agriculture (1974 and 1982), 1, part 51.

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Pareto Efficiency
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The Efficiency of Perfect Competition
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• This very precise concept of efficiency is known as allocative efficiency.
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• Pareto efficiency, or Pareto optimality, is 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.

• The three basic questions in a competitive economy are:
1. What will be produced? What determines the final mix of output? 2. How will it be produced? How do capital, labor, and land get divided up among firms? 3. Who will get what is produced? What is the distribution of output among consuming households?
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The Efficiency of Perfect Competition
General Equilibrium and the Efficiency

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The Efficiency of Perfect Competition
General Equilibrium and the Efficiency

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As we will see, 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.

Efficient Allocation of Resources:
• Perfectly competitive firms have incentives to use the best available technology. • With a full knowledge of existing technologies, firms will choose the technology that produces the output they want at the least cost. • Each firm uses inputs such that MRPL = PL. The marginal value of each input to each firm is just equal to its market price.
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The Efficiency of Perfect Competition
General Equilibrium and the Efficiency

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The Efficiency of Perfect Competition

Efficient Distribution of Outputs Among Households:
• Within the constraints imposed by income and wealth, households are free to choose among all the goods and services available in output markets. Utility value is revealed in market behavior. • As long as everyone shops freely in the same markets, no redistribution of final outputs among people will make them better off.
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Producing What People Want—the Efficient Mix of Output:
• Society will produce the

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efficient mix of output if all firms equate price and marginal cost.

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General Equilibrium and the Efficiency

If P X > MC X, society gains value by producing more X If P X < MC X, society gains value by producing less

General Equilibrium and the Efficiency

The Key Efficiency Condition: Price Equals Marginal Cost

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Efficiency in Perfect Competition
• Efficiency in perfect competition follows from a weighing of values by both households and firms.

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The Sources of Market Failure
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Imperfect Markets
General Equilibrium and the Efficiency

• Market failure occurs when resources are misallocated, or allocated inefficiently. The result is waste or lost value. Evidence of market failure is revealed by the existence of: • Imperfect market structure • Public goods • External costs and benefits • Imperfect information

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• Imperfect competition is an industry in which single firms have some control over price and competition. Imperfectly competitive industries give rise to an inefficient allocation of resources.

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Imperfect Markets
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Imperfect Markets
• In all imperfectly competitive industries, output is lower—the product is underproduced—and price is higher than it would be under perfect competition.
• The equilibrium condition P = MC does not hold, and the system does not produce the most efficient product mix.

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C H A P T E R 11: Perfect Competition

• Monopoly is an industry composed of only one firm that produces a product for which there are no close substitutes and in which significant barriers exist to prevent new firms from entering the industry.

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Public Goods
General Equilibrium and the Efficiency

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Public Goods
General Equilibrium and the Efficiency

• Public goods, or social goods are goods and services that bestow collective benefits on members of society.
• Generally, no one can be excluded from enjoying their benefits. The classic example is national defense.

• Private goods are products produced by firms for sale to individual households.
• Private provision of public goods fails. A completely laissez-faire market will not produce everything that all members of a society might want. Citizens must band together to ensure that desired public goods are produced, and this is generally accomplished through government spending financed by taxes.

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Externalities
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Imperfect Information
General Equilibrium and the Efficiency

• An externality is a cost or benefit resulting from some activity or transaction that is imposed or bestowed on parties outside the activity or transaction.
• The market does not always force consideration of all the costs and benefits of decisions. Yet for an economy to achieve an efficient allocation of resources, all costs and benefits must be weighed.

• Imperfect information is the absence of full knowledge concerning product characteristics, available prices, and so forth.
• The absence of full information can lead to transactions that are ultimately disadvantageous.

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Review Terms and Concepts
General Equilibrium and the Efficiency

efficiency externality general equilibrium imperfect competition imperfect information market failure

monopoly Pareto efficiency, or Pareto optimality partial equilibrium analysis private goods public goods, or social goods

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