5. General Equilibrium
- how to link individual consumer, firm and market to economy as a whole
- Partial Equilibrium Analyses investigate changes in one market assuming that conditions in other markets do not change.
- General Equilibrium Analyses investigate changes in ways that include interrelationships with other markets and changes that might occur there.
- basic assumption: perfect competition
All factors of production are owned by consumers and each consumer supplies inputs of capital (K) and labour (L) according to their preference. All output (x, y) is produced by firms according to their profit maximization possibilities.
The quantity of K & L is fixed. The maximum amount of x or y that can be produced using K & L is fixed with all possible combinations of x & y that can be produced defining a production possibility frontier (see point 7 below).
Consumers choose preferred market baskets subject budget constraint. It is assumed that an initial distribution of income exists and prices are fixed. Conditions for consumer equilibrium:
Every firm maximizes profits subject to constraints fixed by technology, demand for product and price of inputs. Conditions:
Long Run Economic Profits are zero for every firm.
The quantity demanded equals the quantity supplied for all products and inputs.
The Existence of General Equilibrium has been proven - theoretically.
This existence can be illustrated by counting equations and variables that characterize equilibrium.
This counting procedure is not, however, the proof.
Edgeworth Box for consumption reflects allocation of fixed supplies of goods between consumers (M&Y 10th Fig. 16.4, M&Y 11th Fig. 16.3; B&B Fig. 16.15; B&Z not displayed) assuming initial income distribution
Exchange between consumers represented by movement within Edgeworth
The Contract Curve in a Production Edgeworth Box highlights all points that can serve as Exchange Equilibria between the production of two goods, i.e., all points for which the MRTS in the production of both goods are equal or all points for which the isoquants of both goods are tangent to one another (M&Y 10th Fig. 16.5; M&Y 11th Fig. 16.5; B&B Fig. 16.17; B&Z not displayed).
Points on this Contract Curve identify combinations of
outputs for two goods that support a Production Possibility Frontier (M&Y
16.6; M&Y 11th Fig. 16.6; B&B Fig. 16.18; B&Z not displayed).
The Marginal Rate of Product Transformation reflects the rate at which an economy can transform one good into another by reallocating inputs along a contract curve (M&Y 10th Fig. 16.7, M&Y 11th Fig. 16.7; B&B & B&Z not displayed).
The MRPT is the slope of a Production Possibility Frontier
at a specific point.
The optimal allocation of inputs picks a point of the Frontier for which the underlying Exchange Equilibrium can support a common MRS for consumption that equals the MRPT, i.e., the Marginal Rate of Product Transformation.