BSc(Econ) Financial Economics

BSc Statistics and Economics

Introduction to Economics

Lecture 6
Competitive Equilibrium
Chapter 12

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 Ideas
• Concept of General Equilibrium as opposed
to Partial Equilibrium.

• Concept of Efficiency.

• Establish that the Competitive Equilibrium

is efficient.

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 The economy as a whole
• All markets in the economy are linked to
each other
• A change in one market will in principle
affect all markets
• How is equilibrium in the economy as a
whole achieved?
• Why is a competitive market economy
efficient? (And in what sense?)
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 Example: North Sea Oil
• Discoveries increased income and wealth in and
around Abedeen.
• Reduced UK oil imports.
• Caused the £ to appreciate (late 1970s/early
1980s).
• Squeezed manufacturing in the midlands and
elsewhere.
• Led to cheaper imports and hence the consumers
were better off.

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 Example: Corporation Tax
• In short run – tax on rents (short run profits)
– Few repercussions
• Long run
– Effects on wages and prices
– Effects on capital/labour ratio
– Effects on capital in corporate/non-corporate firms
• Who bears the burden? Investors? Firms?
Workers? Consumers?

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Who bears the burden?

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 Partial Equilibrium Analysis
• Analyse a market in isolation
• Alfred Marshall
• When is it OK to do this?
• Small knock-on effects on rest of economy
• Example: tax on tobacco
– Small fraction of budget
– Effects on other markets widely spread
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Partial Equilibrium Analysis

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Is PE Analysis Adequate?

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 Basic Competitive Model
• 3 markets: labour; goods; capital
• Households: supply labour, demand goods,
save (supply capital)
• Firms: demand labour, supply goods, invest
(demand capital)
• 3 prices: wage rate, price level, rate of
return on capital
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 Budget Constraints
• These markets are linked through budget
constraints which are accounting identities:
– Households:
Income from capital + labour income
= spending on goods + saving
– Firms:
Cost of labour + cost of capital (accounting
profits) = value of sales of goods
Retained profits + borrowing = investment in
capital

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 Market Equilibrium Conditions
• When all three markets simultaneously clear
• Supply of labour = demand for labour
– Wage adjusts
• Supply of goods = demand for goods
– Price adjusts
• Supply of capital = demand for capital
– Rate of return (interest rate) adjusts

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 General Equilibrium
• Change in one part of the economy may
affect all markets
• Final effects may differ very much from
impact effects of policies (tax changes,
tariffs on imports)
• Leon Walras

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 Example: technical progress
• Shift in production function
• Labour and capital more productive
• Profits rise
• Shareholders’ incomes rise
• More saving and spending on goods
• Bigger demand for capital goods
• Demand for labour. Up or down?
• Etc
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 Efficiency
• When is a competitive market economy
“efficient”?
• What is meant by “efficient”?

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 Pareto Efficiency
• An allocation of resources is Pareto
Efficient when there is no alteration of it
that could make someone better off without
making someone else worse off
• Vilfredo Pareto (1848-1923)
– Economist and Sociologist

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 A “Pareto Improvement”
• A change in the allocation of resources that
makes someone better off without making
someone else worse off.
• Why use these elliptical concepts?
– They avoid interpersonal comparisons of utility
or welfare.

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A Competitive Market Economy
is Pareto Efficient
• What do we need?
• Exchange efficiency
– If you can Pareto improve, people will trade
• Production efficiency
– Firms profit-maximise
• Product Mix Efficiency
– The economy itself is producing the efficient
mix of products.
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 Exchange Efficiency
• Whatever is produced in the economy must be
distributed among individuals in an efficient way, i.e.
a fixed total amount of goods cannot be re-allocated
among consumers to make one better off while
making no-one worse off.
• All consumers face same prices.
• All choose goods so that
PX/MUX = PY/MUY or MRS = PX/PY
• Example: if A’s MRS = 2 and B’s MRS = 1 between
apples and oranges, then B giving 1½ apples for A’s 1
orange is Pareto improving.
• Trades will occur until MRS is equalised everywhere.
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 Production Efficiency
• Can labour and capital be re-allocated among firms
to increase production of one firm while not
reducing the production of any other?
• All face same wage rate (w) and cost of capital (r)
• All employ labour and capital so that
MC = w/MPL = r/MPK
MPL/MPK = w/r
• Thus the Marginal Rate of Technical Substitution
equates everywhere.
• Economy on production possibility frontier.
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 Product Mix Efficiency
• How many apples and how many oranges should
the economy produce?
• Profit maximising firms: MRT = pO/pA = slope of
PPF.
• Utility maximising consumers: MRS = pO/pA =
slope of indifference curve
• So MRS = MRT.
• But if there is excess demand for oranges and
excess supply for apples, then pO/pA will rise until
product mix efficiency is attained.

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 Welfare Economics
• First Fundamental Theory of Welfare
Economics:
An economy in competitive equilibrium is
Pareto efficient.
• Second Fundamental Theory of Welfare
Economics:
Any Pareto efficient resource allocation that
society desires can be obtained through the
market mechanism.
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 Government Role
• If decentralisation leads to efficiency, then is the
government redundant apart from establishing legal
framework within which to enforce market
transaction?
• Free market advocates: Friedrich von Hayck / Milton
Friedman
• But
– Imperfect competition
– Imperfect information
– Externalities
• This does not however necessarily mean that the
government intervention will improve matters!
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