General Equilibrium,
Efficiency, and
Equity
chapter 16
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Learning Objectives
• Explain how general equilibrium analysis helps
economists to understand interdependence among
markets.
• Use a simple general equilibrium model to answer
positive economic questions.
• Identify criteria for answering normative economic
questions.
• Describe how competitive markets achieve efficient
exchange and efficient production in general
equilibrium.
• Discuss how the goals of equity and efficiency can
come into conflict.
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16-2
Overview
• The analysis of a single market considered in isolation is
often incomplete.
• General equilibrium analysis is the study of competitive
equilibrium in two or more markets at the same time,
allowing us to understand the consequences of
interdependence between markets.
• Competitive markets allocate consumption goods
efficiently among consumers and also assure efficient
production.
• Good economic institutions avoid waste while treating all
members of society fairly, two goals that can come into
conflict.
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16-3
The Nature of General Equilibrium
• Partial equilibrium analysis focuses on a single
competitive market, considered in isolation
• General equilibrium analysis is the study of
competitive equilibrium in many markets at
the same time
– Factors that affect supply and demand in one
market can have significant ripple effects in other
markets, creating unintended consequences
– The interdependence of markets can produce
feedback on the original market
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16-4
General Equilibrium in Two Markets
(a) Pie market
Pie price ($/pie)
Ice cream price ($/gal.)
(a) Ice cream market
Pie: $12
C
1
2
2
6
Ice Cream: $6
25
Ice cream (million gallons)
26
Pies (millions)
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16-5
Market-Clearing Curves
• The market-clearing curve for a good shows
the combinations of prices (both for that good
and for other related goods) that bring supply
and demand for the good into balance.
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16-6
Market-Clearing Curve for Ice Cream
(b) Market-clearing curve
Pie: $6
S1
8
A2
6
4
A1
Pie: $12
Pie: $18
A3
15
Ice cream price ($/gal.)
Ice cream price ($/gal.)
(a) Ice cream market
Marketclearing
curve for ice
cream
8
6
4
25
35
Ice cream (million gallons)
B1
B2
B3
6
12
18
Pie price ($/gal.)
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16-7
A General Equilibrium in Two Markets
General equilibrium
price combination
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16-8
Effects of a Sales Tax
• $3 tax on ice cream
shifts the marketclearing curve for
ice cream upward
• The vertical
distance is the
partial equilibrium
effect of the tax
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16-9
Tax on Ice Cream
Pie: $11
8
Pie: $12
(a) Pie market
Pie price ($/pie)
Ice cream price ($/gal.)
(a) Ice cream market
A4
6
12
11
C2
Ice Cream: $6
C4
Ice Cream: $8
A2
20 25
Ice cream (million gallons)
23
26
Pies (millions)
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Normative Criteria for Evaluating
Economic Performance
• Efficiency
• Equity
• Social welfare functions
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Efficiency
• An economy is wasteful
(or inefficient) if we can
reallocate resources in a
way that will make at
least one consumer
better off without
hurting anyone else
• Utility possibility
frontier: shows utility
levels associated with
all efficient allocations
of resources
Efficient
Inefficient
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Equity
• Equity is a subjective concept
• Process-oriented notions of equity focus on
the procedures used to arrive at an allocation
of resources rather on the allocation itself
• Example: principle of equal opportunity
• Some people believe that the free market
system is a fair process
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Equity
• Outcome-oriented notions of equity focus on whether
the process used to allocate resources yields fair results
• According to utilitarianism, society should place equal
weight on the well-being of every individual
• According to Rawlsianism, society should place all
weight on the well-being of its worst-off member
• According to egalitarianism, equal division of society’s
resources among all members of the population is the
most equitable outcome
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Social Welfare Functions
• A social welfare function summarizes
judgments about resource allocations. For
each possible allocation, the function assigns
a number that indicates the overall level of
social welfare.
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Applying Social Welfare Functions
• For the social
welfare function
corresponding to
the red social
indifference curves,
point A is the best
possible outcome.
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General Equilibrium in an Exchange
Economy
• In an exchange economy, people own and
trade goods, but no production takes place
• An endowment is the bundle of goods an
individual starts out with before trading
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General Equilibrium in an Exchange
Economy
(b) Lauren
(a) Humphrey
PW=1, PF=2
Endowment
Water (gal.)
Water (gal.)
Consumption
CH
7
Endowment
PW=1, PF=2
7
AL
Consumption
6
BH
BL
3
3
AH
CL
PW=1, PF=1
PW=1, PF=1
5
6
8
Food (lb.)
2
4
6
Food (lb.)
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Equilibrium in an Edgeworth Box
Lauren’s food (lb.)
2
4
PW=1, PF=2
Humphrey’s water (gal.)
7
BL
C
3
4
BH
3
7
A
6
Humphrey’s food (lb.)
Lauren’s water (gal.)
2
PW=1, PF=1
8
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First Welfare Theorem
• First welfare theorem: in a general
equilibrium with perfect competition, the
allocation of resources is Pareto efficient
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First Welfare Theorem in an Exchange
Economy
• Point C is a competitive
equilibrium allocation
• Humphrey must like point
C better than all points to
the left of the budget line,
like D
• Lauren must like point C
better than all points to
the right of the budget
line, like D
• Both must like point C at
least as well as all other
points on the budget line
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Efficiency in Exchange
• Point G is inefficient
(Lauren and Humphrey
both like H better)
• Point J makes
Humphrey better off
without hurting Lauren
• Point J is Pareto
efficient
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Exchange Efficiency Condition
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Contract Curve
• The contract curve
shows every
efficient allocation
of consumption
goods in an
Edgeworth box
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Contract Curve and Utility Possibility
Frontier
Every allocation on the contract curve corresponds to a point on the
utility possibility frontier
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Efficiency in Production
• Exchange efficiency is not enough; production
must also be efficient
• Requirements for efficient production
1. Input efficiency
2. Output efficiency
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Input Efficiency
• Input efficiency:
holding constant
the total amount of
each input used in
the economy, there
is no way to
increase any firm’s
output without
decreasing the
output of another
firm
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Input Efficiency
• The production contract curve shows every
efficient allocation of inputs between two
firms in an Edgeworth box
• The input efficiency condition holds if, for
every pair of inputs, every pair of firms share
the same marginal rate of technical
substitution
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Production Possibilities
• The production
possibility frontier
shows the
combinations of
outputs that firms
can produce when
inputs are allocated
efficiently among
them, given their
technologies and the
total inputs available
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Marginal Rate of Transformation
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Output Efficiency
• Output efficiency
means that, among
allocations satisfying
exchange efficiency
and input efficiency,
there is no way to
make one consumer
better off without
harming anyone else
by shifting production
from one good to
another
Output
efficiency
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Efficiency as a Justification for Free
Markets
• The doctrine of laissez faire holds that the
government should adopt a hands-off approach
to private commerce
• The first welfare theorem provides some support
for this position
• Reservations
– When market failures occur, the government may be
able to promote economic well-being by intervening
in markets (chapters 17-20)
– Free markets can produce inequitable outcomes
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Second Welfare Theorem
• Second welfare theorem:
every Pareto efficient
allocation is a competitive
equilibrium for some initial
allocation of resources
• With a lump-sum transfer,
the amount of resources
received or surrendered by
each consumer is fixed; it
does not depend on the
consumer’s choices
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Equity vs. Efficiency
• The second welfare theorem suggests that societies
can use competitive markets in combination with
lump-sum transfers to achieve both efficiency and
equity
• Since wealth is observable, we could try to achieve an
equitable outcome by redistributing resources from
the rich to the poor
• But wealth is not an endowment; it depends on a
variety of choices (education, employment, saving)
• Thus, transfers based on wealth are not lump-sum
transfers
• Equity and efficiency are in direct conflict
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Equity vs. Efficiency
• Endowment A heavily
favors Humphrey
• Equilibrium B is efficient
but arguably unfair to
Lauren
• Government can tax
Humphrey’s food
purchases and give the
food to Lauren
• Point D is more equitable,
but inefficient
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Review
• Economists evaluate economic performance on the
basis of efficiency and equity
• The first welfare theorem tells us that competitive
general equilibria are Pareto efficient
• Market failures may prevent free markets from
operating efficiently
• The second welfare theorem implies that, in
principle, societies can use competitive markets to
achieve efficiency without sacrificing equity, though in
practice governments cannot achieve their
distributional goals through lump-sum transfers
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Looking Forward
• Next, we will study different cases when
markets may not allocate resources efficiently,
the so called market failures
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