Chapter 12: General equilibrium and welfare economics
Short Answer Questions
1. What is general equilibrium analysis and how it defers from most of the
analysis we pursued in the earlier chapters?
Answer: The study of the equilibrium of all markets simultaneously.
2. What is a minimum wage law and how it can be related to equilibrium
analysis?
Answer: A minimum wage law sets a wage rate below which employers cannot pay
their employees. Such forms of regulation are said to be distortionary, in the sense
that they prevent market clearing, thus forcing employers to lower the pre-regulated
employment level.
3. Define the concept of pure exchange economies
Answer: An economy in which the quantities supplied of all goods are fixed and the
main economic problem is how to allocate amounts of the goods among consumers,
using trade.
4. Explain the contract curve relates to the concept of social efficiency.
Answer: A contract curve is the locus of all the consumption-efficient points in an
Edgeworth box.
5. What do economists mean by “market failure”? Give examples to support
your answer.
Answer: A situation in which an economy with freely operating markets may fail to
generate an efficient allocation of resources.
For the remaining questions support your answers with the aid of appropriate
diagrams.
6. What is the production possibilities curve and what is its slope?
Answer: The production possibilities curve shows the maximum amount of output
that can be produced, given the amount of the other output. The slope is the negative
of the marginal rate of transformation.
7. Draw an Edgeworth and show what conditions should be satisfied for a
consumption bundle to be optimal.
Answer:
When the initial allocation is g, e* is the point consistent with general competitive
equilibrium. At e* both individuals are maximising utility, given their budget
constraints, and the quantity supplied equals the quantity demanded in both markets.
8. Using an Edgeworth box, illustrate and briefly explain the concept of Pareto
efficiency.
Answer: We can draw an Edgeworth Box for consumption for any point on the PP
curve. An allocation is Pareto efficient only if (1) the total quantities consumed are on
the PP curve, (2) the allocation is on the contract curve, and (3) the MRSs equal the
MRT. Point v satisfies the first two conditions but not the third. Point p satisfies all
three conditions, and hence is Pareto efficient.
9. What do economists mean by Utilities Possibility frontier? Use an example
and appropriate diagrams to support your answer.
Answer:
The utility possibilities curve, UU, is the locus of Pareto-efficient points. Points inside
of UU are not Pareto efficient. A movement that improves the utility of one individual
without hurting another is a Pareto improvement. Hence, a move from q to r is a
Pareto improvement; so is a move from r to z.
10. Using appropriate diagrams, briefly explain the concept of “efficient risk
sharing”.
Answer:
The movement from bundle b to bundle d illustrates efficient risk sharing. If Ernie
sells Bert bh litres of water if there is a drought in return for hd litres if it rains, each is
better off, because each person’s consumption is less drastically affected by the state
of the world that occurs.
Essay questions
1. Discuss the necessary condition for Pareto-efficient allocation.
Answer: The reader should first discuss the concept of consumption efficient and the
production efficient. Then, the reader should explain that a Pareto-efficient allocation
must be both consumption efficient on the contract curve and production efficient on
the production possibilities curve. And the necessary condition for Pareto-efficient
allocation is MRT =MRS.
2. Consider an economy consisted of two production sectors, A and B. Using
appropriate welfare analysis, discuss the equilibrium implications of a new
regulation that imposes a minimum wage law in sector A, but not in sector B.
Answer: In the absence of a minimum wage, the wage rate is wo in both sectors. When
a minimum wage of w is imposed, employment in the covered sector decreases by ab
workers. When these workers seek employment in the uncovered sector, the wage rate
there falls from wo to wu.
3.
“Private markets are not good on dealing with risky enough projects. That is
when governments kick in”. Discuss.
Answer: Private markets can indeed fail under certain conditions. The prevailing
conditions that can lead to market failure include: (i) market power and (ii) nonexistence of markets. It must be emphasised that, while efficiency problems provide
opportunities for government intervention in the economy, they do not require it. That
the market-generated allocation of resources is imperfect does not mean that the
government can do better. For example, in certain cases the costs of setting up a
government agency to deal with an externality could exceed the cost of the externality
itself. Moreover, governments, like people, can make mistakes. Indeed, some argue
that the government is inherently incapable of acting efficiently, so that while in
theory it can improve upon the status quo, in practice it never will. Although extreme,
this argument does highlight the fact that the First Welfare Theorem is helpful only in
identifying situations in which intervention may lead to greater efficiency.
4. Discuss the main implications of the first and second theorem of welfare
economics.
Answer: Comment on the production efficiency, consumption efficiency and
allocation efficiency implications of the two welfare theorems. See section 12.2
5. “A Pareto efficient allocation must always be socially desirable”. Discuss,
using appropriate diagrams to support your answer.
Answer: A particular Pareto-efficient allocation of resources need not be socially
desirable. Point b is not Pareto efficient, yet it is preferred to point a, which is Pareto
efficient.