General Equilibrium Model
Rehim Kılıç,
Department of Economics, Marshall Hall,
Michigan State University, East Lansing, MI, 48824
e-mail: kilicreh@msu.edu
This version: April, May, and June 2002
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The Model
general equilibrium refers to the equilibrium in
which production, consumption, prices, and international trade are determined simultaneously for all
goods produced and consumed in the economy.
1.1
Assumptions
• A1. Economic agents, consumers, and producersfirms- exhibit rational behavior in the sense that
given all the available information, consumers
maximize utility from consumption, and firms
try to maximize profits.
• A2. Two countries in the world, A, and B. Two
goods, C, and W. Some of each good is consumed
in each country.
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• A3. Consumers and producers when they make
decisions about consumption and production look
at the real prices not the nominal prices. This
assumption excludes the possibility of what is
known as money illusion. Money illusion means
that economic agents agents make decisions by
only looking at some of the prices not all the
prices in the economy. We are assuming here
agents base their decisions on relative prices not
on nominal prices.
• A4. In each country factors of production is fixed
and the level of technology in each country is constant. Note this does not mean that each country
to have the same amount of factor endowments
or each have the same level of technology.
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Under assumptions A1-A4 we can illustrate the
supply conditions of a country by PPF. Draw PPF
to illustrate the supply conditions in each country.
PPF: We can assume that either the economy is
subject to increasing OCs or the constant OCs.
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• A5. Perfect competition prevails in each industries in each country. There are no externalities.
We know that under perfect competition firms
will maximize their profits when P = M C. Then
market prices reflect the true social (opportunity) costs of production. Illustrate this graphically by drawing PPF and price line together.
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• A6. Factors of production are perfectly mobile
between the two industries within each country.
This assumption implies that factors of production can freely move between industries when
there is a potential difference in factor payments
within a country. What does then this suggest for
say wages in different industries within a country?
• A7. Community preferences in consumption can
be represented by a consistent set of community
indifference curves. Or alternatively we can assume that there is a representative agent for each
country whose indifference curve represents that
country’s community indifference curve.
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2.1
Solution of the model
Autarky Solution
Autarky means self-sufficiency. The country is closed
in the sense that she does not trade with the rest of
the world. The autarky solution is the solution for
a closed economy. Under the assumption of constant
OCs we can illustrate the solution graphically as follows.
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The solution with Increasing OCs:
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Aggregate-National- Supply and Demand
Recall the definition of individual supply and demand curves for a particular product. Similarly we
can define aggregate supply and demand for a particular product.
The aggregate-national- supply curve for a
particular product, say W is the locus of points that
gives level of aggregate W produced in a country at
various relative prices of W.
aggregate-national demand curve gives the
locus of consumption points a country wants to consume a particular product at different relative prices
of that product.
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The national supply and demand curves can be
obtained graphically as follows:
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Bringing national supply and demand curves together we can characterized the autarky general equilibrium in an alternative fashion as follows:
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What happens if the economy opens to international trade? To answer this question consider the
following situation.
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