General Equilibrium and Market Failure

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General Equilibrium and Market Failure

• Class 6

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We have been studying partial equilibrium
analysis by examining equilibrium conditions in
individual markets

• General Equilibrium
• The equilibrium when all markets in an economy is
  in equilibrium at the same time
• We know from our study of substitutes and
  complements that what happens in one industry can
  affect other industries

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Example Wine and Everything Else

• Title
• Bullets

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Demand for wine goes up

• Title
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Markets are out of equilibrium

• Title
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Markets adjust to a new general equilibrium

• Title
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Recall our assumptions

• Assumptions
• Perfect competition
• Profit maximization
• Utility maximization
• Full information

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When an economy is in general competitive
equilibrium, it is efficiently allocating of
resources

• Efficiency
• Condition in which the economy is producing what
  people want at the least possible cost.
• resources are allocated among firms efficiently
• final products are distributed among households
  efficiently
• the system produces the things that people want.
• Allocative Efficiency - condition in which no
  change is possible that will make some members of
  society better off without making some other
  members of society worse off.
• Allocative efficiency also called Pareto
  Efficiency or Pareto Optimality

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Efficient DOES NOT MEAN Equitable

• Efficient vs Equity
• Efficiency dictates that resources go to those
  that value them most
• But does not necessarily mean that everyone gets
  the same thing, or that everyone is equally happy

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Firms will use the best technology, and will
produce efficiently

• Efficiency of Perfect Competition
• Firms maximize profits
• If they can cut total cuts, profits go up
• They will make just enough units so that PMC

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Households will make the right consumer choices,
and will spend efficiently

• Efficiency of Perfect Competition
• Households want to maximize their utility
• They will choose among goods until MU/ is equal
• No redistribution of final outputs among people
  will make them better off.

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Efficiency in perfect competition follows from a
weighing of values by both households and firms.

• Key Efficiency Condition
• If PX gt MCX, society gains value by producing
  more X
• If PX lt MCX, society gains value by producing
  less X

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But sometimes the market fails!

• Market Failures
• Imperfect competition
• Public goods
• Externalities
• Imperfect information

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Imperfect competition is an industry in which
single firms have some control over price and
competition.

• Imperfect Competition
• Monopolies, Oligopolies (next class)
• The problem is Output is lowerthe product is
  underproducedand price is higher than it would
  be under perfect competition.
• Inefficient allocation of resources

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Public goods are goods and services that bestow
collective benefits on members of society.

• Public Goods
• As opposed to private goods
• Nonrival in consumption benefits are collective
• Nonexcludable hard (impossible) to exclude
  others from benefiting
• The problem is a free market does not produce
  the right amounts of public goods
• Why not?
• Free-rider problem people get the benefit even
  if they do not pay

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What to do about public goods?
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An externality is a cost or benefit resulting
from some activity that is imposed on people
outside the activity.

• Externalities
• The market does not always force consideration of
  all the costs and benefits of decisions.
• The problem For an economy to achieve an
  efficient allocation of resources, all costs and
  benefits must be weighed.
• For negative externalities, output is too high
• Also called spillovers

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Externalities result in inefficient allocation

• Example Negative Externality
• Harry plays his music loud
• Loud music bothers Jake
• Harrys music has negative
• spillover to Jake

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Harry, meet Jake

• Title
• Bullets

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What to do about negative externalities?
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Most voluntary exchanges are efficient, but in
the presence of imperfect information, not all
exchanges are efficient.

• Imperfect Information
• One party knows more than the other party in a
  transaction
• The problem transactions are not efficient
• Who cares?
• Adverse selection can occur when a buyer or
  seller enters into an exchange with another party
  who has more information.
• Who buys life insurance?
• Moral hazard arises when one party to a contract
  passes the cost of his or her behavior on to the
  other party to the contract.
• How do you behave when you have life insurance?

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What to do about imperfect information?
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Market inefficiency versus Government inefficiency

• You Cant Win
• Government cant always figure out what to do
• Voting is imperfect
• Politicians and bureaucrats have their own
  incentives
• There are reasons to believe that government
  attempts to produce the right goods and services
  in the right quantities efficiently may fail.
• The existence of an optimal level of
  public-goods production does not guarantee that
  governments will achieve it

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Next Week

• Review for midterm on Sunday, July 16
• Haas C230, 3pm-5pm
• Imperfect competition on Monday
• Midterm on Wednesday night!!