Micro Economics, General Equilibrium. Pareto Optimality

1. Prof. Prabha Panth,
Osmania University,
Hyderabad
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2. 2. Equilibrium in Consumption
 There is equilibrium in Consumer Market also.
 Two consumers X and Y, both consume the two
goods A and B.
 Prices of both goods are given.
 Law of Diminishing MU applies.
 Income of consumers is given,
 Also tastes, preferences, etc.
 Total Q of A and B fixed by producing firms M, N.
If X increases his consumption of A&B, Y has to
decrease his consumption.
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3. 3
4. Efficiency in Consumption
0X
0Y
BX
AY
IC 1X
IC2 X
IC3 X
IC4X
BY
IC2Y
IC3Y
IC4Y
AX
IC1Y
1
2
3
4
5

4.  As in the case of production, draw the Edgeworth
box for consumption.
 Taking Indifference curves of consumers X and Y, for
the two goods A and B.
 As X increases his consumption from IC1A to IC4A,
B has to decrease his from ICB4 to ICB1.
 At 5, the ICs of both X and Y intersect, with X on
IC1X, and Y on IC3Y.
 Is it possible to improve this situation?
 If X moves to point 2, he will be on a higher IC =
IC2X, while Y will be on the same IC3Y. So X
improves his welfare (consumption), but no change
in Y. X is better off, Y is not worse off.
 So point 5 is not an efficient position.
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5.  If Y moves to IC4Y, then he will be on a higher IC at
point 1. But X will remain on the same IC2X. So at
point 1, Y is better off, but X is not worse off.
 This is known as Pareto Improvement.
 All points where the two IC curves of the two
consumers are tangents to (touch) each other, are
points of equilibrium, = 1, 2, 3, 4.
 Joining them gives the Contact curve of
consumption, OX 1, 2, 3, 4 OY.
 These are all Pareto optimal points.
 Moving from one to another point on the Contact
curve, it is not possible for one consumer to increase
his consumption, without another one’s decreasing.
 But no unique equilibrium point.
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6.  Take any one point on the Contact Curve, e.g. 2
with X on IC2X and Y on IC3Y.
 The budget line drawn to it (dotted line) shows
the ratio of the prices of A and B.
 The slope of the Indifference curves shows the
Marginal rate of substitution, MRSA,B.
 The slopes of the two IC and that of their Budget
lines are same on each point on the Contact
curve.
 At point 2, the slope of IC2X = IC3Y = PB/PA
 MRSx = MRSy = PB/PA => Equilibrium
 And so on for each of the points on the contact
curve. No unique equilibrium.
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7. General Equilibrium
 Equilibrium in Production, Consumption, and
Factor markets.
 Prices of goods (Pa, and Pb) and Factor prices
(w, i) are given.
 Equilibrium of both consumption and production
to be achieved simultaneously.
 Superimpose the Edgeworth box of
consumption on the PPC to find the General
equilibrium point for a two goods, two
consumers, two firms and two factors market.
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8. 8
CommodityB
Commodity A
0 a
E
B
5. GENERAL
EQUILIBRIUM
IC1X
IC2 X
IC3 X
IC2Y
IC3Y
IC4Y
1
2
3
A
b
p
p

9.  In figure 5, Commodities A and B are measured on
the two axis.
 Edgeworth box of consumption is fitted within the
PPC of production.
 Point E, where it touches the PPC.
 Shows the maximum A and B that can be produced:
0A and 0B.
 These have to be shared between the two
consumers X and Y.
 Slope of the PPC at point E gives the prices of the
two goods: PA/PB.
 Draw a line parallel to pp in the inner space.
 Find the point where it is tangent to any set of IC
curves (e.g. at point 2)
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10.  At point 2, the slope of the Price line pp is same
as slope of the two IC curves.
 Or, MRSX = MRSY = Pa/Pbt
 Point E which is on the PPC also shows the ratio
of prices Pa/Pb,
 This is the equilibrium of Production.
 Hence E is the point of General Equilibrium
 Here, both consumption and production are
determined simultaneously.
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11.  But, it is not a unique point.
 If there is any change in the relative prices, then the
equilibrium will change.
 This will change allocations, employment, and
output.
 Is based on given prices of goods and factors.
 Does not show how they are determined.
 Based on perfect competition in both product and
factor markets.
 Not if there is imperfect competition in any market.
 Difficult to show in the case of multiple goods
markets.
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12. Questions (both 1 and 2)
 Short questions:
 What is general equilibrium? How does it differ from
partial equilibrium?
 Explain the meaning of “Pareto optimality” and “Pareto
improvement”.
 Draw an Edgeworth box of a) production, and b)
consumption. Explain how it works.
 What is a contract curve? What is its significance?
 What is a Production Possibility Curve? How is it
derived? And what is its significance?
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13.  Essay Questions:
 Explain how Production equilibrium is achieved in a
Pareto optimal model.
 How is equilibrium achieved in the consumer’s market
with two consumers, and two goods?
 Show with the help of diagrams, how general
equilibrium is achieved in a Pareto model.
 What are the limitations of the Pareto model of
General Equilibrium?
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