Micro Economics, Welfare Economics, General Equilibrium

1. Prof. Prabha Panth,
Osmania University,
Hyderabad

2.  Partial equilibrium: Marshall -
individual consumer, producer, firm, or
factor’s equilibrium analysis.
 General equilibrium – Walras and
Pareto.
 General Equilibrium: all product and
factor markets achieve equilibrium
simultaneously.
 What will be the nature of this
equilibrium?
 Will all economic units benefit from it?
 How can it be achieved?
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3. Assumptions:
 Free, capitalistic market.
 Perfect competition in the product
market, product prices are given
 Perfect competition in the factor
market, factor prices are given.
 Equilibrium determined simultaneously
in both product and factor markets.
 Other things remaining constant,
 Static, no growth.
 Diminishing returns.
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4.  There is inter connection between product
and factor markets.
 Partial equilibrium in individual markets,
can lead to general equilibrium.
 Achieved through adjustments of product
and factor Ps.
 All resources are allocated in an optimum
manner.
 Welfare of all units is maximised.
 Laissez faire, no government interference.
 Efficient and Equitable market.
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5.  Pareto Optimality: A Market situation,
where in it is not possible to make one
person better off, without making
another worse off.
 Because of Optimum allocation of
resources in General equilibrium.
 If resources are not allocated
optimally, it is possible to increase or
improve one unit’s welfare without
decreasing another’s.
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6.  Basis of Welfare Economics.
 Efficiency and Equity or Social
Justice in general equilibrium in a
capitalist free market.
 Efficiency: in terms of allocation of
resources.
 Equity: in terms of distribution of
income.
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7. Three conditions for Efficiency in the
General equilibrium model:
1. Production efficiency: Maximum
possible output with the given
resources.
2. Consumption efficiency: Maximum
utility for all consumers,
3. Product mix efficiency: optimum
mix of commodities.
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8.  Assume that two commodities are being
produced A and B.
 Two firms M and N. M produces A, and N
produces B.
 Two factors of production, K and L. Firms
M and N use both factor inputs to produce A
and B.
 Two consumers X and Y, who consume both
commodities A and B.
 Perfect competition,
 Static analysis,
 Diminishing returns, and utility
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9.  An allocation of inputs (K,L) is
production efficient if it is not
possible to increase the output of
one commodity (A), without
decreasing the output of the other
commodity (B).
 Assume that there are two firms M, N.
 M produces commodity A,
 N produces commodity B.
 Both use K and L as inputs.
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10. 10
Edgeworth
box
Isoquants of
two firms
M,N.
Both use K
and L.
Each tries to
achieve its
highest IQ.
If M moves
to higher IQ,
then N is
forced to
move to
lower IQ.
More K,L for
one firm M
means less
for N.
So lowers its
output.
1. Efficiency in Production
0M
0N
IQ 1A
IQ2 A
IQ3 A
IQ 4A
LN
IQ2B
IQ3B
IQ4B
KM
IQ1B
LM
KN
a
b
c
d
f

11.  Edgeworth box: Diagrams of isoquants of
each individual firm M and N. Rotate that of
N, and align the two to form a box.
 Firm M’s isoquants are IQ1A, IQ2A, etc.
(purple lines)
 Firm N’s isoquants are IQ1B, IQ2B, etc. (blue
lines).
 OM is the origin for M, and ON is the origin
for N.
 Both firms compete for use of K and L.
 Each firm tries to reach its highest IQ.
 If M wants output of IQ4A, then N can
produce only IQ1B.
 If N wants to produce IQ4B, then M has to
produce IQ1A.
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12.  At ‘f’ combination, M producing IQ2A,
while N is producing output of IQ2B.
 Is it possible to improve the situation?
 If they move to point ‘c’, then M can increase
output to IQ3A, and N can maintain its output
at IQ2B. (all combinations on the same IQ show
the same level of output).
 Now M is better off, but N is not worse off.
 Similarly, if they move to point ‘b’, then N’s
output increases to IQ3B, but M’s output
remains same at IQ2A as on point ‘f’.
 N is better off, but M is not worse off.
 Such adjustments called “Pareto
improvements” – when it is possible to improve
the welfare of one, without reducing another’s
welfare.
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13.  At point b and c, IQ of both firms are
tangents to each other, (touch).
Similarly points a, b, c, and d.
Joining together these points, gives the
“Contact Curve” of production.
Moving along the contact curve leads to
improvement of one firm’s welfare
(output), but decreases the other’s
welfare (output).
Thus all points on the Contact curve are
“Pareto Optimal” points.
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14.  At each of these points, a, b, c, d, the
slopes of their isoquants are the same.
 Also slopes of their isocost curves are
the same.
 We know that at equilibrium, slope of
isoquant = slope of isocost.
 Slopes of isoquants of M and N
= MRTSA = MRTSB
 Slope of isocost of K and L for the two firms:
= w/i
 At each of the equilibrium points ‘a b c d’ on
the contact curve,
= MRTSA = MRTSB = w/i
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15.  Edgeworth box shows output of A and
B with isoquants in input factor space.
 To convert to output factor space, the
two goods should be shown on the two
axis (instead of K and L).
 Can be done using the Production
Possibility Curve (PPC), or the Product
Transformation Curve (PTC).
 The PPC shows the equilibrium outputs
of A and B with different inputs of K,L.
It is the transformation of the contract
curve on to the outer space.
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16. 16
Transformation Curve
shows alternative
combinations of 2 goods
that can be produced
with given amounts of
factor inputs.
Points on Contact Curve
abcd of Figure 1, shown
in outer space.
As Q of A rises, Q of B
falls.
Inverse relationship.
PPC is convex outwards,
the slope increases with
increase in B.
Diminishing returns.
CommodityB
Commodity A
0
a
b
c
d
A
1
A
2
A
3
A
4
B1
B2
B3
B4
2. THE PRODUCTION
POSSIBILITY CURVE OR
TRANSFORMATION
CURVE

17.  The PPC shows how one good A is
transformed into another B, by
transferring resources from the
production of A to that of B.
1) PPC is concave to the origin: To produce
one more unit of B, more and more of A
should be given up. Shows diminishing
returns.
2) Slope of PPC: measures the Marginal
Rate of Product Transformation : MRPT
between the two goods.
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18. MRPT of A, B, shows the amount by which
B has to fall, for A to rise, with the help
of resources released by reducing B.
MRPTA,B = - dA = MCB ----------- (1)
dB MCA
MRPT is the rate at which the economy
can transform one commodity into
another, through reallocation of K and L.
There is no unique Pareto optimum
situation.
All points on the PPC are Pareto optimum.
All points below the PPC are not efficient.
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19. In P.C. firms equate P =
MC, so MCA = PA, MCB=
PB.
Slope of PPC = MRPTA,B
= dB = MCA = PA -----(2)
dA MCB PB
Given product prices,
production equilibrium is
the point where slope of
PPC = ratio of product Ps.
At point T on the
diagram.
CC is the Isocost curve,
whose slope = Pa/Pb
At T, OAT of A is produced
and OBt of B is produced.
Producers’ equilibrium,
and Product Efficiency
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CommodityB
Commodity A
0
T
A2
B2
3. PRODUCT EFFICIENCYC
C

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