1 Chapter 10 General Equilibrium and Economic Welfare Key issues 1. general equilibrium 2. Pareto principal 3. efficiency and equity Partial equilibrium analysis • an examination of equilibrium and changes in equilibrium in one market in isolation • problem: by holding prices and quantities of other goods fixed, we ignore possibility that events in this market affect other markets' equilibrium prices and quantities • doing so is OK for small markets (hoola hoops) General-equilibrium analysis • study of how equilibrium is determined in all markets simultaneously an event in one market may have a spillover effect on other markets may be linked • through demand • through supply • because output in one market is an input in another Compromise between partial and general equilibrium study equilibrium in several - but not all - markets simultaneously Feedback between competitive markets • corn and soybean markets are linked • consumers substitute between corn and soybeans • producers substitute between corn and soybeans 2 Sequence of events • shock in corn market affects soy market • resulting shift in the soy market affects corn market • diminishing reverberations occur until markets settle at new equilibria • whether nearly instantaneously or not depends on reaction speeds of consumers and producers Suppose • Foreign demand for American corn decreases • export of corn falls by 10% at the current price • Total American demand for corn shifts left Figure 10.1a Relationship Between the Corn and Soybean Markets Price, $ per bushel Corn, Billion bushels per year e 0 c e 1 c e 3 c D 0 c D 1 c S 3 c S 0 c $215 $1.9171 $1.9057 8.448.26138.227 (a) Corn Market Figure 10.1b Relationship Between the Corn and Soybean Markets Price, $ per bushel Soybeans, Billion bushels per year e 0 s e 2 s e 4 s D 4 s D 2 s S 4 s S 2 s S 0 s D 0 s $4.12 $3.8325 $3.8180 2.072.05142.0505 (b) Soybean Market Partial equilibrium bias in corn market is small 2.1%11.4%general equilibrium 2.5%10.8%partial equilibrium Drop in quantityDrop in price 3 Sin taxes • justification for taxes on alcohol, tobacco, and other goods and services with poor reputations • they raise revenues for the government • they discourage bad behavior • do these taxes significantly affect other markets? General equilibrium tax effects • study of general equilibrium effects of alcohol and tobacco taxes on 13 goods and services • suppose a $1.3 billion shortfall in drug rehabilitation programs is paid for by higher cigarette and alcohol taxes Effect of tax on government revenues • $1.29 billion rise (partial equilibrium) • $772 million rise due to changes in taxes collected from other sectors (general equilibrium) • Thus, partial-equilibrium analysis overstates the increase in tax revenues by two-thirds Minimum wage • complete coverage (partial-equilibrium analysis): minimum wage causes unemployment (Puerto Rico) • incomplete coverage (general-equilibrium analysis) • wage differentials across sectors • no unemployment U.S. minimum wage • first minimum wage law passed in 1938 • Fair Labor Standards Act • incomplete coverage: exempted agriculture, government, most retail, most service • economists joked that its purpose was to maintain family farms • law drove workers out of manufacturing and other covered industries into agriculture and other uncovered sectors Effect of incomplete coverage • minimum wage in covered sector causes employment in that sector to fall • workers who lose their jobs move to the uncovered sector • minimum wage leads to wage differential between sectors – not unemployment 4 Uncovered sector supply curve residual supply curve: market supply not met by demanders in other sectors at any given wage: S u (w) = S(w) - D c (w) • w = wage • w = minimum wage • S u (w) = uncovered sector residual supply • S(w) = total supply curve • D c (w) = demand for labor in covered sector Figure 10.02 Minimum Wage with Incomplete Coverage w, Wage per hour w, Wage per hour w, Wage per hour L, Annual hours (a) Covered Sector (b) Uncovered Sector (c) Total Labor Market w 1 w 2 w S L c 2 L c 1 L u 2 L u 1 L c 1 L u 1 L 1 = + D c D u S u D L c , Annual hours L u , Annual hours 88%86%61%56% » 50% 19911978196219471938 Share uncovered by minimum wage today: all industry/government sectors are covered, but coverage in agriculture and private household employment is incomplete Solved problem • government starts subsidizing the cost of labor by a payment of s per hour only in a covered sector • wage received by workers in both sectors is w, but the wage paid by firms in the covered sector is w – s • What effect does the subsidy have on wages, total employment, and employment in covered and uncovered sectors of the economy? Solved Problem 10.1 w, Wage per hour w, Wage per hour w, Wage per hour L, Annual hours (a) Covered Sector (b) Uncovered Sector (c) Total Labor Market w 1 w 1 w 2 w 1 w 2 w 2 s S L c 2 D 2 c D 1 c L c 1 L u 2 L u 1 L 1 L 2 e 2 e 1 D u L c , Annual hours L u , Annual hours D 1 D 2 Welfare society decides whether a particular equilibrium (or change in equilibrium) is desirable by answering 2 questions: • Is the equilibrium efficient? • Is the equilibrium equitable? 5 Efficiency • production efficiency: cannot produce more output at current cost given current knowledge • consumption efficiency: goods cannot be reallocated across people so that at least someone is better off and no one is harmed Pareto principle allows us to rank different allocations of goods and services where no interpersonal comparisons need to be made Pareto efficient any allocation where we cannot make one person better off without harming another person is Pareto efficient First theorem of welfare economics any competitive equilibrium is Pareto efficient Second theorem of welfare economics any Pareto-efficient equilibrium can be obtained by competition, given an appropriate endowment Socially desirable decision- making system • should satisfy • social preferences should be complete and transitive, as are individual preferences • if everyone prefers Allocation a to Allocation b, then a should be socially preferred to b • society's ranking of a and b should depend only on individuals' ordering of these two allocations (not on how they rank other alternatives) • dictatorship not allowed: social preferences must not reflect preferences of only a single individual 6 Arrow’s Impossibility Theorem • it is impossible to find a social decision making rule that always satisfies all of these criteria • his result indicates that democratic decision making may fail - not that democracy must fail Choices of three people bacthird choice acbsecond choice cbafirst choice 321Individual: 1. General equilibrium • shock in one market has spillover effect in another market • general-equilibrium analysis takes account of spillover unlike partial-equilibrium analysis • partial-equilibrium and general-equilibrium analyses give different answers if spillover effects are large 2. Pareto efficiency competition produces Pareto efficiency . another person is Pareto efficient First theorem of welfare economics any competitive equilibrium is Pareto efficient Second theorem of welfare economics any Pareto-efficient equilibrium can be. individual preferences • if everyone prefers Allocation a to Allocation b, then a should be socially preferred to b • society's ranking of a and b should depend only on individuals'. Standards Act • incomplete coverage: exempted agriculture, government, most retail, most service • economists joked that its purpose was to maintain family farms • law drove workers out of manufacturing