General Equilibrium and Welfare Flashcards
What is the definition of Partial Equilibrium analysis?
When analysis is focused on a single market -> ignores the idea that markets are interrelated and that spillovers between markets may exist
What is General Equilibrium analysis?
Analysis that views the economy as a system of related markets -> it endogenises prices and incomes
Partial vs General: which analysis is better?
General is a lot more effective in analysing the impacts of policies or changes in other markets on the economy as a whole. Partial analysis only analyses the effects on the localised market
What are the conditions of pure exchange?
There are 2 people, 2 goods and no production -> only exchange
How does pure exchange work?
Consumers have an initial endowment of goods and will try to maximise their utility
What is the name of the diagram where the 2 IC’s in pure exchange are combined?
The Edgeworth Box
What is the shape of the IC’s in the Edgeworth box?
One set of axis is flipped and where the ICs of the 2 consumers cross at their bundles, this will be the endowment point
What does the lens area in an Edgeworth box represent?
It represents the area where trade can occur for both parties to increase utility -> the more trade occurs the smaller the lens area gets
What does Pareto Optimality look like in the Edgeworth box?
The two ICs will have shifted until they have achieved tangency and their MRS’s are equal -> there will be no lens area left
What is the definition of Pareto Optimality?
The point at which no party can increase their utility without the utility of the other party being diminished
Can there be more than 1 Pareto Efficient point? If yes, where do they lie?
Yes there can be several Pareto Optimal points and they all lie on the Contract Curve
What is a competitive equilibrium?
A condition where profit-maximising and utility-maximising consumers in a freely competitive market with freely determined prices reach an equilibrium price
What does the First Welfare Theorem state?
That a competitive equilibrium can become a Pareto efficient one -> everyone is as well off as they can be
What assumption is made in the first welfare theorem about market imperfections?
That they do not exist -> externalities, monopolies or public goods are assumed to not exist
How is the First Welfare Theorem achieved?
Through trade, where consumers trade to reach efficiency
What does the Second Welfare Theorem state?
That any efficient equilibrium can be converted into an efficient equilibrium
How is the Second Welfare Theorem achieved?
The government will redistribute the initial endowments to a point where there are in line with Pareto Efficiency
What must not happen during the redistribution in the Second Welfare Theorem for it to hold?
It cannot shrink the economy
How is it very difficult not to shrink an economy when redistributing endowments?
The government will use things like taxes and subsidies to redistribute goods, which often lead to deadweight losses -> which shrink the economy
For a diagram and the Second Welfare Theorem:
Check notes
What must the preferences of both parties be for the Second Welfare Theorem to stand?
Both parties must have convex preferences where the budget curve only touches the IC once
What would happen if preferences are not convex?
The Second Welfare Theorem may not hold because although there may be Pareto Efficiency, this point may not be at a price level where both parties want to consume
