General Equilibrium and Welfare

Question 1

What is the definition of Partial Equilibrium analysis?

Answer 1

When analysis is focused on a single market -> ignores the idea that markets are interrelated and that spillovers between markets may exist

Question 2

What is General Equilibrium analysis?

Answer 2

Analysis that views the economy as a system of related markets -> it endogenises prices and incomes

Question 3

Partial vs General: which analysis is better?

Answer 3

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

Question 4

What are the conditions of pure exchange?

Answer 4

There are 2 people, 2 goods and no production -> only exchange

Question 5

How does pure exchange work?

Answer 5

Consumers have an initial endowment of goods and will try to maximise their utility

Question 6

What is the name of the diagram where the 2 IC’s in pure exchange are combined?

Answer 6

The Edgeworth Box

Question 7

What is the shape of the IC’s in the Edgeworth box?

Answer 7

One set of axis is flipped and where the ICs of the 2 consumers cross at their bundles, this will be the endowment point

Question 8

What does the lens area in an Edgeworth box represent?

Answer 8

It represents the area where trade can occur for both parties to increase utility -> the more trade occurs the smaller the lens area gets

Question 9

What does Pareto Optimality look like in the Edgeworth box?

Answer 9

The two ICs will have shifted until they have achieved tangency and their MRS’s are equal -> there will be no lens area left

Question 10

What is the definition of Pareto Optimality?

Answer 10

The point at which no party can increase their utility without the utility of the other party being diminished

Question 11

Can there be more than 1 Pareto Efficient point? If yes, where do they lie?

Answer 11

Yes there can be several Pareto Optimal points and they all lie on the Contract Curve

Question 12

What is a competitive equilibrium?

Answer 12

A condition where profit-maximising and utility-maximising consumers in a freely competitive market with freely determined prices reach an equilibrium price

Question 13

What does the First Welfare Theorem state?

Answer 13

That a competitive equilibrium can become a Pareto efficient one -> everyone is as well off as they can be

Question 14

What assumption is made in the first welfare theorem about market imperfections?

Answer 14

That they do not exist -> externalities, monopolies or public goods are assumed to not exist

Question 15

How is the First Welfare Theorem achieved?

Answer 15

Through trade, where consumers trade to reach efficiency

Question 16

What does the Second Welfare Theorem state?

Answer 16

That any efficient equilibrium can be converted into an efficient equilibrium

Question 17

How is the Second Welfare Theorem achieved?

Answer 17

The government will redistribute the initial endowments to a point where there are in line with Pareto Efficiency

Question 18

What must not happen during the redistribution in the Second Welfare Theorem for it to hold?

Answer 18

It cannot shrink the economy

Question 19

How is it very difficult not to shrink an economy when redistributing endowments?

Answer 19

The government will use things like taxes and subsidies to redistribute goods, which often lead to deadweight losses -> which shrink the economy

Question 20

For a diagram and the Second Welfare Theorem:

Answer 20

Check notes

Question 21

What must the preferences of both parties be for the Second Welfare Theorem to stand?

Answer 21

Both parties must have convex preferences where the budget curve only touches the IC once

Question 22

What would happen if preferences are not convex?

Answer 22

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