L21 - General Equilibrium and Welfare Flashcards
What is a pure exchange economy?
- no product, no money
- A pure exchange economy is a very simple characterisation of an economy since people simply possess goods and choose whether to swap them. Goods are not produced.
- good exist in fixed endowments and there needs to be enforced property rights to those endowments
What is Walrasian Auctioneer?
- Based on a 2x2 trading economy
- We assume that an auctioneer is employed to set a price for good 2 in terms of good 1. –> he successively calls out prices until he gets a reaction of from a price that will clear the market
- The individuals A and B are price-takers, and do not attempt to deceive the auctioneer about their preferences.
- [Alternatively, A and B represent large cohorts of two different types of consumer]
- Only when the auctioneer finds a market-clearing price does trading proceed. We call this Tatonnement.
What happens if we use a price that doesn’t clear the market?
- the flatter red line now indicates the budget lines at the new price, (must got through E because they both need to be able to afford their initial endowment)
- we now get few bananas per apples (bananas are more expensive)
- this now means that consumer A wants to trade at D** and consumer by at D* –> there is now an excess demand (apples) and supply (bananas) of the different goods
- because the two consumers are trading the excess demand and supply should equate to zero (Walras’s law)
- the auctioneer would cancel trading at this price
- then make apples more expensive (and bananas cheaper) to get the blue budget curve
What happens when substitution effects outweigh income effects?
Comparing E with D, we find that in market-clearing A sells good 2 and buys good 1 and B sells good 1 and buys good 2.
then a lower price for G1 would imply both parties want more of G1 and less of G2 than in equilibrium at D. The market doesn’t clear
if we start from a single distribution of resources, is there only one price that clears the market? –> in this case when substitution > income then yes there is only one price that clear the market
What happens when income effects outweigh substitution effects?
it is conceivable that a fall in the price of G1 may cause one consumer to demand more of it and the other to demand less.
- if bananas become more expensive the who distribution of income will change (and wealth)
In this case, MULTIPLE EQUILIBRIA are possible even with a single endowment point.
From here on, we assume SUBSTITUTION EFFECTS DOMINATE INCOME EFFECTS.
What does different initial endowment points lead to?
- E and E’ are different income distributions that rely on different budget lines
- lead to different market equilibrium but may or may not change the price
- Notice that at D’ consumer A is Better off, but consumer B is worse off.
- In Pareto’s terms its hard to compare these two points as it make one better off at the expense of the other consumer - we need to be able to value and compare the effects of making one person better or worse off
- but both are Pareto optimal,
What is the Contract Curve?
- Every point on the contract curve represents a possible competitive outcome, where A’s indifference curve and B’s indifference curve are tangent.
- Which competitive outcome actually takes place depends upon initial endowments.
- But EVERY POINT ON THE CONTRACT CURVE IS PARETO EFFICIENT
- AND EVERY PARETO EFFICIENT POINT LIES ON THE CONTRACT CURVE. - and is thus a competitive equilibrium
What is the First Fundamental Theorem of Welfare Economics?
•“As long as producers and consumers act as price takers and there is a market for every commodity, the equilibrium allocation of resources is Pareto efficient. That is, the economy operates at some point on the utility possibilities frontier”.
All agents are price takers + There is a complete set of markets –> Pareto Efficiency
How could this be violated:
- could have monopolies
- may have externalities (not a complete set of markets)
- all uncertainty
What if there is no auctioneer in the pure exchange economy?
Notice that to get to the Pareto efficient outcomes, we had to assume that there was a price-setting mechanism (an auctioneer) and that A and B gave the auctioneer accurate information about their preferences at the offered price level.
If A or B have monopoly power, they may be able to influence the auctioneer’s price by altering their bids. In this case, the outcome would not be Pareto efficient.
(later the auctioneer theory has been developed into a complicated theory of bargaining - where there are lots of people on either side of the market and as long as the don’t collude, the market will clear)
What is the Utility Possibility Frontier?
- shows the distribution of A’s and B’s utilities which its possible to react without making the other worse off
- Anthing within the curve you can reach but is inefficient
- Anything on the curve is efficient
- Any point shows the trade-off between the two consumers utility
- It also shows the pareto efficient distribution’s of inefficiency
What is the Second Fundamental Theorem of Welfare Economics?
- Most economists believe there are social preferences
- on the whole, if everyone’s utility is close together the economy is fair but if one person holds it all it is unfair –> may be a trade-off between fairness and productivity
- “Provided that all indifference curves and isoquants are convex to the origin, for each Pareto efficient allocation of resources there is a set of prices that can attain that allocation as a general competitive equilibrium.”
- Diminishing marginal returns to substitution + the ‘correct’ initial distribution –> You can maximise social welfare
- Logic behind this: every Pareto efficient point lies on the contract curve. And every point on the contract curve is the equilibrium from one initial starting distribution of resources.
- So if you can redistribute wealth costlessly, then you can use the market to achieve the best possible overall use of resources.
- How realistic is this?
- there have been attempts at lump-sum redistribution –> countries who found independent cut up large farmer states and gave it to smaller farmers - Mexico did this in the 1920
- it worked well at the time - but after a couple of decades the big farmers had built back up to their initial base level
- over time some people are simply more productive, some save more and some are just lucky
- Will tend to happen
How realistic is it to redistribute wealth in an economy?
- there have been attempts at lump-sum redistribution –> countries who found independent cut up large farmer states and gave it to smaller farmers - Mexico did this in the 1920
- it worked well at the time - but after a couple of decades the big farmers had built back up to their initial base level
- overtime some people are simply more productive, some save more and some are just lucky
- Over time the social welfare and wealth gap will tend to open - the only way to solve this is to keep distributing wealth over time
- but this brings in a wealth tax (but this is a tax on saving which will distort savings)
- so you basically can just distribute resources (by surprise) once and you can’t really carry out the same type of distribution
in reality, there is a distribution efficiency and equity
What does an investment project normal involve?
•An investment project (private or public), generally involves spending money up front (capital investment), to provide the capacity to earn an income (or provide a benefit) later on.
- which the public sector modify (with respect to welfare economics)
What are some other aspects of DCF analysis?
- This is an analysis that private firms may carry out that the public sector may modifier (with respect to welfare economics) - or provide subsidies for a project that has public interest
- If you are a private firm, revenue should be net of taxes. –> public sector using the green book for investment project guideline (some project may be a transfer and come back to the government)
- Interest costs on loans to fund investment may appear in profit and loss statements, but they are not usually included in DCF analysis (because we are already discounting future profits, and charging interest as an extra expense would be double-counting).
- •Capital may need an annual maintenance. This is a cash flow, and should be included in the DCF analysis.
- Capital may need replacing or upgrading every few years, or decommissioning at the end of the investment. These costs should also be included.
- Maybe every 10 years there will be a partial upgrade and every 20 a full one
- Accountants cover these costs in profit/loss statements as a ‘depreciation’ charge. We don’t put an extra ‘depreciation’ cost into the DCF, as, again, it would be double-counting.
When performing DCF analysis what should be discounted?
- •When you do a DCF analysis of a project, it is the cash flow that you discount, not the profit/loss statement.
- •But if the accountants do the P/L analysis correctly, it should give the same answer.
- •Often, the project appraisers will work out both a DCF and a financial projection (P/L account) for the project – both should be consistent.
Why are large public projects different?
- e.g. building a railway or bridge is a large but discrete change in the supply of capacity
- Critically, does the shaded area exceed the cost of building new capacity
- Even if it does it may make a loss if people are charged MC - discriminating monopoly may be utilised
