A Closed Economy One-Period

Macroeconomic Model
Chapter 5

Topics in Macroeconomics 2
Economics Division
University of Southampton

February 2010

Chapter 5

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Topics in Macroeconomics

Competitive Equilibrium
Economic Efficiency
Using the Model

Introduction
Definition
Graphical Analysis

Closing the Model

We have seen the optimal behavior of the representative

consumer and the representative firm

We now want to impose consistent behavior

We will study a closed economy: markets are restricted to

a single country

We will impose market clearing in the country: resources

produced must be consumed by economic agents in the
model

Other market clearing condition: labour inputs into

production must be supplied by consumers

The result will be our first model of the Macroeconomy

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Introduction
Definition
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From Chapter 4

The representative consumer faces a tradeoff between

consuming and working (work/leisure)

The consumer is paid labour income for hours worked, and

buys goods from the firm

The firm hires labour to produce output (consumption

goods) which it sells to the consumer

Both markets (goods and labour) need to clear

Chapter 5

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Competitive Equilibrium
Economic Efficiency
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Introduction
Definition
Graphical Analysis

The Government Budget Constraint

G=T

G is the amount of government spending (these are

consumption goods that also need to be produced)

T is the total amount of taxes collected by the government

(these are also consumption goods)

The government budget constraint imposes that

government spending be financed by taxes

We will assume that G is exogenous, that is, determined

outside of the model

Fiscal policy refers to the governments choice over

spending and taxes

Other fiscal instruments: government debt and transfers

Chapter 5

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Competitive Equilibrium
Economic Efficiency
Using the Model

Introduction
Definition
Graphical Analysis

Endogenous and Exogenous Variables

Exogenous variables are determined outside the model:

they are taken as given

Endogenous variables are determined by the model:

we have to find those

Exogenous variables in our model:

G, z, and K

Endogenous variables in our model:

C, N s , N d , T , Y , and w

Chapter 5

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Competitive Equilibrium
Economic Efficiency
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Introduction
Definition
Graphical Analysis

Definition: Competitive Equilibrium

A competitive equilibrium is a set of endogenous variables (C,
N s , N d , T , and Y ) and an endogenous real wage rate (w ) such
that, given exogenous variables (G, z, and K ), the following
conditions are satisfied:
1. Given (w , T and ), the bundle (C, N s ) maximizes the
consumers utility subject to the budget constraint
2. Given (w , z, and K ), the labor demand (N d ) maximizes
profits ( = Y wN d is paid to consumers as dividend)
3. The government budget constraint is satisfied (G = T )
4. Markets clear:
Labour market: N d = N s = N
Goods market: C + G = Y

Chapter 5

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Competitive Equilibrium
Economic Efficiency
Using the Model

Introduction
Definition
Graphical Analysis

Redundance of One Market Clearing Condition

If the labour market clears, so will the goods market!

The consumers budget constraint has to hold:

C = wN s + T

But dividend income is the firms profits:

= Y wN d

If we replace profits in the consumers budget constraint:

C = wN s + Y wN d T

Since N d = N s = N, these terms cancel out. And since the

government budget constraint holds, T = G

It follows that C = Y G or C + G = Y our goods market

clearing condition

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Competitive Equilibrium
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Introduction
Definition
Graphical Analysis

Production Possibilities Frontier

Chapter 5

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This is our good old production

function

Notice that the maximum number

of hours that firms can hire is h,
where the firm produces
Y = zF (K , h)

When no labour is used, nothing

is produced
F (K , 0) = 0

Topics in Macroeconomics

Competitive Equilibrium
Economic Efficiency
Using the Model

Introduction
Definition
Graphical Analysis

Production Possibilities Frontier

Chapter 5

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We can change the horizontal

axis from N to

The production function can be

written zF (K , h )

The minimum number of hours of

leisure ( = 0) occurs when
N = h, where the firm still
produces Y

As before, when no labour is

used ( = h), nothing is produced

The slope is now equal to MPN

Topics in Macroeconomics

Competitive Equilibrium
Economic Efficiency
Using the Model

Introduction
Definition
Graphical Analysis

Production Possibilities Frontier

Chapter 5

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We can change the vertical axis

from Y to C since C = Y G
(NOT Y G)

The maximum amount of

consumption is Y G (point D)

When nothing is produced,

consumption is equal to G

The shaded area is the

production possibilities set

The arc DA is the production

possibilities frontier

Topics in Macroeconomics

Competitive Equilibrium
Economic Efficiency
Using the Model

Introduction
Definition
Graphical Analysis

Production Possibilities Frontier

C = zF (K , h ) G

The production possibilities frontier (PPF) describes what

the economy can produce as a whole, in terms of
production of consumption and leisure

All points in the production possibilities set are

technologically possible to produce

The slope of the PPF (MPN ) is also called the marginal

rate of transformation (MRT )

MRT,C is the rate at which leisure can be converted into

consumption goods

So we have: MRT,C = MPN = slope of the PPF

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Introduction
Definition
Graphical Analysis

Equilibrium Wage Rate

Chapter 5

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Recall that firms optimize when

MRT,C = MPN = w

So if w is an equilibrium wage
rate, then AD with slope w is
tangent to the PPF

But if w is an equilibrium wage

rate, then ADB is the budget
constraint

Recall that consumers optimize

when the budget line is tangent
to the indifference curve, i.e.
when MRS,C = w

Topics in Macroeconomics

Competitive Equilibrium
Economic Efficiency
Using the Model

Introduction
Definition
Graphical Analysis

Equilibrium Profits: Firms Perspective

= zF (K , h ) w (h )

Chapter 5

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Y = zF (K , h ) = C + G

At point J: C = A w
At point D: C = A w h

The vertical distance between

these two points is
A w (A w h), which is
equal to the wage bill w (h )

Subtracting w (h ) from Y
give us profits: distance DH

Topics in Macroeconomics

Competitive Equilibrium
Economic Efficiency
Using the Model

Introduction
Definition
Graphical Analysis

Equilibrium Profits: Consumers Perspective

Chapter 5

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Recall that at point D, the

consumer does not work at all so
consumption must equal T

Since T = G, the
distance DH is total profits again

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Competitive Equilibrium
Economic Efficiency
Using the Model

Welfare Theorems
Sources of Inefficiencies

Pareto Optimality
Definition
An allocation is Pareto Optimal if there is no way to rearrange
production or to re-allocate resources so that someone is made
better off without making someone else worse off

To find efficient allocations we use a benevolent Social

Planner

The Planner wants to make the representative consumer

as well off as possible
The Planner does not face markets it chooses quantities:

How many hours the consumer works Y = zF (K , N)

G is given to the government
Y G is given to the consumer

Chapter 5

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Economic Efficiency
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Welfare Theorems
Sources of Inefficiencies

Pareto Optimum Allocation

Chapter 5

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Point B is the Pareto optimum:

MRS,C = MRT,C = MPN

To the left of point B:

MRT,C < MRS,C
Could make the consumer better
off by giving him more leisure
(less work) and less consumption

To the right of point B:

MRT,C > MRS,C
Could make the consumer better
off by giving him less leisure
(more work) and more
consumption
Topics in Macroeconomics

Competitive Equilibrium
Economic Efficiency
Using the Model

Welfare Theorems
Sources of Inefficiencies

Welfare Theorems
First Welfare Theorem
The first fundamental theorem of welfare economics states that,
under certain conditions, a competitive equilibrium allocation is
Pareto optimal

Second Welfare Theorem

The second fundamental theorem of welfare economics states
that, under certain conditions, a Pareto optimal allocation can
be decentralized as a competitive equilibrium
How does this look on a graph?

Chapter 5

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Competitive Equilibrium
Economic Efficiency
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Welfare Theorems
Sources of Inefficiencies

Welfare Theorems

Chapter 5

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The competitive equilibrium

allocation (C , ) is Pareto
optimal since moving away from
point B makes the consumer
worse off

The Pareto efficient allocation

can be decentralized as a
competitive equilibrium under
price w , the slope of the line that
is tangent to the indifference
curve and the PPF

Topics in Macroeconomics

Competitive Equilibrium
Economic Efficiency
Using the Model

Welfare Theorems
Sources of Inefficiencies

Sources of Inefficiencies

Externalities
Whereas the Planner would take externalities into account,
individuals and firms DO NOT

Distortionary taxes
For example, a proportional labour income tax consumers
and firms do not face the same price (the competitive
equilibrium will have MRS,C < MRT,C and is therefore not
Pareto optimal)

Firms may have market power

Firms with market power do not take price as given, as they
know they can influence them, which typically leads to
under-production

Chapter 5

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Economic Efficiency
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Making use of the Welfare Theorems

Effects of a Change in Government Spending
Effects of a Change in TFP

Working with the Planners Problem

Chapter 5

Since the welfare theorems hold,

we can either work with the CE
concept or the Planners problem

In general, the Planners problem is

considerably easier to work with
than the CE since we need not
worry about prices

Efficiency dictates having a point of

tangency between the indifference
curve and the PPF (point B)

We can always find prices to

decentralize the allocation as a CE

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Effects of a Change in Government Spending
Effects of a Change in TFP

Increase in G

Chapter 5

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With G2 > G1 , the PPF shifts

down from PPF1 to PPF2 (same
vertical distance everywhere)

Note that at each the slope of

the PPF is the same as before

Since G = T , an increase in G
means an increase in taxes for
consumers

This part is exactly like a pure

(negative) income change: since
goods are normal, we should
expect both C and to decrease

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Competitive Equilibrium
Economic Efficiency
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Making use of the Welfare Theorems

Effects of a Change in Government Spending
Effects of a Change in TFP

Increase in G: Crowding Out

Chapter 5

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Notice that 2 < 1 , or N2 > N1

Production must increase

(Y = Y2 Y1 > 0)

Since C1 = Y1 G1
and C2 = Y2 G2 ,
C2 C1 = Y2 G2 (Y1 G1 ),
or C = Y G

Since Y > 0 we must have

C > G (AE vs AD)

Consumption is crowded out by

government spending, but not
completely

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Economic Efficiency
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Making use of the Welfare Theorems

Effects of a Change in Government Spending
Effects of a Change in TFP

Increase in G: Equilibrium Effect

How can we make firms hire

more labour?

The real wage rate must fall

As N increases, the MPN

decreases, so w2 < w1

But individuals still want less

(even if it is cheaper) because
the pure income effect from
higher taxes dominates

Exercise: Decompose the total

effect into an income and a
substitution effect
Chapter 5

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Economic Efficiency
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Making use of the Welfare Theorems

Effects of a Change in Government Spending
Effects of a Change in TFP

Increase in G: Predictions of the Model

In the model, an increase in
government spending:

Key business cycles comovements (from Chap. 3):

Increases employment

Employment is pro-cyclical

Increases output

Decreases consumption
(counter-cyclical)

Consumption is
pro-cyclical

Real wage rate is

pro-cyclical

Decreases the real wage

rate (counter-cyclical)

We conclude that business cycles are not likely to be the result

of government spending fluctuations

Chapter 5

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Making use of the Welfare Theorems

Effects of a Change in Government Spending
Effects of a Change in TFP

Increase in z and the Production Function

Chapter 5

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With z2 > z1 , the production

function shifts up

An increase in z also increases

MPN at each quantity of labour
input

Notice that the maximum amount

of output (zF (K , h)) is higher with
z2 than with z1

The amount of output produced

with no labour is zero regardless
of the value of z

Topics in Macroeconomics

Competitive Equilibrium
Economic Efficiency
Using the Model

Making use of the Welfare Theorems

Effects of a Change in Government Spending
Effects of a Change in TFP

Increase in z and the PPF

Chapter 5

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With z2 > z1 , the PPF shifts

outward from BA to DA

More consumption can be

produced at any level of leisure

Since MPN is higher, the PPF is

steeper under z2 than under z1

The equilibrium (or efficient)

allocation moves from F to H

Topics in Macroeconomics

Competitive Equilibrium
Economic Efficiency
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Making use of the Welfare Theorems

Effects of a Change in Government Spending
Effects of a Change in TFP

Increase in z: Total Effect

Chapter 5

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Consumption increases from C1

to C2

Leisure could increase,

decrease, or stay the same
here it remains 1

Production increases by the

same amount as C (G did not
change)

The wage rate increases to w2 (N

did not change and MPN is
higher at all levels of N)
That will to be true in general

Topics in Macroeconomics

Competitive Equilibrium
Economic Efficiency
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Making use of the Welfare Theorems

Effects of a Change in Government Spending
Effects of a Change in TFP

Increase in z: Substitution Effect

Chapter 5

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We can construct an artificial

PPF3 such that it is tangent to the
original indifference curve I1

Just like we did in chap. 4, this is

taking away consumption (or
income) away from the consumer
in order to concentrate on the
substitution effect

Notice that PPF3 implies the

same wage rate as PPF2 (same
MPN )

Topics in Macroeconomics

Competitive Equilibrium
Economic Efficiency
Using the Model

Making use of the Welfare Theorems

Effects of a Change in Government Spending
Effects of a Change in TFP

Increase in z: Substitution Effect

Chapter 5

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With PPF3 , the efficient allocation

is given by D

The substitution effect is the

move from A to D

Consumption increases from A to

D

Leisure decreases from A to D

This is just like an increase in the

wage rate in Chap. 4

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Competitive Equilibrium
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Making use of the Welfare Theorems

Effects of a Change in Government Spending
Effects of a Change in TFP

Increase in z: Income Effect

The income effect is the move

from D to B

Consumption increases from D to

B

Leisure increases from D to B

This is just like an increase in

dividend income in Chap. 4

Total effect:
Consumption: must go up
Leisure: uncertain

Chapter 5

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Making use of the Welfare Theorems

Effects of a Change in Government Spending
Effects of a Change in TFP

Increase in z: Long-Run Predictions of the Model

In the model, increases in TFP:

Since WWII, we have observed:

Increase output

A rise in output

Increase consumption

A rise in consumption

Increase the real wage rate

A rise in the real wage rate

Have an ambiguous effect

on hours worked

Roughly constant hours

worked

We conclude that if the income and substitution effects roughly

cancel each other out over the long run, the model is consistent
with technological innovations having been key to changes in
these variables

Chapter 5

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Competitive Equilibrium
Economic Efficiency
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Making use of the Welfare Theorems

Effects of a Change in Government Spending
Effects of a Change in TFP

Increase in z: Short-Run Predictions of the Model

In the model, an increase in
TFP:

Key business cycles comovements (from Chap. 3):

Increases output

Employment is pro-cyclical

Increases consumption
(pro-cyclical)

Consumption is
pro-cyclical

Increases the real wage

rate (pro-cyclical)

Real wage rate is

pro-cyclical

Has an ambiguous effect

on hours worked (?)

We conclude that fluctuations in TFP may be the primary cause

of business cycles if in the short run the substitution effect
dominates the income effect (Real Business Cycle Theory)
Chapter 5

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