Partial and General Equilibrium

Partial and General Equilibrium

a. Partial equilibrium
b. Factor markets
October 12 2006
c. Production possibilities frontier and profit
maximization
d. Indifference curves and utility maximization
In this topic we examine how producers and consumers e. General equilibrium
come together and interact in markets. We first
return to the partial equilibrium supply-demand
model. Then we examine the general equilibrium
model which examines several markets together. 2

Partial Equilibrium
Partial Equilibrium, cont.
„ Once we obtain supply and demand
curves for a perfectly competitive
market (for the run of interest) we „ The model of partial equilibrium shows equilibrium in one
can put them together to examine a price market, taking given prices of other goods and inputs, income, etc.
model of a market.
„ Equilibrium is attained in the market demand „ Equilibrium in the economy as a whole requires equilibrium in all
in the way discussed earlier: the markets. Otherwise some price will change, which will affect other
price rises if there is excess demand markets. There is interdependence. Why? Examples:
and falls in there is excess supply. „ Changes in prices of substitutes, complements
Equilibrium in the market occurs at E
E. „ Changes in input prices
We can then examine how the P* supply
„ „ Changes in production of goods affects wage income and profit
equilibrium is affected by changes
of various kinds, including changes income and therefore income of consumers
in government policies „ This makes it somewhat misleading to examine equilibrium in only
„ Behind the supply and demand one market. So we consider general equilibrium – equilibrium in
curves is the behavior of producers all markets at the same time taking into account the
and consumers. Note how we now
have a fuller understanding of the interdependence of markets
effects of changes in income, prices „ We will examine a simple general equilibrium model with one
of other goods, tastes, technology, quantity input, labor, and two goods, to examine their interdependence.
input prices, etc. Q*
It will give us the basic idea of general equilibrium analysis we will
discuss later. All markets perfectly competitive – price takers
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Factor Markets Factor markets

Demand for labor
„ Market for labor, only input, can be analyzed „ To maximize profits we have seen that firm produces at
the output at which P = MC.
with usual supply-demand model.
„ What is marginal cost if labor is the only factor of
„ Consider supply and demand for labor to a production? MC = W (DL/DQ) = additional labor
particular industry. Only a brief discussion required to produce additional output multiplied by the
cost of one unit of labor. This implies that
here; more detail in next topic.
MC = W/(DQ/DL) = W/MPL.
„ Who demands labor? Firms or producers. How „ Profit maximization implies:
much labor will firms demand? The quantity P = MC = W/MPL.
that maximizes a firm’s profit. „ We can also write this condition as
„ Who supplies labor? Households or consumers. W = P x MPL.
Assume for now that there is a fixed supply of Says that the marginal cost of employing one more
worker (W) is equal to the marginal benefit (P x MPL).
labor to the industry.
P x MPL is called the value of marginal product of
labor, VMPL.
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 Factor markets Factor Markets
Demand curve for labor Labor market equilibrium
Profit maximization implies „ Assume that the supply of labor
W = P x MPL = VMPL for the industry is given. Supply
curve is vertical line
VMPL curve is downward sloping wage, VMPL „ Demand curve for labor is a wage
because MPL is downward downward-sloping line which
sloping (diminishing returns) sums up the firm demand curves
and P is fixed. (or VMPL curves).
VMPL supply
Given the wage, firm will decide to „ Equilibrium in this labor market is
employ workers up to where P determined at the intersection,
= VMPL. with the equilibrium wage being
W*
For a higher wage firm will hire For higher wages there is excess
fewer workers. W1 „
supply of labor and the wage will
W* demand
VMPL curve gives the demand fall. For lower wages there is
curve for labor excess demand for labor and the
Add up demand curves for labor of wage will fall.
all firms in the industry „ The total value of output for the
(horizontally) – gives demand industry is given by the area
under the VMPL curve. Adds up
curve for labor of industry. L1 quantity of labor the value of marginal product for
Downward sloping line each worker. quantity of labor

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Factor Markets Factor Markets

Labor markets for two sectors Labor allocation equilibrium
wage wage wage wage
DA DB DA DB
PA given in
drawing DA PB given in
curve drawing DB
curve
WA WA DL WB
WB

0A 0B 0A 0B
L1 quantity of labor quantity of labor L*
Total amount of labor for the economy is fixed and shown by distance 0A0B. Labor will move from sector B to sector A till wages are equalized between
There are two industries, producing autos (A) and butter (B), both using labor. Draw sectors. Equilibrium labor allocation will be at L*.
the labor market demand curve for B “backwards”. Suppose that initially there is
0AL1 amount of labor in sector A and L10B amount in sector B. Total value of production for the two sectors is maximized at L*. At the other
allocation shown there is a deadweight loss of DL.
Equilibrium wages in the two sectors is as shown. Where will workers wish to work
assuming other conditions are same in the two sectors? 9
What happens when a price changes? Say PA increases. DA shifts up. Labor
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will move to the auto sector.

Production Possibilities Frontier and Profit Production Possibilities Frontier and

Maximization Profit Maximization
Production Possibilities Frontier Profit maximizing production equilibrium
Production possibilities for butter „ Take prices of the two goods to be
and autos are shown with the given to price-taking firms: PA and
production possibilities frontier. QB PB. PA/PB > MRPT
„ Given prices we can draw lines with QB = MCA /MCB
The slope of the PPF shows the slope - PA/PB, like budget lines. The Increase A Equilibrium
amount of one good the economy lines show the value of total output production P=MC for
must give up to produce more of of the two goods. Lines further out both goods
the other. It is called the marginal show higher values. implies PA/PB
rate of product transformation = MRPT=
or MRPT. DQB „ Profit maximizing equilibrium: MCA /MCB
„ where one of these lines is
DQB /DQA = MRPT = - MCA /MCB DQA
tangent to the PPF. PA/PB =
Why? MRPT= MCA /MCB
„ also where the value of output PA/PB < MRPT
DQB/DQA =(DQB/WDLA)/(DQA/WDLA) of the two goods is highest = MCA /MCB
= -(DQB/WDLB)/(DQA/WDLA) „ Also have full employment: on PPF, Increase B
not inside it. production
=-(WDLA / DQA)/(WDLB / DQB)
QA „ If PA/PB irises, slope of value of
= - MCA /MCB output line rises. Equilibrium QA
output for B will fall and A will rise
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 General Equilibrium
Indifference Curves and Utility Equilibrium
Maximization
General equilibrium
„ Given the price ratio and requires: Slope gives equilibrium price ratio
production point we get the QB QB
value of income line which is „ Full employment of
also the budget line of all Slope = resources (labor) I1
consumers: value of - PA/PB
production = value of income „ Equal wages in both
„ Preferences shown with sectors
“community” indifference Production and
curves assuming all consumers „ Profit maximization by consumption
have the same preferences Consumption
(which also satisfy some other producers
conditions) Production
„ Given the budget line „ Utility maximization by Equilibrium
consumers choose consumers quantities
consumption point to reach
their highest utility level. „ Quantity supplied = PPF
„ Note: we don’t need Quantity demanded for
consumers to have identical
preferences. But all QA both goods. This is shown QA
consumers will set price ratio by having production and
equal to MRS.
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consumption at same point 14

General Equilibrium
Excess demand and supply

When the economy is not in

equilibrium, at least one of the
equilibrium conditions not QBQB
satisfied. I2
Slope =
Here we find quantity supplied -PA/PB
not equal to quantity demanded production
for both goods, although other
conditions are satisfied. There is consumption
excess supply (ES) of good B and ESB DQB
excess demand (ED) for good A. DQA
PA will increase and PB will
decrease, making the value of
production line steeper.
Production of B will fall and of A PPF
will rise, consumption of B will
rise and of A will fall. Price will
adjust till the economy reaches QAQA
equilibrium. EDA

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