Lecture 1 1-1

ECN407 Adv. Macroeconomics

Lecture 3
[A Closed-Economy One-Perod Model]

Competitive Equilibrium

Dr. Arshad Ali Bhatti

Fall 2018

A Closed-Economy
One-Period Macroeconomic Model

• Closed Vs Open Economy

• Introducing Goverment
• Govt. Purchases a given quantity of consumption
goods, G, and finances these purchases by
taxing the representative consumer.
• Usually, governments provide many different
goods and services, including roads and bridges,
national defense, air traffic control, and education.
• Economists are interested in public goods, such
as national defense, which are difficult or
impossible for the private sector to provide.

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 Lecture 1 1-2

A Closed-Economy
One-Period Macroeconomic Model

Government
• Here, we are not concerned (for simplicity) with the
nature of Public Goods
• We want to capture that government spending
uses up resources, and we model this by
assuming that government spending simply
involves taking goods from the private sector.
• Output is produced in the private sector, and the
government purchases an exogenous amount
G of this output, with the remainder consumed
by the representative consumer.
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A Closed-Economy
One-Period Macroeconomic Model

Government
• Exogenous variables?
• Examples?
• Government spending is exogenous in our
model, as we assume that G is independent of
what happens in the rest of the economy.
• The government must abide by the government
budget constraint, which we write as G = T, in
real terms.
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 Lecture 1 1-3

A Closed-Economy
One-Period Macroeconomic Model

Government
• Introducing government allows us to study
some basic effects of Fiscal Policy.
• In general, Fiscal Policy refers to the govt.’
choices over its expenditures, taxes, transfers,
and borrowing.
• As this is a one-period economic environment,
the govt.’ choices are very limited, as shown by
the government budget constraint; G=T.

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A Closed-Economy
One-Period Macroeconomic Model

Government
• The govt. cannot borrow to finance G, because
there is no future to repay its debt &
• … the govt. does not tax more than it spends.
• The govt. budget deficit, which is G - T here, is
always zero.
• Thus, the only elements of Fiscal Policy we
study is the setting of G, and the macroeconomic
effects of changing G.
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 Lecture 1 1-4

A Closed-Economy
One-Period Macroeconomic Model

Setting
• Construct closed-economy one-period macroeconomic
model, which has:
• (i) representative consumer;
• (ii) representative firm;
• (iii) government.
• Economic efficiency and Pareto optimality.
• Experiments: Increases in government spending (G)
and total factor productivity (TFP).

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A Model Takes Exogenous Variables and

Determines Endogenous Variables

• Exogenous variables are determined outside a macroeconomic

model.

• Given the exogenous variables, the model determines the

endogenous variables.

• In experiments, we are interested in how the endogenous variables

change when there are changes in exogenous variables.

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 Lecture 1 1-5

Let’s first look at the competitive equilibrium

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Competitive Equilibrium
• Representative consumer optimizes
given market prices.
• Representative firm optimizes given market
prices.
• The labor market clears.
• The government budget constraint is satisfied,
or G = T.
• NB: In our model economy, there is only
one price, which is the real wage w.
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 Lecture 1 1-6

Competitive Equilibrium

Recall that
 representative
consumer’s optimal
consumption problem
involved a graph with
consumption and
leisure

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Competitive Equilibrium

Recall that
 representative firm’s
profit maximization
problem involved a
graph with labor and
output

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 Lecture 1 1-7

Competitive Equilibrium

• Recall that
– representative consumer’s optimal consumption problem
involved a graph with consumption and leisure
– representative firm’s profit maximization problem involved a
graph with labor and output
• We want to be able to put these two problems in one
graph
– transform output into consumption
– transform labor into leisure

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Resource Constraint (RC)

• An important property of a competitive

equilibrium is that

• That is, the income- expenditure identity is

satisfied.
• In this economy, I = 0 , as there is only
one period, and NX = 0, as the economy
is closed,
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 Lecture 1 1-8

Derivation of RC

This can be verified from the consumer’s

budget constraint.

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The Production Function

• In equilibrium, N = h – l, so

• This allows us to look output as a function of

leisure

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 Lecture 1 1-9

Production Function

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Output as a Function of Leisure

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 Lecture 1 1-10

Consumption as a Function of
Leisure

C=Y-G

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Production Possibilities Frontier

 Production Possibilities Frontier

(PPF): the technological relationship
between consumption and leisure

 Marginal Rate of Transformation

(MRT): slope of PPF, rate at which
leisure can be converted in the
economy into consumption goods
through work
 Then
MRT = MPN

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 Lecture 1 1-11

Production Possibilities Frontier

• An increase in G shifts PPF

downwards
• AB is infeasible as
consumption is negative

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Competitive Equilibrium

• Now we can put the representative consumer’s

optimal consumption problem and the
representative firm’s profit maximization
problem in the same graph to find the competitive
equilibrium

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 Lecture 1 1-12

Competitive Equilibrium

This figure brings together the

representative consumer’s
preferences and the representative
firm’s production technology to
determine a competitive equilibrium.

AD: budget constraint

DB: non-labor income

Slope =

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Key Properties of a Competitive

Equilibrium

=w

MRS: slope of indifference curve

MRT, MPN: slope of PPF

w: slope of budget constraint

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 Lecture 1 1-13

Now let’s discuss the optimality of the competitive

equilibrium

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Optimality

Definition:
A competitive equilibrium is Pareto optimal if there is no way
to rearrange production OR
to reallocate goods so that someone is made better off without
making someone else worse off.

• The Pareto optimum is the allocation that a social

planner would choose.

• The social planner’s problem is to maximize consumer

welfare given the technology and the resource
constraints
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 Lecture 1 1-14

Pareto Optimality

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Key Properties of a Pareto

Optimum

• In this model, the competitive equilibrium and

the Pareto optimum are identical, as

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 Lecture 1 1-15

First and Second Welfare

Theorems

• These theorems apply to many macroeconomic

models
• First Welfare Theorem: Under certain conditions,
a competitive equilibrium is Pareto optimal.

• Second Welfare Theorem: Under certain

conditions, a Pareto optimum is a competitive
equilibrium.

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When might competitive equilibria

fail to be Pareto Optimal?

• Externalities
– Pollution (negative), fine architecture (positive)

• Distorting taxes
– Income tax, sales tax, property taxes are all
distortionary (e.g. MRS < MPN = MRT)

• Price setters
– Monopolistic firms are not price takers

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 Lecture 1 1-16

Now let’s discuss how the competitive equilibrium

changes in response to exogenous changes

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Effects of an Increase in G

• Essentially a pure income effect

• T increases

• C decreases, l decreases

• Y increases, w falls

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 Lecture 1 1-17

Equilibrium Effects of an Increase in

Government Spending (G)

PPF shifts down by the increase in G

Since we assume G=T, increase in T

reduces consumer disposable
income

Consumption and leisure fall,

employment and output rises
[N ↑= h- ᶩ↓]

Real wage rate (w)

decreases as a result of
increased employment.

Do increased Govt.
expenditures cause BC?
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GDP, Consumption, and

Government Expenditures

The model correctly

predicts that a large
increase in G leads to
an increase in output
and a decrease in
consumption

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-18

Effects of an Increase in z
(or an increase in K)

• PPF shifts out, and becomes steeper – income

and substitution effects are involved.

• C increases, l may increase or decrease, Y

increases, w increases

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Increase in Total Factor

Productivity

Increase in z
 increase in MPN
 increase in w
 Income effect
 Consumption, leisure increase
 Substitution effect
 Substitute away from leisure

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 Lecture 1 1-19

Effects of an Increase in Total

Factor Productivity

• An increase in z leads to an
increase in output and
consumption.
• Labor may increase or
decrease depending on the
size of substitution vs.
income effects
• In this case, employment
remains same at l1
• BUT, it may increase or
decrease depending on the
size of SE and IE.
• Consistent with LR effects
of an increase in Z….US
data after WW2

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Effects of an Increase in Total

Factor Productivity

• Income & Substitution

Effect:
• PPF2 is obtained after an
increase in Z.
• PPF3 is obtained after
taking out the increased
C...thus shift is parallel and
downward.
• AD is the substitution effect
(-ve)
• DB is the income effect
• Employment effect of an
increase in Z depends
upon the dominance of
substitution or income
effects

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 Lecture 1 1-20

Deviations from Trend in Real

GDP and the Solow Residual

The model correctly

predicts that an increase
in z leads to an increase
in output and
consumption.

It can also be consistent

with procyclical labor and
real wages if the
subsitution effect is
greater than the income
effect of real wages.

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Any questions?

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-21

Competitive equilibrium

Definition: A competitive equilibrium is a set of

(C; Ns;Nd; T; Y; w) such that given (G; z; K):

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Competitive equilibrium

Definition: A competitive equilibrium is a set of

(C; Ns;Nd; T; Y; w) such that given (G; z; K):

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 Lecture 1 1-22

Characterizing the competitive

equilibrium

• To characterize the competitive equilibrium, note

that from the consumer’s problem we get:

• From the firm’s problem we get

• and finally, we need the market clearing

condition, plus the government budget constraint:

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Characterizing the competitive

equilibrium

• From Eqbm.
• Substituting in above equations

• Substituting in consumer’s equation

• Substituting the definition of π from the

firm’s problem into BC along with G=T

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 Lecture 1 1-23

Characterizing the competitive

equilibrium

• Hence, our competitive equilibrium can be

uniquely characterized by the following
equations:

• Above two eqs. form a system of two eqs. in

two variables (C and ℓ);
• Hence, we can solve them together and obtain
the equilibrium values (C∗, ℓ∗).
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Characterizing the competitive

equilibrium

• In addition, the equilibrium wage rate can be

obtained from

• and aggregate output is given by

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 Lecture 1 1-24

Characterizing the competitive

equilibrium
/ /
Example-1: Let , , h=14,
/ /
, Z=1, K=1225, G=0.
• We want to find the competitive equilibrium.
Note first the production function is given by

• With this, we can calculate eqbm. conditions

as:

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Characterizing the competitive

equilibrium
/ /
Example-1: Let , , h=14,
/ /
, Z=1, K=1225, G=0.

• Considering N = h − ℓ = 14 − ℓ, we can equate

above eqs. as:

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 Lecture 1 1-25

Characterizing the competitive

equilibrium
/ /
Example-1: Let , , h=14,
/ /
, Z=1, K=1225, G=0.

• so that ℓ∗ = 28/3 = 9.33.

• Further, N∗ = 14 − ℓ∗ = 14 − 28/3 = 14/3 = 4.67,
• C∗ = 35N1/2 = 35(14/3)1/2 = 75.61 and w∗ = 17.5N−1/2
= 17.5(14/3)−1/2 = 8.1.
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Characterizing the competitive

equilibrium
/ /
Example-1: Let , , h=14,
/ /
, Z=1, K=1225, G=0.
• so that ℓ∗ = 28/3 = 9.33.
• Further, N∗ = 14 − ℓ∗ = 14 − 28/3 = 14/3 = 4.67,
• C∗ = 35N1/2 = 35(14/3)1/2 = 75.61 and w∗ = 17.5N−1/2
= 17.5(14/3)−1/2 = 8.1.
• Since, G = 0, from the income-expenditure
identity it follows that Y = C, thus Y∗ = 75.61.
• Hence, ℓ∗ =9.33, N∗ = 4.67, C∗ = 75.61, w∗ = 8.1, Y∗ = 75.61

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 Lecture 1 1-26

Characterizing the competitive

equilibrium

• Example-2: Repeat Example-1 but now assume

that G = 10. Go as far as you can into obtaining the
competitive equilibrium allocation (C∗, ℓ∗, N∗, w∗, Y∗).

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The Pareto optimal equivalence

• Earlier, we have discussed the concept of a

social planner and showed the equivalence
between a competitive equilibrium allocation
and a Pareto optimal allocation.
• Now, we present the social planner’s problem
more formally.
• Recall that the social planner’s objective is to
maximize the representative consumer’s utility
subject to technology constraints. i.e.
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 Lecture 1 1-27

The Pareto optimal equivalence

• We can solve this problem by setting up a

Lagrangian.
• As we are assuming Inada conditions (which
rule out corner solutions), we can disregard the
non-negativity constraints.
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The Pareto optimal equivalence

• Using Lagrangian:
• Instead of forcing the planner to respect the
resource constraint, C = zF(K, h − ℓ) − G, we
let the planner choose consumption and leisure
freely but penalize the planner with λ > 0
when violating the constraint.
• The planner’s payoff, net of the penalty is
given by the following Lagrangian:
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 Lecture 1 1-28

The Pareto optimal equivalence

• Using Lagrangian:

• FOC

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The Pareto optimal equivalence

• Using Lagrangian:

• From fisrt two eqs.

•
• Combining this result with third equation will
constitute a solution to the planner’s problem.
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 Lecture 1 1-29

The Pareto optimal equivalence

• Using Lagrangian:
• Example-3: Assume the same conditions as in
/ /
Example 2.1 hold, i.e., let , ,
/ /
h=14, , Z=1, K=1225, G=0.
• We want to obtain a solution using the social
planner’s problem. Hence, we set up the
Lagrangian:

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The Pareto optimal equivalence

• Using Lagrangian:
• Example-3: Assume the same conditions as in
/ /
Example 2.1 hold, i.e., let , ,
/ /
h=14, , Z=1, K=1225, G=0.
• FOC

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 Lecture 1 1-30

The Pareto optimal equivalence

• Using Lagrangian:
• Example-3:

• From the first two equations we get:

• Substituting in the third equation:

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The Pareto optimal equivalence

• Using Lagrangian:
• Example-3:

• Substituting in the third equation:

• We get

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 Lecture 1 1-31

The Pareto optimal equivalence

• Using Lagrangian:
• Example-3:
• and thus ℓ∗ = 28/3 = 9.33, the same as in
Example 1.
• Also check that C∗ = 75.61.

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Thanks

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017