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Slide 1
Slide 2
Examples of GE models
We will mostly work with simple examples
of general equilibrium models.
You already know the exchange economy in
the Edgeworth box.
We will talk about the so-called Robinson
Crusoe economy: One input, one consumer.
And the 2x2 production model with two
consumers: 2 goods, 2 inputs, 2 consumers
Slide 3
Production Efficiency
Robinson can spend an hour of leisure or he can
spend an hour gathering 3 coconuts.
Since he has 12 hours available per day, he could
spend 12 hours of leisure and zero hours of
gathering coconuts. This is production efficient,
because he spends every hour available to him to
produce the maximum amount of leisure.
Similarly he could spend all his time gathering
coconuts and then ending up with 36 coconuts per
day. Again this would be production efficient.
Slide 6
Production
Possibility Set
1/3
36 coconuts
The slope of the PPF is also called the marginal rate of transformation
(MRT leisure for coconut): in order to produce one additional coconut Crusoe
Slide 8
sacrifices 1/3 hr of leisure.
leisure
Utility for
Robinson
increases
Production
possibility set
in Crusoes
problem plays a
role similar to
the budget set
in the
consumers
problem.
1/3
12
36 coconuts
Slide 9
Pareto Efficiency
1
maxU(c,l) s.t. l = 12 c
3
Intertiorsolution :
(1) MRSleisure for coconut = MRTleisure for coconut
==>
l
1
=
2c 3
1
(2) Need to be on PPF : l = 12 c
3
1
12 c
3 1
=
2c
3
Slide 10
Slide 11
max l f 2l1/f 2 + 12 l f
1/ 2
Interior solution :
1
=0
l f = 12 c 2 , =
2c
1/ 2
f
2 12 l f
c = 12 l f
1/ 2
1/ 2
12 c
df
dc
PPF : f (c) = 2 12 c 2
Slide 14
Slide 16
Concave PPF
Slide 18
Slide 19
Also need to
make sure
that we really
are on the
PPF, hence
fish is
expressed as
a function of
coconuts in
MRS.
Slide 20
10
Summing Up
We have looked at a very simple economy with
production.
We have learned how to find the PPF if there is
only one input.
We have learned how to find the Pareto efficient
interior allocation of goods if there is only one
consumer: (1) MRS = MRT and (2) need to be on
PPF.
In order to determine what is Pareto efficient we
need production efficiency. Production efficiency
is a necessary condition for Pareto efficiency. Slide 21
11
Slide 23
Consumption Efficiency
You already know consumption efficiency
from the exchange economy.
A distribution of goods is consumption
efficient if it is not possible to reallocate
these goods and make at least one person in
the economy better off without making
someone else worse off.
Slide 24
12
Production Efficiency
An allocation of inputs (K and L) is
production efficient if it is not possible to
reallocate these inputs and produce more of
at least one good in the economy without
decreasing the amount of some other good
that is produced.
Slide 25
13
Slide 27
Isoquants of Y
Amount of
capital devoted
to production of
good X
Good Y
Isoquants of X
Good X
labor
Amount of labor devoted
to production of good X
Slide 28
14
capital
A
Good X
labor
Point A is not
production efficient.
Slide 29
Good X
Good Y
labor
15
Production Efficiency
max f ( L ,K ) + ( f ( L L ,K K ) y )
L1 ,K1 ,
Interiorsolution :
f1
f
1 =0
L1
L 2
f1
f
1 =0
K1
K 2
y 2 = f 2 ( L L1,K K1 )
Slide 32
16
Slide 33
17
capital
X=12,
Y=28
Good X
Good Y
28
X=24,
Y=20
X=30,
Y=10
labor
PPF
20
10
12
24
30
Good X
Slide 36
18
Slide 37
19
Good Y
X,Y
PPF
Good X
Slide 39
PPF
X,Y
Person 2s highest
utility given X and
Y
Keep person 1 at Good X
this utility level.
Slide 40
20
X,Y
PPF
By shifting to yet
another point on the
PPF, we can again
increase person 2s
utility without making
person 1 worse off.
X,Y
Keep person 1 at
this utility level.
Good X
Slide 41
Keep person 1 at
this utility level.
Good X
Slide 42
21
s.t. u2 ( x 2 , y 2 ) = u2
s.t. x1 + x 2 = f x ( Lx ,K x )
s.t. y1 + y 2 = f y Ly ,K y
s.t. Lx + Ly = L
s.t. K x + K y = K
Slide 44
22
s.t. u2 ( x 2 , y 2 ) = u2
s.t. x1 + x 2 = x
s.t. y1 + y 2 = y ( x )
x1 ,y1 ,x,
Slide 45
Exercise
Suppose there are 2 consumers, Ara and Bahar,
and two goods, good X and good Y. Aras utility
function is given by UA=XY and Bahars utility
function is given by UB=X1/4Y3/4. Both goods are
produced with labor and capital and good Xs
production function is fX=(KXLX)1/2 while good
Ys production function is fY=(KYLY)1/2. Suppose
there are 8 units of labor and 8 units of capital in
this economy.
Slide 46
23
Exercise Contd
Suppose Ara receives one unit of good X.
How many units of good Y must Ara
receive and how many units of good X and
good Y must Bahar receive for the
allocation to be Pareto efficient?
Slide 47
Answer
Production efficiency: We have 8 units of labor
and eight units of capital. If for both goods the
capital labor ratio is equal to one, then KX/LX=1=
MPLX/MPKX and KY/LY=1= MPLY/MPKY so
MRTSX capital for labor = MRTSY capital for labor
Moreover PPF: Y= 8 X.
Slide 48
24
Answer Contd
Next we need to ensure that consumption
efficiency and product mix efficiency are satisfied.
For consumption efficiency
MRSAra Y for X = MRSBahar Y for X
We know that XB =X 1, YA + YB = 8-X
YA /XA=YB /3XB
Slide 49
Answer Contd
For product mix efficiency
MRS = MRT, YA /XA=YB /3XB = 1.
The allocation KX=LX=2.5, KY=LY=5.5,
XA=1 , XB=1.5 , YA=1, YB= 4.5 is Pareto
efficient.
We have shown that with this allocation of
resources and consumption goods all three
conditions of Pareto efficiency are satisfied.
Slide 50
25
Competitive Equilibrium
Now that we understand Pareto efficiency in
a general equilibrium model with
production, we want to find out if the
competitive equilibrium in this model is
Pareto efficient.
First discuss what happens in the
competitive equilibrium, then determine
whether its Pareto efficient.
Slide 51
Slide 52
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27
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Reading Suggestion
29
Assumptions in FFTW
30