Dominick Salvatore Schaums Outline of Microeconomics, 4th edition Schaums Outline Series 2006

CHAPTER 14
General Equilibrium
and Welfare Economics
General Equilibrium
14.1 PARTIAL AND GENERAL EQUILIBRIUM ANALYSIS
In Section 1.6, we defined partial equilibrium as the study of the behavior of individual decision-making units
and of the workings of individual markets, viewed in isolation. In Chapters 2 through 13 of this book, we have dealt
with partial equilibrium analysis. General equilibrium analysis, on the other hand, studies the behavior of all
individual decision-making units and of all individual markets simultaneously (see Problems 14.1 to 14.4).
In this chapter, we look at a simple perfectly competitive economy composed of two individuals (A and B),
two commodities (X and Y), and two factors (L and K) and present a graphical treatment of general equilibrium
of exchange only, of production only, and then of production and exchange simultaneously. In the second part
of the chapter we consider the welfare implications of this simple general equilibrium model.
14.2 GENERAL EQUILIBRIUM OF EXCHANGE
General equilibrium of exchange in the very simple economy of two individuals, two commodities, and no
production was already presented in Section 4.8. There we concluded that the two individuals reached equilibrium
in the exchange of the two commodities when the marginal rate of substitution (MRS) in consumption for
the two commodities was the same for both individuals. Thus, the following example is in the way of a review
(of Section 4.8 and Problems 4.24 to 4.27).
EXAMPLE 1. Fig. 14-1 refers to a very simple economy of two individuals (A and B), two commodities (X and Y), and
no production. Every point in (or on) the box represents a particular distribution between individuals A and B of the 12X and
12Y available in the economy. Three of A’s indifference curves (with origin at O A ) are A 1 ,A 2 , and A 3 ; B’s indifference
curves (with origin at O B ) are B 1 ,B 2 , and B 3 . If the initial distribution of the 12X and 12Y between individuals A and B
is given by point H in the figure, the slopes of A 1 and B 1 at point H differ (i.e., the MRS xy for A is not equal to the
MRS xy for B) and there is a basis for exchange. Mutually advantageous exchange comes to an end at a point such as D
(on A 2 and B 2 ) in the figure, where one of A’s indifference curves is tangent to one of B’s indifference curves. At that
point, the MRS xy for A equals the MRS xy for B. Joining such points of tangency, we define the consumption contract
curve O A CDEO B in the figure (for a more detailed discussion, see Problems 4.24 to 4.27). This simple exchange
Copyright © 2006, 1992, 1983, 1974 by The McGraw-Hill Companies, Inc. Click here for terms of use.
312