Summary

1. In this chapter, we’ve stepped outside our normal approach of looking at markets in isolation and have instead specifically contemplated how markets are interrelated. This recognition of markets’ interrelatedness and explicit accounting for its effects is called general equilibrium analysis. It focuses on what is necessary for all markets to be in equilibrium simultaneously and what happens when they are. [Section 15.1]

2. General equilibrium analysis allows us to consider fundamental questions about whether market outcomes are desirable. Social welfare functions (functions that summarize the utility levels of every individual in society) are one tool that economists use to make such judgments, but they have several drawbacks. As a result, economists often instead focus on Pareto efficiency as a criterion. A market is Pareto-efficient if resources cannot be reallocated without making at least one person worse off. Individual markets must have three types of efficiencies to create economy-wide efficiencies: exchange efficiency, input efficiency, and output efficiency. [Section 15.2]

3. Edgeworth boxes display a simple model economy with two consumers and two goods, and allow for an analysis of exchange efficiency. A Pareto-efficient allocation occurs at the tangency point between two consumers’ indifference curves. The consumption contract curve represents all such Pareto-efficient allocations between any two individuals’ consumption of two goods. [Section 15.3]

4. Input efficiency considers the production side of the economy, and occurs where two firms’ isoquants are tangent, or where the firms’ marginal rates of technical substitution are equal. The production contract curve maps out these efficient allocations across two producers, while the production possibilities frontier (PPF) looks at the possible output combinations of two goods given efficient production. [Section 15.4]

5. Output efficiency links the concepts of exchange and input efficiency, and exists when the tradeoffs on the consumption and production side of the economy are equal. The tradeoff between the production of any two goods is the marginal rate of transformation (MRT), equal to the slope of the production possibilities frontier. When the marginal rate of transformation equals the marginal rate of substitution (the consumption tradeoff), a market has achieved output efficiency. [Section 15.5]

6. Under certain conditions, markets can lead to efficiency without any interventions being necessary. The First Welfare Theorem shows how markets can result in Pareto-efficient distributions of goods. The Second Welfare Theorem states that every Pareto-efficient allocation is a general equilibrium outcome for some initial allocation. While the conditions that lead to market efficiency may not always hold in the real world, the market efficiency result is nevertheless a powerful finding that strengthens our understanding of both market efficiencies and market failures. [Section 15.6]