Microeconomics II General Equilibrium Compiled by: Mesfin A.

CHAPTER SIX

GENERAL EQUILIBRIUM ANALYSIS

1. Introduction

So far our analysis of markets is partial equilibrium analysis. A partial equilibrium analysis studies the
determination of price and output in a single market, taking as given the prices in all other markets.
When determining the equilibrium prices and quantities in a market, we presumed that the activity in
that market had little or no effect on other markets. Often a partial equilibrium analysis of this sort is
sufficient to understand market behavior. However, market interrelationships can be important. In this
chapter, we introduce general equilibrium analysis. Unlike partial equilibrium analysis, general
equilibrium analysis determines the prices and quantities in all markets simultaneously, and it explicitly
takes feedback effects into account. A feedback effect is a price or quantity adjustment in one market
caused by price and quantity adjustments in related markets

General Equilibrium Analysis is the study of how price and output are determined in more than one
market at the same time. However, in practice, a complete general equilibrium analysis, which evaluates
the effects of a change in one market on all other markets, is not feasible. Instead, we confine ourselves
to two or three markets that are closely related. For example, when looking at a tax on oil, we might
also look at markets for natural gas, coal, and electricity. We will look at how General Equilibrium is
attained in two related markets first and in many related markets at last.

2. General Equilibrium Analysis: Two Markets Case

To see how the two types of analysis differ, let’s consider a simple example with two markets: coffee
and tea, as illustrated in Figure 6.1. General equilibrium analysis is applicable only if something links
these two markets. In this example, we will assume that consumers view coffee and tea as substitute
goods. Thus, an increase or decrease in the price of one good (holding the price of the other good fixed)
will cause a corresponding increase or decrease in the demand for the other good. (For example, an
increase in the price of coffee—holding the price of tea fixed—will cause an increase in the demand for
tea.)

Suppose that both markets are initially in equilibrium. The equilibrium price of coffee is $0.93 per
pound, where the demand curve for coffee DC intersects the supply curve for coffee SC. The equilibrium
price of tea is $0.63 per pound, where the demand curve for tea DT intersects the supply curve for tea ST.

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Panel (a) of figure 6.1 shows supply and demand in the market for coffee, while panel (b) shows supply
and demand in the market for tea.

Figure 6.1: Supply and Demand in Coffee and Tea Markets

Now imagine that a bad weather condition (frost) destroys a significant portion of the coffee crop. As a
result, the coffee supply curve shifts leftward, from SC to S’C. The initial impact is to increase the price of
coffee from $0.93 to $1.50 per pound. But because coffee and tea are substitutes, the increase in the
price of coffee increases the demand for tea. This shifts the demand curve for tea to the right. As a
result, the equilibrium price of tea goes up. But things don’t stop here. Because coffee and tea are
substitutes, the increase in the price of tea increases the demand for coffee, which shifts the demand
curve for coffee to the right, which drives the price of coffee up some more. This in turn increases the
demand for tea, shifting the demand curve for tea even further to the right. When all of these effects
have played out, the demand curve for tea has shifted from DT to driving up the price of tea from $0.63
to $0.79 per pound. The demand curve for coffee is now and the equilibrium price is $1.59.

We have just gone through a simple general equilibrium analysis. This analysis is significant for two
reasons. First, we see that events in the coffee market cannot necessarily be viewed in isolation. The
decrease in coffee supply had a significant impact on the price of tea. Second, because coffee and tea
are substitutes, an exogenous event in the coffee market, for example, bad weather, that tends to
increase the price of coffee, will also tend to increase the price of tea; similarly, an exogenous event that
tends to decrease the price of coffee will also tend to decrease the price of tea. This tells us that the
prices of substitute goods will tend to be positively correlated. Let’s now look at a numerical example.

Numerical Example: The following table shows the equations of some of the demand and supply curves
depicted in the previous figure. Using the information provided in the table we will attempt to solve the
subsequent problems.

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Initial demand curve Initial Supply Curve Supply Curve after

Coffee

Tea

Problems:
a) What are the general equilibrium prices of coffee and tea initially?
b) What are the general equilibrium prices after a frost damages the coffee crop?
Solutions:
General equilibrium in the two markets occurs at prices at which supply equals demand in both markets
simultaneously.

a) Initially, general equilibrium occurs when and Using the equations in the
table above, we can rewrite these equilibrium conditions as:
120 - 50PC + 40PT = 80 + 20PC
80 - 75PT + 20PC = 45 + 10PT
This is a system of two equations in two unknowns, PC and PT. Solving these equations
simultaneously gives us: PC=$0.93 and PT = $0.63. These are the prices at the initial equilibrium.
b) After the frost, the equilibrium conditions are and . Again using the
equations in the given table, we can rewrite these equilibrium conditions as:
120 - 50PC + 40PT = 40 + 20PC
80 - 75PT + 20PC = 45 + 10PT
Again, this is a system of two equations in the two unknown prices. Solving this system gives us
PC = $1.59 and PT = $0.79. These are the prices at the equilibrium after the frost.
Exercise: Suppose that the demand curve for new automobiles is given by:
Where QA and PA are the quantity (millions of vehicles) and average price (thousands of dollars per
vehicle), respectively, of automobiles in the United States, and PG is the price of gasoline (dollars per
gallon). The supply of automobiles is given by: . Suppose that the demand and supply curves
for gasoline are: and
a) Find the equilibrium prices of gasoline and automobiles.

b) Do the demand schedules indicate that automobiles and gasoline are substitute goods,
complementary goods, or independent goods in use? How do you know?

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3. General Equilibrium: Four Markets Case

Let’s consider an economy consisting of two types of households, white-collar households and blue-
collar households. Each type of household purchases two goods, energy (e.g., electricity, heating fuel,
motor fuel) and food. And each of these goods is produced with two input services, labor and capital.
Figure 6.2 outlines the interactions between households and business firms in this economy.

Figure 6.2: Interactions

between firms and households
in a general equilibrium

The interactions are as follows:

Households: In their role as consumers of finished goods, households purchase the energy and food
supplied by firms. Additionally, households supply labor as employees in business firms that need their
services and supply capital by renting the land or the physical assets that they own to business firms or
by selling their intellectual capital to these firms

Firms: In their role as consumers of input services, firms purchase the services of labor and capital
supplied by households. Additionally, they supply finished goods.

As the figure illustrates, this economy thus has four major components:

 Household demand for energy and food

 Firm demand for labor and capital
 Firm supply of energy and food and
 Household supply of labor and capital

In the next section we will discuss about the determination of demand and supply curves for these four
components.

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3.1 The Demand Curves for Energy and Food

The Demand Curves for Energy and Food Come from Utility Maximization by Households. To derive the
demand curves for energy and food, we need to consider the utility maximization problems of individual
households. Let’s suppose that the quantity of energy a household purchases is denoted by x and the
quantity of food a household purchases by y. The label W denotes white-collar households, and B
denotes blue-collar households. A white-collar household has a utility function UW(x, y), and a blue-collar
household has a utility function UB (x, y).

Each household derives income from supplying labor and capital inputs to business firms. We’ll assume
that each household has a fixed endowment of labor and capital. Let’s suppose that Blue-collar
households are the primary suppliers of labor in our economy, and that White-collar households are the
primary suppliers of capital. The aggregate supply of labor is greater than the aggregate supply of
capital. This could be because there are more blue-collar households than white-collar households or
the amount of labor supplied by each blue-collar household is greater than the amount of capital
supplied by each white-collar household. If the price received for a unit of labor is w and the price
received for a unit of capital is r, then the income of each type of household, IW and IB, will depend on w
and r.
Suppose, now, that the price of energy is Px per unit, while the price of food is Py. When a household
maximizes its utility, it takes these prices and input prices as fixed. The utility-maximization problems for
households are thus:

Where, IW (w, r) and IB (w, r) signify that household incomes depend on the returns that
households receive from selling their labor and their capital and that these returns depend on
the prices of labor and capital, w and r.
The solutions to these utility-maximization problems yield the optimality conditions that you have
learned in Consumer Behavior chapter of Microeconomics I:

and

That is, each household maximizes utility by equating its marginal rate of substitution of x for y with the
ratio of the price of x to the price of y. These optimality conditions, along with the budget constraints,
can be solved for the demand curves for each household, which depend on the prices and household
income.
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Figure 6.3 shows the aggregate demand curves for energy and food for each type of household. For
example, in panel (a): is the aggregate demand for energy by all white-collar households, while
is the demand for energy by all blue-collar households. We find these demand curves by summing the
demand curves of all the individual households. The overall market demand curve for energy, , is the
horizontal sum of and . The same principles hold in the food market as well.

Figure 6.3: Demand Curves for Food and Energy

The position of these demand curves will, in general, depend on the:
• Income levels of households,

• The price of good y, and

• The particular tastes of each household as embodied by its utility function. That is, changes in
household income or in the price of good y will cause and to shift.

To summarize, the demand curves for energy and food in our simple economy come from utility
maximization by households. Summing the energy and food demand curves of all individual households
generates the market demand curves for each commodity.

3.2 The Demand Curves for Labor and Capital

The Demand Curves for Labor and Capital Come from Cost Minimization by Firms. To derive the demand
curves for labor and capital in the economy, we need to consider the cost-minimization problems (i.e.,
the input choice decisions) faced by individual firms. We assume that some firms produce energy while
others produce food; all energy producing firms are identical; all food-producing firms are identical, and
each market is perfectly competitive.

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Each individual energy producer has a production function:

,
Where, l and k denote the amount of labor and capital used by an individual producer
(uppercase L and K will refer to the aggregate amounts of labor and capital in the market).

Furthermore, we also assume that this production function is characterized by constant returns to scale.
This means that doubling the amount of labor and capital exactly doubles the quantity of energy a
typical producer can make).

For an energy producer that produces x units of energy, the cost-minimization problem is:

Similarly, each food producer has the following production function which is also characterized by
constant returns to scale:

The cost-minimization problem for a food producer is:

The solutions to these cost-minimization problems yield the optimality conditions that you learned in
the Theory of Production chapter of microeconomics I:

That is, each firm chooses its cost-minimizing input combination by equating its marginal rate of
technical substitution of labor for capital, , to the ratio of the price of labor to the price of

capital.

These optimality conditions, along with the production constraints for energy and food, can be solved to
determine the demand curves for labor and capital for individual energy and food producers. These
demand curves depend on the input prices w and r and on the total amount of output produced by a
firm. Figure 6.4 shows the aggregate demand curves for labor and capital for each industry, energy and
food.

We find these demand curves by summing the demand curves of all the individual firms in each industry.
For example, in panel (a) of figure 6.4, is the aggregate demand for labor by firms in the energy
industry, While is the aggregate demand for labor by firms in the food industry. The overall market
demand curve for labor, DL, is the horizontal sum of and .

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Figure 6.4: Demand

Curves for labor and
Capital

The position of these demand curves depends on the total amount of output produced in each industry,
the price of the other input, and the nature of the technology embodied in the production functions. For
example, an increase in the amount of output in the energy industry would increase the demand for
labor in that industry and would thus shift (and thus DL) rightward. By contrast, a decrease in the
price of capital, r, would encourage firms to substitute capital for labor and would shift both and
(and thus DL) to the left.

To summarize, the demand curves for labor and capital in each industry in our simple economy come
from cost minimization by individual firms. Summing the labor and capital demand curves of all
individual firms in both industries generates the market demand curves for both inputs.

3.3 The Supply Curves for Energy and Food

In production (cost-minimization) theory, you have seen that each firm’s decision yields a total cost
curve and a marginal cost curve. Because each firm has a production function characterized by constant
returns to scale, the marginal cost curve for an energy producer is a constant, , and the marginal
cost curve for a food producer is also a constant, , as shown below.
Figure 6.5: Supply Curves for Energy and Food

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The height of each curve depends on the input prices w and r. Because the production function for food
differs from the production function for energy, the curves may depend on the input prices in different
ways. For example, if food production is labor-intensive (if it involves a high ratio of labor to capital),
then might be more sensitive to the price of labor than is. Furthermore, since the energy and
food industries are assumed to be perfectly competitive, firms in these industries act as price takers.

Because a firm in the energy industry faces a constant marginal cost, energy producers are willing to
supply any positive amount of output at a price Px equal to marginal cost MCx. This means that the
industry supply curve for energy is perfectly elastic at that price. Thus, the industry supply curve for
energy Sx coincides with the marginal cost curve for energy production MCx, as shown in Figure 6.5(a).
Similarly, the industry supply curve for food Sy coincides with the marginal cost curve for food
production MCy, as shown in Figure 6.5(b).

Because the supply curves coincide with the marginal cost curves, the equilibrium prices must equal the
marginal costs:
and
Since we have constant returns to scale, marginal cost and average cost are equal, so at these prices
each producer earns zero profit. At this point, we still cannot say what these equilibrium prices are:
Since the marginal costs in each market, and , depend on the input prices w and r. And these
input prices, in turn, depend on supply and demand in the input markets. Thus, each of the markets in
this economy is interdependent.

To summarize, the supply curves in each industry in our economy arise from profit maximization by
firms. Because production in both the energy and food industries is characterized by constant returns to
scale, the supply curves in each industry are horizontal lines corresponding to the industry’s marginal
cost of production.

3.4 The Supply Curves for Labor and Capital

The final components of our economy are the supply curves for labor and capital. Labor and capital in
this economy are provided by households. As already mentioned, each household can offer a fixed
supply of labor and capital. Assume that there is no opportunity cost to offering this supply of labor or
capital. This simplifies the presentation without affecting the main conclusions. Profit maximization by
individual households thus implies that a household will supply its labor and capital as long as those
services can fetch a positive price in the marketplace.

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Also assume that households are indifferent between selling their labor to the energy or food industries
as long as the wage w that they get from either industry is the same. Similarly, households will supply
capital to either industry as long as the price of capital services r is the same in each industry.

Figure 6.6 shows the implications of the above assumptions.

Figure 6.6: Supply

Curves for Labor and
Capital

The market supply curve for labor, SL, is a vertical line corresponding to the overall supply of labor,
which is predominantly provided by blue-collar households. Similarly, the market supply curve for
capital, SK, is a vertical line corresponding to the overall supply of capital, which predominantly comes
from white-collar households.

To summarize, the supply curves for labor and capital in our economy come from profit maximization by
households. Because we have assumed that each household has a fixed supply of labor and capital that
it can offer, these supply curves will be vertical lines.

3.5 The General Equilibrium in our Simple Economy

In our simple economy, four prices are simultaneously determined in a general equilibrium: a price Px
for energy, a price Py for food, a price w for labor services, and a price r for capital services. These latter
two prices, in turn, determine household income, which is derived from their sales of labor and capital
services to firms. The four prices in our economy are interdependent. For example, the price of energy
is determined by the marginal cost of energy, but the marginal cost of energy depends on the prices of
labor and capital. These prices are pinned down by market-clearing conditions in each of our four
markets:

Household demand for energy = Industry supply of energy

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Household demand for food = Industry supply of food

Industry demand for labor = Household supply of labor

Industry demand for capital = Household supply of capital

Figure 6.7 illustrates our simple economy when it is in a general equilibrium—that is, when supply
equals demand in all four markets simultaneously.
Figure 6.7: General Equilibrium

Panels (a) and (b) show that when the prices of labor and capital are $0.48 and $1.00, respectively, the
marginal costs of energy and food production are $0.79 and $0.70, respectively. The equilibrium input
prices thus determine the height of the industry supply curves, Sx and Sy. These input prices also
determine household incomes, IW(w, r) and IB(w, r), which determines the positions of the demand
curves for energy and food (Dx and Dy). The intersection of demand and supply in the energy and food
markets determines the total output in these industries: 6202 units in the energy industry and 4943
units in the food industry.

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The outputs 6202 and 4943, in turn, determine the positions of the labor and capital demand curves in
panels (c) and (d). And it is the intersection of these input demand curves with the input supply curves,
SL and SK, that determines the equilibrium prices of labor and capital ($0.48 and $1.00).

This explanation of Figure 6.7 began and ended with the prices of labor and capital. Figure 6.7 illustrates
the same cycle of interdependence at a general equilibrium that is pictured in figure 6.2.

Thus, to summarize, we have seen the following:

• The equilibrium input prices in the labor and capital markets determine the positions of the
supply and demand curves in the energy and food markets.

• These supply and demand curves determine the equilibrium prices and quantities in the energy
and food markets.

• The equilibrium quantities of energy and food determine the positions of the demand curves in
the labor and capital markets, and the point where these curves cross the supply curves of labor
and capital determines the equilibrium prices of labor and capital.

From this analysis we can see that, even in our simple economy, we cannot analyze events in one
market without taking into account how those events affect the other markets. The general equilibrium
analysis in Figure 6.7 highlights the relationship between the scarcity of factors of production, the
relative prices of those factors, and the distribution of income in the economy.

In the economy in Figure 6.7, the aggregate supply of capital is much less than the aggregate supply of
labor (i.e., SK is closer to its vertical axis than is SL). As a result, the price of capital services exceeds the
price of labor (i.e., capital services trade at a price premium compared to labor services). This, in turn,
allows the providers of capital inputs—the white-collar households in our economy—to earn higher
incomes than the providers of labor inputs—primarily blue-collar households.

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