CHAPTER FIVE

GENERAL EQUILIBRIUM ANALYSIS

5.1. PARTIAL VERSUS GENERAL EQUILIBRIUM ANALYSIS

Dear students, in the previous chapter we studied the behavior of individual decision making
units and individual markets in isolation. We examined how an individual maximizes satisfaction
subject to his or her income constraint, how a firm minimizes its costs of production and
maximizes profit under various market structures, and how the prices and employment of each
type of input is determined. We have shown how demand and supply in each market determine
the equilibrium price and quantity in that market independently of other markets. The model that
we have used has taught us that the prices and quantity in each such market is determined by the
supply and demand. Each market has been regarded as independent and self–contained units,
for practical purpose. In doing so, we have abstracted from all the interconnections that exist
between the market under study and the rest of the economy. The analyses that assume that
changes in prices can occur without causing significant changes in prices in other markets are
called Partial Equilibrium

However, the assumption may be in reality be seriously flawed. No market can adjust to changes
in it condition without causing changes in other market, and the change in the other market can
be substantial and significant. A change in any market has spillover effects on other markets and
the change in the other markets will, in turn, has repercussions or feedback effects on the original
market. For example, suppose demand for housing increases, supply remaining the same, at
some point of time in an economy. As a result of this (increase in housing demand) home rents
will go up and profitability of the housing industry increases which in turn increases the number
of firms in the industry whop are attracted by the increase in profits.

Furthermore, the demand for intermediate goods steel cements and bricks and construction labor
increases. The number of firms producing intermediate goods increases and their demand for
factor inputs such as land, labor and capital. If these factors are in short supply, factor payment

1
increases. Consequently, larger factor incomes flow to the households. When household income
increases, demand for other consumer goods and services increases and creates another chain of
action and reaction between household and firms in product and factor markets. The complexity
is further increased as change in relative prices of products and factors lead to substitution effects
and other effects. In this way the whole economic system functions in a complex manner. These
effects are studied by general equilibrium analysis.

General equilibrium analysis studies the interdependence or interconnections that exist among all
markets and prices in the economy and attempt to give a complete, explicit, and simultaneous
answer to the questions of what, how and for whom to produce.

A general equilibrium is, thus, defined as a state in which all economic units
optimize their respective objective function and all prices are simultaneously in
equilibrium, and all markets are cleared.

Both are very useful. Partial equilibrium analyses are perfectly adequate in the case in
which the effect on a change in the market condition in one market has little or no effect on
prices in other market. The studying the effect of small excise tax on the production of an
insignificant commodity may work perfectly well under the assumption that the price of all
other goods are fixed. Those prices might not change, and so it would not be worth the effort
to model feedbacks and interactions that are not at large; a partial equilibrium of sort
presented above would then be appropriate. On the other hand, studying the effects of the
large of excise tax on commodity whose purchases absorb significant proportion consumers
income could be inappropriate if it repercussions on other prices were not considered. In
this case, a general equilibrium analysis could be required to make certain that the feedbacks
and interaction did not seriously undermine the validity of the conclusions drawn from a
partial equilibrium approach.

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5.2. THE EXISTENCES OF GENERAL EQUILIBRIUM

The general equilibrium analysis, like partial equilibrium analysis, can be used to solve problems
of many kinds. It is based on the notion that general equilibrium for all the economic agent and
market can be reached. The general equilibrium is a state of in which the following conditions
hold:
1. Every consumer chooses his or her preferred market basket subjected to his or her budget
line.
2. Every consumer supplies whatever amount of inputs he or she chooses, given the
input and product prices that prevail.
3. Every firm maximizes its profit subjected to the constraints imposed by the
available technology , the demand for its product, and the supply of inputs
4. Long-run economics profits are zero for every firm.
5. The quantity demanded equals the quantity supplied at the prevailing prices in all
product and input market.

It is evident from the definition that a great many conditions must be satisfied simultaneously if
the equilibrium is to be achieved. These include equilibrium in
 exchange
 production
 Consumption… etc.
Given the above conditions for equilibrium; can we be sure that it can be achieved? If so, what
are these conditions?

The first and simplest general equilibrium model was introduced in 1874 by Leon Walras,
thought he was never able to prove the existence of a general equilibrium. In the Walrasian
system, all prices and quantities in all markets are determined simultaneously through their
interaction with one another (by the solution of the system of equations). Thus the first task in
establishing the existence of a general equilibrium is to describe the economy by means of a
system of equations in which the number of unknowns should be equal to the number of
equations. His system one of the equations has a redundant (not an independent) equation and

3
deprives the system of a solution since the number of independent equations is less than the
number of unknowns. Hence, in this model, the absolute level of prices cannot be determined.

To solve these problem general equilibrium theorists have adopted the device of choosing
arbitrarily the price of one commodity as a numeraire (or unit of account) and express all other
prices interims of the price of the numeraire. With this device each price is given relative to the
price of the numeraire. Even if there is equality of independent equations and unknowns there is
no guarantee that a general equilibrium solution exists.

In 1954 Arrow and Debreu provided a proof of the existence of a general equilibrium in perfectly
competitive markets, in which there are no indivisibilities and no increasing returns to scale. In
1971 Debreu and Hahn proved the existence of a general equilibrium for an economy with
limited increasing returns and monopolistic competition, without indivisibilities. There is no
proof so far that shows the existence of a general equilibrium in oligopoly and monopoly
markets.

Apart from the existence problem, two other problems are associated with equilibrium: the
problem of its stability and the problem of its uniqueness. That is related to the price and output
that make up the general equilibrium. Are the price and output that make up the general
equilibrium be unique? Or is there one set of prices and outputs that for which the quantity
supplied equals quantity demanded in all market? Clearly the answer is no. This is beyond the
scope of the course.

Thought it have all these drawbacks, it is important to know the general equilibrium can be
achieved under perfectly competitive market. Because the circumstances under perfectly
competitive economy has a variety of desirable characteristics as the market is a benchmark for
comparison with other market. Hence, we look at general equilibrium form under competitive
market from those major activities: exchange, production, consumption and their
interdependences.

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5.3. SIMPLE MODELS OF GENERAL EQUILIBRIUM

5.3.1. General equilibrium in exchange: Two-Commodities-Two Consumer

Case

To illustrate the concept of general equilibrium in simple model we make assumptions about the
economic agent and the market the economy. Suppose that our simplified economy have only
two individuals with certain level of resource endowments isolated from the rest of the world.
More specifically we create a world where;
 There are two commodities “X: and “Y”; and these commodities are available in a fixed
amount.
 There are two individuals say, A and B, each possess a given amount of both resources as
their initial endowment.
 The preference and taste of agents for the two products differs. All assumption for the
rational individual we discussed under consumer preference theory. For instances, their
goal is maximization of utility, non-satiation, usual U-shaped indifference curve...etc

 Suppose the total amount of goods X and Y are represented by x and y respectively.
Both individuals own some of X and some of Y as their initial endowment. Thus, x = x A

+ x B and y = y A+ y B.

This can be presented graphically by labeling the vertical axis the level of output Y
consumed by each individual, whereas the horizontal axis the level output X consumed by
each individual in such a way that each of them are on their respective indifference curve IA
and IB . At any point in the diagram indicate a certain allocation of the commodity for
consumption.

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 Y Y

𝑦𝐴
IA(x, y)

𝑦𝐵
IB(x,y)

0A 𝑥𝐴 X 0B 𝑥𝐵 X

Figure 5.1: Initial endowment of individual A and B

Suppose further that the two agents interact in such a way that each maximizes its satisfaction. In
other word they voluntary participate in trade assuming both individuals gain from the exchange.
There is a convenient graphical tool known as the Edgeworth Box1 that can be used to analyze
the exchange of two commodities between two people. Simple models can make productive use
of what economists have dubbed the “Edgeworth box diagram”. The box allows us to depict the
endowment and preferences of two individual in a convenient diagram, which can be used to
study the various trading process.

An Edgeworth box diagram shows the interaction between two economic activities when the
total quantities of commodities consumed or inputs are fixed. The length and width of an
Edgeworth box diagram represent the quantities of two commodities that are available to both
consumers. And each point in the box represents an allocation between two consumers of the
total quantities of the two goods supplied. To show their interaction we put together these two
graphs by making certain rearrangement on the presentations. This can be done if we rotate Bs
graph by 1800 it appears to be upside- dawn and connect it with that of A. The Edgeworth Box
diagram is formed by bringing the two graphs together as shown below.

The allocation can be read from the box. Point P for example, indicates that A’s consumes O AXA
unit of X and OAYA unit of Y. But B’s consumption is measured from its vertex at the top upper

1
The Edgeworth box is a convenient graphical tool that can be used to analyze the exchange of two goods between
two people. It is named in honor of Francis Ysidro Edgeworth (1845-1926), an English economist who was one of
the first to use this analytical tool.

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right corner of the box diagram OB. The quantity of X consumed by B is measured by the
horizontal distance to the left of a second origin OB. That is, OBXB unit of X. Vertical distances
downward from the same origin measures the quantity of Y consumed by B – OBYB unit of Y.

Every point in the box therefore indicates a certain allocation of food (X) and medicine (Y) to A
and B. The dimensions of the box provide even more information- they define the total quantity
available for consumption for the two agents. So point P indicate that A consumes OAXA of X,
thus the rest will be consumed by B. That is X-OAXA= OBXB. The same analogy will hold for Y.

As we have seen in module one the under consumer preference theory, the economic agents
preferences for good differs depending on the endowment and other factors. Hence, agent may
have series of indifference curves. Suppose that individual A’s preferences for good X and good
Y are shown by indifference curves, IA, IIA, IIIA. On the other hand, individual B’s indifference
curves are shown by IB, IIB and IIIB in the following figure.

B
XB 0B
Y

B
P
YA YB

XA X
0A A

Figure: 5.2. Edgeworth Box of both individuals in one.

If we rotate individual B’s indifference curve by 1800 we get the following Figure 5.3. We can
now use the Edgeworth box construction to anchor a discussion of the process of exchange. To

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that end, consider our simple economy of two consumers (A and B), and only two commodities
(X and Y). There is no production. The only economic problem is the allocation of a given
amount of X and Y between the two consumers. Not much of an economy, to be sure, but one
with enough richness to assist in exploring the process of exchange. We need first to establish
individual endowments of X and Y. Suppose that point P represents the initial distribution
(Endowment) of commodity X and Y by individual A and B. Individual A has x A units of X and
y A unit of Y. Similarly individual B has 𝑥𝑏 units of X and 𝑦𝑏 unit of Y. What sort of trading
might take place (if the two men were free to trade with one another)? What can be said about
the efficient allocation of the commodities between the two men?

IIIA
D
YA IIA
IIIB
IA
IIB
D
YB
IB

0A XA OB XB
(a) (b)

Figure 5.3: Individual A’s (a) and B’s (b) preference for good X and Y

To find out, we must insert indifference curves to our analysis and select the combination that
maximize their satisfaction. Given the indifference curve of A, A’s well-being is increased by
moving towards the origin of B. Three of A’s indifference curves are drawn there: IA, IIA, and
IIIA. Of the three, the highest indifference curve is IIIA; the lowest is IA. Similarly, B’s wellbeing
will be increased by moving towards the origin of A. Three of B’s indifference curves are also
drawn there: IB, IIB and IIIB. The highest indifference curve of the three is IIIB; the lowest is IB.
A’s satisfaction would generally improve if we moved his allocation from points close to his
origin (point OA) to points closer to the upper-right corner of the box. Conversely, B’s

8
 satisfaction would generally improve if we moved his allocation from points close to the upper-
right corner of the box to points closer to the origin OA.

Given the initial allocation of food and medicine, we find that A is on indifferences curve IIA and
B is on indifference curve IIB at point P. At this point, A’s marginal rate of substitution of X for
Y is much higher than B’s. How do we know that? Figure 5.4 shows that the slope of IIA at
point P is larger than the slope of IIB. If both men were free to trade, therefore, A would be
interested in trading some Y to B in exchange for some X. The exact point to which they might
move cannot be predicted. If A were the more astute bargainer, then he might get B to accept the
allocation at point E4 where B would be no better off than before (since he would still be on in
differences curve IIB). If, on the other hand, B were better negotiator, then he might get A to
accept the allocation at point E2 where A would be no better off than before (since he would still
be on in differences curve IIA). If neither B nor A were so skilled in negotiating that they could
not extract all of the “surplus value” from the trade, then (as would be most likely), the ultimate
point of equilibrium would lie somewhere between E2 and E4.

XB
B

IB OB

YB
IIB
A P B
IIIB E5
E4 VA

IVB E3
IVA
E2 IIIA

VB E1 IIA

IA
YA

OA
A
XA

Figure 5.4: Simultaneous equilibrium of both individuals

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And what would characterize this equilibrium? Compared to the absence of any trades that (1)
would be acceptable to both B and A, and (2) would improve the welfare of one or both of them.
That is to say, the marginal rates of substitution of food for medicine would have to be the same
for both i.e., their indifference curves would have to be tangent to one another at the point of
equilibrium.

5.3.1.1. Pareto Efficiency

The notion of equilibrium can be extended. If the object were to make the men as well-off
possible (given their unfortunate circumstance to begin with), then an efficient allocation of the
commodities would be one in which the marginal rate of substitution of X for Y were the same
for both men. As we just argued from the other side, if that were not the case, one man could be
made better off without making the other worse off. Tangency of indifference curves is therefore
the key to characterizing equilibrium, but it does not yield a unique solution to the trading
question. Indeed, there is a locus of points at which the two men’s indifference curves are
tangent; this locus is called the contract curve. It is shown in Figure 5.4 and it includes all of the
points, like E1, E2, E3, E4 and E5, for which the marginal rates of substitution are equal for both
consumers. The contract cure is a set of efficient points in a very special sense. Consumers like
B and A who might be at a point that lies off the contract curve can always find a point on the
contract curve that is preferable to both. Why? Because moving to such a point would not cost
either any welfare even though it guarantees that the welfare of at least one of them would
improve.

Pareto efficiency is defined, as a point (condition) where it is impossible to make any one better-
off without making some one worse-off. But, if it is possible to make any one better- off without
making the other worse- off, then the condition (that point) is not Pareto - efficient. A point is a
Pareto optimal if and only if there is no change that can make some one better off, without
making any one worse-off.

Thus, the above condition (point P) is not Pareto efficient for both individuals. Because, it is
possible to make better- off one of the two individuals without making the other-worse-off by

10
having voluntary exchange between these two individuals. The initial endowment places
individual A on indifference curve IIA and individual B on IIB. A is willing to give up more units
of Y in order to get additional unit of X (Because it will be on higher level of indifference curve).
Similarly B is following to give up more unit of X to obtain additional unit of Y. Such situation
will lead to the exchange between individuals. From the point P, A will trade some Y to B,
receiving X in exchange.

The exact bargain reached by the two parties.

I- If A is more skill-full negotiator, A may induce B to move along indifference curve
IIB form point P to E4 while A moves from indifference curve IIA to IVA.
Thus, individual A receives all the gain from the exchange while B gains or loses
nothing (indifferent) That is, the Pareto optimality occurs, (the Pareto improvement).
At point E4 IVA and IIB is tangent so that their slope of indifference curve (MRSXY)
are equal and there is no future base for exchange.
II- On the other hand, if B is more skill-full negotiator and induces A to move along its
indifference curve IIA from point P to E2 then B would get all benefits of exchange,
and A would neither gain nor lose. At E2 the MRSXY of A equals MRTSXY of B. And
there is not base for further exchange.
III- Finally if A moves from point P to E3 and B moves also from P to E3 (i.e. A moves
from IIA to IIIA and B moves from IIB to IIIB) both individuals gain from exchange.

Thus, starting from point P, both individuals gain through exchange by moving to a point on a
line E2E4 or between E2 and E4. The curves that join the locus of all tangency points of the
indifference curves of the two individuals (OA, OB) is called the contract curve of exchange
Along this curve the MRSXY is the same for individuals A and B, and the economy is in general
equilibrium of exchange.

Thus, equilibrium implies MRSAXY=MRSBXY

Starting from any point outside the contract curve A or B or both can be benefited from
exchange without making the other worse-off. Once on the contract curve the two individuals

11
cannot be better off without making the other worse-off. Thus, every point on the contract curve
is Pareto optimal and the contract curve is a low of Pareto optimality.

5.3.2. General Equilibrium in production: Two-Input-Two–Output Case

The preceding section focused our attention on the case in which consumers exchange quantities
of commodities in the absence of production. In this section and the next, we take up the
equivalent simple case in which there is production but no consumption. What do general
equilibrium look like?

To examine general equilibrium in production, we make assume about the product produced and
factor used. Let us consider
 a very simple economy that produces only two goods, X and Y, with only two inputs
(L and K)
 The country has fixed endowment of L and K which will be used to produce both X
and Y
 Suppose L x unit of labor and K x unit of capital are used in producing commodity X.
̅𝑦 unit of capital are used to produce commodity
The remaining 𝐿𝑦 unit of labor, and 𝐾
̅𝑦
Y. That is 𝐿= L x + 𝐿𝑦 and K = K x +𝐾

To examine general equilibrium of production, we again start from an Edgeworth box diagram
for production using the isoquants for commodities X and Y in a manner completely analogous
to the Edgeworth box diagram for consumption above of Figure 5.4. The general equilibrium in
production is presented by the figure 5.5. In the Edgeworth diagram for production shown above
in figure5.5, the size of the box refers to the total amount of L and K available to the economy.
While the curves inside the box indicates how the total amount of the two inputs is utilized in the
production of the two commodities. Accordingly, let the total amount of labor to be allocated
between the two sectors be 𝐿 and the total amount of capital to be allocated between the two
̅ . Finally, suppose that the initial allocation of labor and capital between the two
sectors is 𝐾
sectors were represented by point Z in the Edgeworth box diagram portrayed in Figure 5.5. Note

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that; the X industry starts with OxLx units of labor and OxKx units of capital, while the Y sector
comes to the table with OyLy units of labor and OyKy units of capital.

On the basis of the production functions for X and Y, we can insert isoquants for both X
production and Y production in Figure 5.5. There isoquants for X production are displayed there:
Ix, IIx, and IIIx. Of the three, the isoquant that reflects combinations of capital and labor with the
highest output of food is IIIx, and the isoquant for the lowest –output of foods is Ix. Three
isoquants for medicine production are also displayed: Iy, IIy, and IIIy. Again, of the three, the
isoquants that reflects combinations of capital and labor with the highest output of medicine is
IIIy, and the isoquant for the lowest output of medicine is Iy.

Ly 0y

Ly OY
̅
𝐾
Z Iy e4
Kx Ky
IIy IVx KY
e3

IIIx

e2
IIIy IV4
S IIx
IVy U’
e1

Ix
KX
OX LX R 𝐿

0x Lx

Figure 5.5: General equilibrium in production

What would be an efficient allocation of inputs between the two outputs? At the original
allocation at point Z, the marginal rate of technical substitution of labor for capital in producing
X is higher than it is in producing Y. This observation is based on the fact that the slope of IIx at

13
point Z is greater than the slop of IIy. The fact that the marginal rates of technical substitution
are unequal at point Z means that the inputs are not being allocated efficiently.

To see why, suppose that the X industry operating at point Z could substitute 2 units of labor for
1 unit of capital without changing its output while the Y industry would have to substitute 1 unit
of labor for 2 units of capital to maintain its output. In this case (where the Y industry uses more
labor and less capital relative to the food industry), it would be possible for one industry to
expand its output without any reduction in the other industry’s output. Specifically, it would be
possible to move to point ‘e2’, where the output of X would be the same as at point Z even
though the output of Y would climb to the level corresponding to IIIy. It would also be possible
to move to point ‘e3’, where the output of medicine would be the same as at point Z but the
output of food would climb to the level corresponding to IIIx. And, of course it would be
possible to move to a point between ‘e2’ and ‘e3’ for which the outputs of both sectors would
expand relative to their levels at point Z.

Regardless of which point were chosen, the same idea described above should apply. Production
should occur at a point at which the marginal rates of technical substitution between inputs are
the same for all producers. Only then would the allocation of inputs be efficient in the sense that
an increase in the output of one commodity could be achieved only by a reduction in the output
of the other commodity. An efficient allocation of inputs must, therefore, lie somewhere along
the locus of points where the marginal rates of technical substitution are equal, and so it must lie
at a points were the Y isoquant is tangent to the X isoquant. The locus of these points, like the
analogous set in the preceding section, is also called the contract curve; it is shown in Figure
5.5. The curve Oxe1e2e3e4Oy is the contract curve for production. It is the locus of tangency
points of the isoquants for X and Y at which the Marginal Rate of Technical Substitution of labor
for capital is the same in the production of X and Y. that is, the economy is in general
equilibrium of production when
MRTSLKX= MRTSLKY
Producers who find themselves at a point that lies off the contract curve can, if society is
interested in producing as much as possible of each good, move to a point where the output of
one industry can be increased without a reduction the other industry’s output. Thus by simply

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transferring some of the given and fixed amounts of available L and k between the production of
X and Y, this economy can move from a point not on the contract curve for production to a point
on the curve and increase its output of either or both commodities. For an economy of many
commodities and many inputs, the general equilibrium of production occurs where the marginal
rate of technical substitution between any pair of inputs is the same for all commodities and
producers using both inputs.

5.3.2.1. The Production Possibilities Curve

The contract curve in Figure 5.5 showed the various allocations of inputs that are efficient in the
special sense describe in the preceding section, There is , of course, a level of output for X and
Y corresponding to each point on the contract curve. Consider, for example, point e2 in Figure
5.5. If the level of output of X corresponding to isoquant IIx were 100 and if the level of output
of Y corresponding to isoquant IIIy were 200, then an output of 100 units of X and 200 units of
Y would correspond to the point e2. Similarly, if the level of output of X corresponding to
isoquant IIIx were 200 and if the level of output of Y corresponding to isoquant IIy were 100,
then an output of 200 units of X and 100 units of medicine would correspond to the point e3.

Proceeding in this way, we can find the pair of outputs corresponding to each point on the
contract curve. And we can then plot each such pair of points in a graph like that in Figure 5.6
below, where the amount of X produced is shown on the horizontal axis and the amount of Y
produced is shown on the vertical axis. For example, the pair of outputs corresponding to point
e2 on the contract curves is plotted as point A in Figure 5.6, and the pair of outputs corresponding
to point e3 on the contract cure is plotted as point B in Figure 5.6. And the opposite origin in
Figure 5.6, where X production is zero because Y employs all of the capital and labor, is
portrayed by point P in figure5.6. By joining points or the output pairs corresponding to each
isoquant tangency points we can derive the certain curve. The curve PP’ in Figure 5.6 is the
result of plotting all these points i.e. the output combinations associated with all of the points on
the contract cure. It is called the production possibility curve. You may remember this concept
from your first lecture in introductory economics (but it was probably derived from a production
function with only one input).

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 Y

P Production possibilities curve

A
200 ’ .D

.E

100 B

100 200 P’ X

Figure 5.6: Production possibilities curve

The production possibilities curve shows the various combination of X output and Y output that
can be derived from the economy’s input base. In our simple model above at the beginning in
̅ units of capital. More specifically, it shows
figure 5.5, this base is Ox𝐿 units of labor and Ox𝐾
the maximum output of one good that can be produced under the assumption that the output of
the other good is held fixed. For example; at point e2 given quantity of X is IIx, the maximum
quantity of Y that can be produced is IIIy. Similarly, point e3 of the contract curve of production
shows that given IIIx the maximum amount of Y the economy can produce is IIy.

Given the economy’s input base and existing technology, it is impossible to attain a point like D
in Figure 5.6 that is outside the production possibilities curve. On the other hand, a point inside
the PPF corresponds to a point off the production contract curve indicates that the economy is
not in general equilibrium of production, and is not utilizing its inputs of labor and capital most
efficiently. It is possible to attain a point like E that is inside the production possibilities curve,
but it would be inefficient to do so. Indeed, a point like E would correspond to a point like Z in

16
Figure 5.6 (go to production part) an allocation of inputs that does not lie along the contract
curve.

5.3.2.2 Production Efficiency and Equilibrium

As long as production is efficient, input allocations lie along the contract curve for which the
marginal rates of technical substitution are equal for each sector, production occurs at some point
along the production possibilities cure. Once on the PPF, the output of either commodity can be
increased only by reducing the output of the other. The amount of commodity Y that the
economy must give up, at a particular point on the PPF so as to release just enough labor and
capital to produce one additional unit of commodity X, is called the Marginal Rate of (Product)
Transformation of X for Y (MRPTxy). This is given by the absolute value of the slope of the PPF
at that point. It is also equal to the ratio of the marginal cost of X to the marginal cost of Y.
y
That is, 
x
The MRPT measures the amount of Y that must be sacrificed in order to obtain an additional unit
of X.

In perfect market the profit maximizing producer or firm equate the price of the commodity to
the marginal cost production. i.e., P= MC which implies

MC X P PX
MRPTXY   x  MRPTXY 
MCY PY PY

Given the commodity prices, general equilibrium of production can be attained on the PPC at
which the slope of PPC equal to the ratio of the prices of the products. To further clarify with
the help of graph assume that the market price of commodity define the slope of the line AB. The
ratio OA/OB measures the ratio of the marginal cost of these two products. The general
equilibrium of product mix is shown below in Figure 5.7. The country is in equilibrium at point
T where the level production is X* and Y*.

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 A
Slope = MRPTXY

Y* T= MRPTXY= PX/PY

Slope= PX/PY

X*
Figure 5.7: General equilibrium in product mix

5.3.3. General Equilibrium in a Two-Factor, Two-Commodity, Two-

Consumer (2x2x2) Economy

Dear students, up until now we have been developing tools for measuring the attainment of
general equilibrium in exchange and production respectively. This section brings the tools
together so as to determine the simultaneous general equilibrium of production and exchange.
That is, we can use the PPF and the contract curve for exchange to examine how our simple
economy can reach simultaneously general equilibrium of production and exchange. We will
analyze how the economy comes to equilibrium. For this purpose, we combine our exchange and
production assumptions above together.

Assumptions of the 2x2x2 model

1. There are two factors of production (L and K) whose quantities are given exogenously.
These factors are perfectly divisible and homogeneous.
2. Only two commodities (X and Y) are produced. Technology is given. The isoquant
maps have the usual properties (smooth and convex to the origin implying diminishing
MRTS between factors along any isoquant). Each production function exhibits constant

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 returns to scale. The two production functions are independent (no externalities in
production).
3. There are two consumers in the economy (A and B) whose preferences are represented by
ordinal indifference curves, which are convex to the origin, exhibiting diminishing MRS
between commodities. Consumers’ choices are independent (no externalities in
consumption).
4. The goal of each firm is profit maximization and that of each consumer is utility
maximization.
5. The factors of production are owned by the consumers.
6. There is full employment of factors of production, and all incomes received by their
owners (A and B) are spent.
7. There is perfect competition in both commodity and factor markets. Consumers and firms
face the same set of prices (Px, Py, w, r).

The allocation question can now be cast in this combination world. Given the input base, the
indifference maps of the consumers, and the production functions in the two industries, how
should these inputs be allocated between industries? And how should the output of goods be
allocated between the consumers?

In this model a general equilibrium is reached when the four markets (two commodity and two
factor markets) are cleared at a set of equilibrium prices and each participant economic agent
(two firms and two consumers) is simultaneously in equilibrium. As in the preceding two
̅ units of capital.
sections, this economy can use a total of Ox𝐿 units of labor and Ox𝐾

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 Y
Production possibilities curve
P A”

200

A’
N
C1 ’

B” A”
H3’

T1’
B
M1 H2’

B”
T2’
H1’
C1
T3’
O
F1 100 Q 200 P’ X

Figure 5.8: Production and exchange equilibrium

A. Allocating consumption between individuals

If the isoquant map in each industry displayed in figure 5.5 were applicable then we would know
from the preceding section that the various combinations of X output and Y output that could be
derived from this input base were given by the production possibilities curve PP’ in Figure 5.6.
This curve PP’ reproduced in figure 5.8. Suppose, for the moment, that we also knew the
composition of output (i.e., the amount of X and Y) that should be produced in the economy.
We could then insert an Edgeworth box diagram similar to that in Figure 5.5 as in exchange case
into Figure 5.8. The upper-right corner of the box would simply be the point on the production
possibilities curve corresponding to this predetermined composition of output.

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To be more specific, suppose that we knew that the composition of output in the economy should
be represented by point A’, where the quantity of X produced would equal Q and the quantity of
Y produced would be N. We could then draw an Edgeworth diagram for consumption with Q as
its width and N as its height. Since Q and N would be the total amount of X and Y to be
distributed to A and B, respectively. This box diagram could be used to see how much of total
output of each good would go to each consumer. Figure 5.8 shows indifference curve for each
consumer (H1’, H2’, and H3’ for A; T1’, T2’, and T3 for B) within the box defined by Q, A’, N,
and the origin. It also shows the contract cure, C1C1’. Recall that this is the locus of points where
A’s indifference curves are tangent to B’s.

We know that the distribution of output between the two consumers should be such that they
should lie on the contract curve C1C1’. But, where? We show in the following section that, if the
economy’s output were allocated so that consumer satisfaction were maximized, then the
marginal rate of product transformation (the magnitude of the slope of the production
possibilities curve ) should equal the marginal rate of substitution. If the economy’s output were
allocated to maximize consumer satisfaction, then the consumers should be at the point of the
contract curve where the common slope of their indifference curves equals the slope of the
production possibilities curve at A’.

Where on the contract curve would the common slope of their indifference curves equal to the
slope of the production possibilities curve at A’? An examination of Figure 5.8 shows that this
condition would be fulfilled at point B on the contract curve, where A would receive F1 units of
X and M1 units of Y while B would receive Q-F1 units of X and N-M1 units of Y. The slopes of
the indifference curves at point B equal the slope of the production possibilities curve at point
A’. How do we know? The tangent lines B”B” and A”A” are parallel. So, given the amount to be
produced of each commodity, we have devised a way to determine the amount of each
commodity, we have devised a way to determine the amount of each commodity that should be
allocated to A and B.

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B. Allocating inputs between commodities

We can also find the amount of labor and capital that should be allocated to the production of
each commodity by consulting the Edgeworth box diagram in Figure 5.5. Recall that the contract
curve drawn there underlies the production possibilities curve drawn in Figure 5.8. Recall, as
well, that each point on the production possibilities curve corresponds to a point on the contract
curve in Figure 5.5 that corresponds to a particular allocation of labor and capital between the
productions of the two commodities. For example, assume that point A’ on the contract curve in
Figure 5.8 corresponds to a particular allocation of labor and capital between the productions of
the two commodities. For example, assume that point A’ on the production possibilities curve
corresponds to point U’ on the contract curve in Figure 5.5. So, if we knew that the composition
of output in the economy should be given by point A’, then we would know that OxR units of
labor should be devoted to the production of X and OxL-OxR units of labor should be devoted to
the production on Y. We would know that OxS units of capital should be devoted to the
production of X, and that OxK-OxS units of capital should be devoted to the production of Y.
Finally, we would know that this allocation of inputs would guarantee that the marginal rates of
technical substitution between capital and labor would be equal in the production of both X and
Y.

C. The marginal rate of product transformation, marginal rate of substitution, and

consumer satisfaction

We asserted in the preceding section that consumer satisfaction would not be maximized unless
the marginal rate of product transformation between two goods is equal to the marginal rate of
substitution between the two goods.

5.3.4. Three Conditions for Economic Efficiency

The preceding sections have told a long story from which we can draw some general insight into
the conditions that characterize an efficient allocation of resource, i.e., an allocation where it is
impossible to improve somebody’s welfare without causing harm to anybody else. These
properties are called marginal conditions of Pareto optimality or Pareto efficiency. Indeed, it

22
turns out that there are three such conditions to be fulfilled. If resources are to be allocated
efficiently, simultaneous general equilibrium of production and exchange has to be reached.
These require three conditions to be fulfilled. These are;

1. The marginal rates of substitution between any two goods must be the same for all
individuals (otherwise, at least two individuals can get together for a mutually beneficial
trade and thereby increase the utility of one or both people). That is, general equilibrium
of exchange (distribution) for two individual is given by:
MRSAXY=MRSBXY

2. The marginal rates of technical substitution between any two inputs must be the same in
the production of all goods (otherwise, two producers can get together to trade inputs and
thereby increase the output of one or both products). General equilibrium in production is
given by relation can be stated as
MRPTXY=PX/PY

3. The marginal rate of transformation between any two goods must equal the common
marginal rate of substitution for all individuals (otherwise resources can be reallocated to
increase the production of some goods at the expense of others to bring the product mix
into line with consumer preference).Then the general equilibrium of the system as a
whole requires the fulfillment of the third condition, i.e.
MRPTXY=MRSAXY=MRSBXY or

For prefect market case

MRSAXY=MRSBXY=PX/PY

For instances, general equilibrium for the simple 2*2*2 model can be attained if the following
three Pareto optimum (efficiency) conditions are satisfied;
1. The MRSXY must be equal for both consumers (efficiency in exchange).
2. The MRTSXY must be equal for all firms (efficiency in production).
3. The MRSXY and MRPTXY must be equal for two goods (efficiency in product mix)

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