General equilibrium : Neo-classical analysis

Neo classical general equilibrium theory which is based on Walrasian theory of general equilibrium 2*2*2 model and Marshallian graphical representation

1. GENERAL EQUILLIBRIUM ANALYSIS NEO CLASSICAL Presented by, Snehal S. Athawale School of Social Sciences Ph.D (Agri. Economics) 1 st Year College of Post Graduate Studies in Agriculyural Sciences Central Agricultural University, Umiam Ri-Bhoi District- 793101 Meghalaya. MONDAY ● MAR 05 ● 2022

2. CLASSICAL & NEO CLASSICAL ECONOMICS 01. WALRASIAN MODEL 04. ASSUMPTIONS OF WALRASIAN MODEL 03. EXISTENCE, UNIQUENESS AND STABILITY OF AN EQUILIBRIUM 06 TABLE OF CONTENTS INTRODUCTION 02. NATURE OF EQUILIBRIUM 05.

3. CLASSICAL & NEO CLASSICAL ECONOMICS CLASSICAL ECONOMICS NEO-CLASSICAL ECONOMICS Refers to the dominant school of thought for economics from late the 18th to mid 19th centuries. Self-regulating democracies and capitalistic market developments form the basis for classical economics. Broad theory that focuses on supply and demand as the driving forces behind the production, pricing, and consumption of goods and services. From mid 19 th to late 20 th Century.

4. INTRODUCTION A general equilibrium is defined as a state in which all markets and all decision-making units are in simultaneous equilibrium. General equilibrium theory deals with the problem of whether the independent action by each decision-maker leads to a position in which equilibrium is reached by all. A general equilibrium exists if each market is cleared at a positive price, with each consumer maximising satisfaction and each firm maximising profit. : An equilibrium exists if there is P* - this is fixed point (termed as Brouwer’s fixed point ) A state , where all Sales= Purchases , that all consumers get maximum satisfaction and all producer get maximum profit. No Excess Demand and No Excess Supply. What is General Equilibrium in Economics?

5. A fundamental feature of any economic system is the interdependence among its constituent parts. The markets of all commodities and all productive factors are interrelated, and the prices in all markets are simultaneously determined. Interdependence of the activity within an economic system can be illustrated with a simple economy composed of two sectors, a consumer sector, which includes households and a business sector, which includes firms. Assumptions: All production takes place in the business sector. All factors of production are owned by the households; All factors are fully employed All incomes are spent. Household Firm Factor services Money Income Commodities Expenditures on commodities Circular Flow in two-sector economy The economic activity in the system takes the form of two flows between the consumer sector and the business sector: A real flow – It is the exchange of goods for the services of factors of production A monetary flow - is the real flow expressed in monetary terms. expenditures of firms become the money incomes and e expenditures of households become the receipts of firms

6. General equilibrium emerges from the solution of a simultaneous equation model , of millions of equations in millions of unknowns. The unknowns are the prices of all factors and all commodities and the quantities purchased and sold by each consumer and each producer . The equations of the system are derived from the maximising behaviour of consumers and producers. In principle a simultaneous-equation system has a solution if the number of independent equations is equal to the number of unknowns in the system. This approach has been followed by the founder of general equilibrium analysis Leon Walras (1834-1910). Léon Walras (1834 –1910) French mathematical economist . Walras is best known for his book Elements of pure economy.

7. Assumptions of Walrasian Model All firms have equal access to inputs, have the same technology, Implies that firms have identical long run cost functions All firms have identical cost functions All resources in the economy are fully utilised (employed). Full Employment An increase in input results in a proportional increase in output. Constant returns to scale Tastes, preferences and habits of consumers are constant 01 02 04 03 06 05 Perfect mobility of factors. Perfect Competition Many Buyers and Sellers Homogeneity Free Entry and Exit Perfect Knowledge Uniform Price The factors of production like labour , raw materials and capital have total mobility.

8. Walrasian model There are as many markets as there are commodities and factors of production. Millions of simultaneous equations defines the ‘unknowns ’ of the model (prices and quantities of all commodities & all factor inputs). For each market there are three types of functions: 1) Demand functions 2) Supply functions 3) ‘Clearing-the-market' equation Behaviour of each individual decision-maker is presented by a set of equations. eg , each consumer has a double role: he buys commodities and sells services of factors to firms. Similarly, firm - demand for factor & supply of commodity produced A necessary condition for the existence of a general equilibrium is that there must be in the system as many independent equations as the number of unknowns. 1 1 5 4 3 2 1 Assumption: An economy consists of two consumers, A and B, who own two factors of production, K and L. These factors are used by two firms to produce two commodities, X and Y. Each firm produces one commodity, and each consumer buys some quantity of both. Both consumers own some quantity of both factors (but the distribution of ownership of factors is exogenously determined). 2 x 2 x 2 general equilibrium model

9. Quantities demanded of X and Y by consumers 2*2=4 Quantities supplied of K and L by consumers 2*2=4 Quantities demanded of K and L by firms Total 2*2=4 Quantities of X and Y supplied by firms 2 Prices of commodities X and Y 2 Prices of factors K and L 2 Number of 'unknowns’ 18 Demand functions of consumers 2*2=4 Supply functions of factors 2*2=4 Demand functions for factors 2*2=4 Supply functions of commodities 2 Clearing-the-market of commodities 2 Clearing-the-market of factors 2 Total number of equations 18 To find these unknowns we have the following number of equations: In this simple model we have the following 'unknowns':

10. Nature of Equilibrium Stable Equilibrium When any small disturbances put economy away from equilibrium and other forces to re-establish to the initial point of equilibrium. Unstable Equilibrium When any small disturbances put the economy away from equilibrium and other forces to further take the economy away/deviate more from the initial point of equilibrium. Neutral Equilibrium When any small disturbances put the economy away from equilibrium and no forces comes into play to re-establish the economy to the initial point of equilibrium. The economy remains at the shifted or new equilibrium position forever.

11. Unique, stable equilibrium The equilibrium is stable if the demand function cuts the supply function from above. In this case an excess demand drives price up, while an excess supply drives the price down Unique, unstable equilibrium The equilibrium is unstable if the demand function cuts the supply function from below. In this case an excess demand drives the price down, and an excess supply drives the price up EXISTENCE, UNIQUENESS AND STABILITY OF AN EQUILIBRIUM

12. Multiple equilibria The case of multiple equilibria . It is obvious that at P1 there is a stable equilibrium, while at P2 the equilibrium is unstable. No equilibrium exists In figure an equilibrium (at a positive price) does not exist. Because supply and demand curve does not intersect each other ( at a positive prices).

13. Stable Equilibrium : E(P)<0 The excess demand function, E• intersects the vertical (price)-axis when there is an equilibrium, that is, when the excess demand is zero. If QD = QS, then E(P) = 0 The equilibrium is stable if the slope of the excess demand curve is negative at the point of its intersection with the price-axis Unstable Equilibrium : E(P)>0 The equilibrium is unstable if the slope of the excess demand curve is positive at the point of its intersection with the price-axis

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