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Advanced Microeconomics General Equilibrium Theory (GET) Why GET? Logistics Consumption: Recap Production: Recap References Advanced Microeconomics General Equilibrium Theory (GET) Giorgio Fagiolo [email protected] http://www.lem.sssup.it/fagiolo/Welcome.html LEM, Sant’Anna School of Advanced Studies, Pisa (Italy) Introduction to the Module Why GET? Logistics Consumption: Recap Production: Recap References How do markets work? GET: Neoclassical theory of competitive markets So far we have talked about one producer, one consumer, several consumers (aggregation can be tricky) The properties of consumer and producer behaviors were derived from simple optimization problems Main assumption Consumers and producers take prices as given Consumers: prices are exogenously fixed Producers: firms in competitive markets are like atoms and cannot influence market prices with their choices (they do not have market power) Why GET? Logistics Consumption: Recap Production: Recap References How do markets work? GET: Neoclassical theory of competitive markets So far we have talked about one producer, one consumer, several consumers (aggregation can be tricky) The properties of consumer and producer behaviors were derived from simple optimization problems Main assumption Consumers and producers take prices as given Consumers: prices are exogenously fixed Producers: firms in competitive markets are like atoms and cannot influence market prices with their choices (they do not have market power) Introduction Walrasian model Welfare theorems FOC characterization WhyWhy does GET? demandLogistics equalConsumption: supply? Recap Production: Recap References How do prices emerge? Simple storySimple story: A single market Quantity produced as a function of price (production theory) QuantityQuantityproduced consumed as as functiona function of price of price (consumer(producer theory) theory) QuantityHow toconsumed solve for an equilibrium? as function of price (consumer theory) Under suitable assumptions on the shapes of supply/demand schedules, by equating demand and supply one gets the equilibrium price/quantity pair Two equations(p∗; q in∗) two unknowns give a solution p p p y(p) y(p) p∗ x(p, w) x(p, w) q q q q∗ 4/94 Why GET? Logistics Consumption: Recap Production: Recap References How do prices emerge? Actually, the story is more complicated. The economy is composed of many interdependent markets (goods, services, labor, financial, . ) Individual decisions depend on prices through profits, budget constraints, individual income and wealth, etc. Prices depend on individual choices because in all markets demand should equal supply Are there prices that magically make all these decisions and constraints mutually compatible and let them to be carried out simultaneously? A little bit more formally: Prices are a vector p Aggregate supply is a vector y(p) Aggregate demand is a vector x(p; w) General equilibrium prices satisfy y(p) = x(p; w) Potentially a very complicated system of equations to solve (given resource constraints) GET: Exploring solutions of this system of equations and their properties Why GET? Logistics Consumption: Recap Production: Recap References How do prices emerge? Actually, the story is more complicated. The economy is composed of many interdependent markets (goods, services, labor, financial, . ) Individual decisions depend on prices through profits, budget constraints, individual income and wealth, etc. Prices depend on individual choices because in all markets demand should equal supply Are there prices that magically make all these decisions and constraints mutually compatible and let them to be carried out simultaneously? A little bit more formally: Prices are a vector p Aggregate supply is a vector y(p) Aggregate demand is a vector x(p; w) General equilibrium prices satisfy y(p) = x(p; w) Potentially a very complicated system of equations to solve (given resource constraints) GET: Exploring solutions of this system of equations and their properties Why GET? Logistics Consumption: Recap Production: Recap References GET and the “Invisible-Hand” Paradox The homo oeconomicus “intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention [. ] By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it”. (Adam Smith, The Wealth of Nations, Book IV, chapter II, paragraph IX). “One of the major themes of economic theory is that the behaviour of a complex economic system can be viewed as an equilibrium arising from the interaction of a number of economic units with different motivations.” (Scarf, 1973; p. 1). “The most intellectually exciting question in our subject remains: is it true that the pursuit of private interest produces not chaos but coherence, and if so how is it done?” (Hahn, 1970; p. 1) “On the surface, at least, modern capitalist economies seem to be chaotic. and yet somehow the thing works. There is order — not chaos. (Katzner, 1989; pp. 1, 6–7)” Why GET? Logistics Consumption: Recap Production: Recap References GET as a solution of the “Invisible-Hand” paradox? 1 How is it that the economy seems to function smoothly when millions of decision-making units operate independently and in their own self interest? 2 How do prices emerge? 3 Why is it that certain commodities are produced in certain quantities? 4 What determines the specific distribution of income and final goods actually realized in the economy? Why GET? Logistics Consumption: Recap Production: Recap References GET and the “laissez-faire” view of market functioning The basic Walrasian conjecture The laissez faire operation of the price mechanism, in a environment of deregulated competitive markets where agents are motivated by self-interest, will produce not chaos but a coherence, in the sense of market clearing, optimal outcomes (Bryant, 2010). Pre and Post-institutional (market) concepts Socially-optimal (Pareto efficient) allocation: an allocation (how much any firm produces, how much any consumer consumes) where it is impossible to make some individuals better off without making some other individual worse off (a minimal test without any distributional or equity content) Socially desirable allocation: an allocation that can be the target of a social planner who wants to maximize the well-being of all individuals in the economy Institutions: decentralized markets. They operate without the need of any central coordination device and deliver equilibrium prices and equilibrium allocations Why GET? Logistics Consumption: Recap Production: Recap References GET and the “laissez-faire” view of market functioning The basic Walrasian conjecture The laissez faire operation of the price mechanism, in a environment of deregulated competitive markets where agents are motivated by self-interest, will produce not chaos but a coherence, in the sense of market clearing, optimal outcomes (Bryant, 2010). Pre and Post-institutional (market) concepts Socially-optimal (Pareto efficient) allocation: an allocation (how much any firm produces, how much any consumer consumes) where it is impossible to make some individuals better off without making some other individual worse off (a minimal test without any distributional or equity content) Socially desirable allocation: an allocation that can be the target of a social planner who wants to maximize the well-being of all individuals in the economy Institutions: decentralized markets. They operate without the need of any central coordination device and deliver equilibrium prices and equilibrium allocations Why GET? Logistics Consumption: Recap Production: Recap References Positive vs Normative Qestions 1 Do equilibrium states exist? 2 Are they unique? Are they stable? 3 Are they socially optimal, i.e. can a socially-optimal state be reached just by letting the market work? 4 Are they socially desirable from the point of view of a social planner wanting to maximize individual well-being? 5 How do equilibrium states respond to variations in the parameters that define the economy? Why GET? Logistics Consumption: Recap Production: Recap References Positive vs Normative Qestions 1 Do equilibrium states exist? 2 Are they unique? Are they stable? 3 Are they socially optimal, i.e. can a socially-optimal state be reached just by letting the market work? 4 Are they socially desirable from the point of view of a social planner wanting to maximize individual well-being? 5 How do equilibrium states respond to variations in the parameters that define the economy? Why GET? Logistics Consumption: Recap Production: Recap References GET and the Real World GET is a highly sophisticated mathematical model GET is “logically entirely disconnected from its interpretation” (Debreu, cited in Kaldor, 1972, p. 1237) GET is the perfect example of the instrumentalist (positive) approach to economic theory that informs all neoclassical models “Truly important and significant hypotheses will be found to have assumptions that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions” (Friedman, Essays in Positive Economics, p. 14). Models must be judged by their predictive capability, not for the realism of their assumptions Goal: find a mathematical model of competitive market behavior such that sharp implications can follow from a minimal set of assumptions on primitives and agent behaviors Assumptions as free goods Example: Does an equilibrium state in the GE model exist? Yes, provided
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