General Equilibrium and Welfare Economics - Essay Example

General Equilibrium and Welfare Economics Introduction In this essay we will study briefly the main concepts of General Equilibrium and Welfare Economics. These microeconomic models are very helpful in the fields of policy-making, but they are also useful for everybody in order to understand how Microeconomics works. First, we will take a look at Microeconomics from a general point of view. Then we will see the partial equilibrium model of supply and demand. Next, we will study General Equilibrium and Welfare Economics. All along the way, we will do our best to follow the advice of a very famous economist called Gerard Debreu (1991). His words are full of insight into the economic wisdom. He stated the following: "Being denied a sufficiently secure experimental base, economic theory has to adhere to the rules of logical discourse and must renounce the facility of internal inconsistency. A deductive structure that tolerates a contradiction does so under the penalty of being useless since any statement can be derived flawlessly and immediately from that contradiction. In its mathematical form, economic theory is open to an efficient scrutiny for logical errors." We will try to be coherent, and we will do our best to avoid any contradiction when speaking about General Equilibrium and Welfare Economics. It is easy to get confused with these microeconomic models, so we will deal with them using simple and logical words. The most important thing is to understand those models and to apply the knowledge in our everyday life as much as possible. General Equilibrium Microeconomics is defined by the Wikipedia (2005d) as "the study of the economic behaviour of individual consumers, firms, and industries and the distribution of production and income among them. It considers individuals both as suppliers of labour and capital and as the ultimate consumers of the final product. It analyzes firms both as suppliers of products and as consumers of labour and capital." It is necessary to understand this simple definition to apply that knowledge to General Equilibrium and Welfare Economics. We have to keep in mind that General Equilibrium belongs to Microeconomics, but Welfare Economics is a bridge between Microeconomics and Macroeconomics. Arnold C. Harberger (2002) speaks about the importance of Microeconomics as follows: "The strength of microeconomics comes from the simplicity of its underlying structure and its close touch with the real world. In a nutshell, microeconomics has to do with supply and demand, and with the way they interact in various markets." In microeconomic theory, the partial equilibrium supply and demand economic model was originally conceived by Alfred Marshall when he tried to explain changes in the price and quantity of goods sold in competitive markets. This microeconomic model just deals with an imperfectly competitive market. It has its foundation in the theories used by some economists before Marshall like Adam Smith, and it is one of the most fundamental models of economic schools in the present time, widely used as a basic building block for many other economic models. The theory of supply and demand is important for understanding a market economy as it is an explanation of the mechanism by which many economic decisions are made. Nevertheless, unlike General Equilibrium models, the supply and demand theory offers a partial equilibrium model fixed by unexplained forces. (Wikipedia, 2005d). The theory of supply and demand frequently considers that markets are perfectly competitive. This means that there are many buyers and sellers in the market. It also means that none of them have the capacity to influence the price of the good. In real life, this assumption usually fails because some economic agents have the ability to influence prices. (Wikipedia, 2005d). Wikipedia, 2005h In Microeconomics we say that the market "clears" at the point where the supply and demand find a balance at a given price. It means that the amount of a commodity at a given price equals the amount that buyers are willing to buy at that same price. If we make a graph or diagram showing four variables (price, quantity, supply, demand) we will see that a market clears where the supply curve and the demand curve are in equilibrium, that is, where the curves intersect. In a General Equilibrium model, all markets in each and every goods clear at the same time. For around a century, economists applied Say's Law, which states that markets, in a general way, would always clear and thus they would be always in balance. (Wikipedia, 2005h). Say's Law or Say's Law of Markets is a principle by Jean-Baptiste Say (1767-1832) stating that there can be no demand without supply. "A central element of Say's Law is that recession does not occur because of failure in demand or lack of money. The more goods (for which there is demand) that are produced, the more those goods (supply) can constitute a demand for other goods. For this reason, prosperity should be increased by stimulating production, not consumption. In Say's view, creation of more money simply results in inflation; more money demanding the same quantity of goods does not represent an increase in real demand." (Wikipedia, 2005f). General Equilibrium theory is defined in the Wikipedia (2005b) as "a branch of theoretical microeconomics. It seeks to explain production, consumption and prices in a whole economy. General equilibrium tries to give an understanding of the whole economy using a bottom-up approach, starting with individual markets and agents. () Calculating the equilibrium price of just one good, in theory, requires an analysis that accounts for all of the millions of different goods that are available." Leon Walras made the first attempt in Neoclassical economics to model prices for a whole economy. Walras' 'Elements of Pure Economics' uses many models, each taking into account more aspects of a real economy (two commodities, many commodities, production, growth, money). Walras laid down a research program followed by 20th century economists. It is important to keep in mind that "in partial equilibrium analysis, the determination of the price of a good is simplified by just looking at the price of one good, and assuming that the prices of all other goods remain constant. The Marshallian theory of supply and demand is an example of partial equilibrium analysis. Partial equilibrium analysis is adequate when the first-order effects of a shift in, say, the demand curve do not shift the supply curve." (Wikipedia, 2005b). Proofs by Walras of "the existence of General Equilibrium often was based on the counting of equations and variables. Such arguments are inadequate for non-linear systems of equations and do not imply that equilibrium prices and quantities cannot be negative, a meaningless solution for his models. The replacement of certain equations by inequalities and the use of more rigorous mathematics improved general equilibrium modeling." (Wikiepedia, 2005b). Kenneth Arrow and Gerard Debreu in the 1950s provided with new criteria for the modern General Equilibrium. Gerard Debreu presents this model in Theory of Value (1959). In his approach, the interpretation of the terms in the theory (e.g., goods, prices) is not fixed. Three important theorems have been proved. "First, existence theorems show that equilibria exist under certain abstract conditions. The first fundamental theorem of welfare states that every market equilibrium is Pareto optimal under certain conditions. The second fundamental theorem of welfare states that every Pareto optimum is supported by a price system, again under certain conditions." (Wikipedia, 2005b). The complete Arrow-Debreu model can be said to apply when goods are identified by when they are to be delivered, where they are to be delivered, and under what circumstances they are to be delivered, as well as their intrinsic nature. A General Equilibrium model with complete markets seems to be unrealistic. It doesn't look like a model in real life. Some critics of General Equilibrium modeling argue that a lot of research in these models constitutes exercises in pure mathematics with no connection to actual economies. "Although modern models in general equilibrium theory demonstrate that under certain circumstances prices will indeed converge to equilibria, critics hold that the assumptions necessary for these results are completely unrealistic. The necessary assumptions include perfect rationality of individuals; complete information about all prices both now and in the future; and the conditions necessary for perfect competition." (Wikipedia, 2005b). On the other hand, the Wikipedia (2005e) defines Pareto efficiency or Pareto optimality as "a central theory in economics with broad applications in game theory, engineering and the social sciences. Given a set of alternative allocations and a set of individuals, a movement from one alternative allocation to another that can make at least one individual better off, without making any other individual worse off is called a Pareto improvement or Pareto optimization. An allocation of resources is Pareto efficient or Pareto optimal when no further Pareto improvements can be made." But not every Pareto efficient result can be considered to be desirable. For instance, in the case of a dictatorship this is run for the benefit of only one person. This system will be Pareto optimal because it will be impossible to raise the well-being of anyone (excluding the dictator) without reducing the well-being of the dictator, and vice versa. But most people (except the dictator) would not see this as a desirable economic system. The Wikipedia (2005c) defines the Kaldor-Hicks efficiency as "a type of economic efficiency that captures some of the intuitive appeal of Pareto efficiency, while having less stringent criteria and therefore being applicable in more circumstances. Using Kaldor-Hicks efficiency, a more efficient outcome can leave some people worse off. Here, an outcome is more efficient if those that are made better off could in theory compensate those that are made worse off and lead to a Pareto optimal outcome. The key difference is the question of compensation. Kaldor-Hicks does not require compensation to be paid, merely the possibility for compensation to take place, and thus does not necessarily make each party better off. Pareto efficiency does require making each party better off (or at least no worse off). () The Kaldor-Hicks criterion is widely applied in welfare economics and managerial economics. For example, it forms an underlying rationale for cost-benefit analysis. In cost benefit analysis, a project (for example a new airport) is evaluated by comparing the total costs, such as building costs and environmental costs, with the total benefits, such as airline profits and convenience for travelers. The project would typically be given the go-ahead if the benefits exceed the costs." Bryan Caplan (2005) seems to be very critical of General Equilibrium, but his position is against the methodology rather than with the content of this economic model. Let's see: "In practice, the main use of general equilibrium theory is to torture first-year graduate students with the hardest math they'll never use again (unless they go on to teach it themselves!). But that's a problem with the pedagogy, not the material. () The deep lesson of general equilibrium theory is that markets are inter-connected in countless subtle ways. If you throw a stone into the water of the market, it doesn't ripple out in concentric circles. The ripples are many and irregular." Welfare Economics The Encyclopedia Britannica (2005) defines Welfare Economics with the following words: "a branch of economics that seeks to evaluate economic policies in terms of their effects on the well-being of the community. It became established as a well-defined branch of economic theory during the 20th century. Earlier writers conceived of welfare as simply the sum of the satisfactions accruing to all individuals within an economic system." On the other hand, Wikipedia (2005j) defines Welfare Economics as "a branch of economics that uses microeconomic techniques to simultaneously determine the allocational efficiency of a macroeconomy and the income distribution consequences associated with it. It attempts to maximize the level of social welfare by examining the economic activities of the individuals that comprise society." Welfare economics deals with the welfare of individuals, as opposed to groups, communities, or societies because it takes into account that the individual is the basic unit of measurement. It assumes that individuals are the best judges of their own welfare, that people will prefer greater welfare to less welfare, and that welfare can be adequately measured either in monetary terms or as a relative preference. Social welfare deals with the general utilitarian state of society. It is often defined as the sum total of the welfare of all the individuals in the society. Welfare Economics can be seen from two different perspectives: economic efficiency and income distribution. "Economic efficiency is largely positive and deals with the "size of the pie". Income distribution is much more normative and deals with "dividing up the pie"." (Wikipedia, 2005j). There are two approaches for Welfare Economics: the Neo-classical approach and the New Welfare Economics approach. The Neo-classical approach was developed by Pigou, Bentham, Sidgwich, Edgeworth, and Marshall. The New welfare economics approach is based mostly on the work of Pareto, Hicks, and Kaldor. Most economists use Pareto efficiency, as their efficiency goal. There are a number of conditions that, most economists agree, may lead to inefficiency. They include: imperfect market structures (such as monopoly, monopsony, oligopoly, oligopsony, and monopolistic competition) factor allocation inefficiencies () market failures and externalities () price discrimination () long run declining average costs () certain types of taxes and tariffs. (Wikipedia, 2005j). There are a lot of consumer and production equilibria that yield Pareto optimal results. Pareto efficiency is a necessary, but not a sufficient condition for social welfare. Each Pareto optimum goes hand in hand with a different income distribution in the economy. Some of them may involve great inequalities of income. So how do we decide which Pareto optimum is most desirable This decision is made through the social welfare function. "A utilitarian welfare function (also called a Benthamite welfare function) sums the utility of each individual in order to obtain society's overall welfare. Everyone is treated the same, no matter what their initial level of utility is. One extra unit of utility for a starving person is not seen to be of any greater value than an extra unit of utility for a millionaire that already has all the wealth he/she could ever spend. At the other extreme is the Max-Min function proposed by John Rawls. According to the Max-Min criterion welfare is maximized when the utility of those society members that have the least is the greatest. No economic activity will increase social welfare unless it improves the position of the society member that is the worst off. Most economists specify social welfare functions that are intermediate between these two extremes. () Finding a solution to an abstract function does not directly yield a policy recommendation! In other words, solving an equation does not solve social problems. However, a model like the one above can be viewed as an argument that solving a social problem (like achieving a Pareto-optimal distribution of wealth) is at least theoretically possible." (Wikipedia, 2005j) Welfare Economics employs many of the techniques of Microeconomics and it is an intermediate or advanced microeconomic theory. Its results are also applicable to Macroeconomics so Welfare Economics is a bridge between the two branches of Economics. As many of the uses of Welfare Economics we have them in different fields of knowledge. Cost-benefit analysis is an application of Welfare Economics techniques. Political science also looks into the issue of social welfare. Human development theory explores Welfare Economics too, and considers its issues to be fundamental to the development process itself. According to the Wikipedia (2005g), a social welfare function, in Welfare Economics, is "a function which gives a measure of the material welfare of society, given a number of economic variables as inputs. Kenneth Arrow proved that it is impossible to have a social welfare function that satisfies a set of given 'reasonable' criteria, in his so called impossibility theorem. The idea of a social welfare function was first introduced by Abram Bergson in 1938. In this form, social welfare is a function of the levels of utility of members in society. Alternatively, the social welfare function can be expressed as a function of other variables relevant to welfare, such as income or life expectancy". In Welfare Economics, the first welfare theorem establishes that a system of free markets will lead to a Pareto efficient equilibrium. Kenneth Arrow and Gerard Debreu demonstrated this theorem mathematically, although the restrictive assumptions necessary for the proof mean that the result may not necessarily reflect the workings of real economies. The conditions for the theorem are the following: Markets exist for all possible goods. Markets are perfectly competitive. Transaction costs are negligible. There are no externalities. Under ideal conditions, the first welfare theorem means that Pareto efficiency can be obtained with very little government action as the function of government can be restricted to that of protecting property rights and allowing trade. The real meaning of the theorem is that the result of free markets, under the conditions mentioned, will be efficient. Thus there is nothing we can do to change this result without hurting some participants. The question if we want to accept this result, believing in the value of individual rights, or if we think the state should change it to attain some other goal, is really philosophical. "The second fundamental theorem of welfare economics states that any desired Pareto efficient allocation can be achieved using competitive markets. This theorem requires the assumption of convex consumer preferences and producer production sets and complete/competitive markets". (Wikipedia, 2005i). Arnold C. Harberger (2002) gives his definition of Applied Welfare Economics enumerating its areas of application: "Applied welfare economics is the fruition of microeconomics. It deals with the costs and benefits of just about anything-public projects, taxes on commodities, taxes on factors of production (corporation income taxes, payroll taxes), agricultural programs (like price supports and acreage controls), tariffs on imports, foreign exchange controls, different forms of industrial organization (like monopoly and oligopoly), and various aspects of labor market behavior (like minimum wages, the monopoly power of labor unions, and so on)." When speaking about Nobel Prize winner James M. Buchanan, David R. Henderson (2002) explains Buchanan position about Welfare Economics with the following words: "Buchanan also believes that because costs are subjective, much of welfare economics-cost-benefit analysis, and so on-is wrongheaded. He spells out these views in detail in Cost and Choice, an uncommonly impassioned economics book. Yet Buchanan has not persuaded most of his economist colleagues on this issue." Welfare Economics as well as General Equilibrium show a theoretical microeconomic model that it is useful to have an idea of the general state of an economy, but they fail to answer all our questions about improper distribution of income, poverty and all kinds of socioeconomic problems. So General Equilibrium and Welfare Economics are not sufficient to study microeconomic problems, but they are necessary as a starting point into such a study. Conclusion As we can see General Equilibrium and Welfare Economics do not solve all the microeconomic problems as they are mostly theoretical in nature. A different practical approach is given by Michael Albert (2003) on a new field of Economics that he calls "Participatory Economics" or "ParEcon". This system is very interesting in its economic feature, not really in its political aspect. The concept of self-management is very interesting, so ParEcon seems to work from the point of view of Albert. He presents an ideological perspective that could not be very popular, but he is right when he speaks about self-management and participation in an economic model. To sum up, we have the following words by Vilfredo Pareto (1906) about the ethical aspect of Political Economics: "Political economics does not have to take morality into account. But one who extols some practical measure ought to take into account not only the economic consequences, but also the moral, religious, political, etc., consequences." The ethical problem in Economics should be taken into account because there are many decisions that affect poor people. For example, the state plays a central role in helping poor people by taking appropriate measures in their favor. Thus social welfare has to be taken into account at all times when making important economic decisions. Pareto seems to be against Ethics, but if we read his words carefully he is in favor of Ethics as he states that every consequence has to be considered when making economic decisions. So we can say that General Equilibrium and Welfare Economics will keep being relevant in Microeconomics as they help us understand certain vital issues at hand. Social welfare has to be the goal in any economy so General Equilibrium and Welfare Economics will always be necessary to be taken into account when making significant decisions that may affect the poor people or the well-being of society in general. Works Cited Albert, Michael. "Revolution Based on Reason Not Faith or Fantasy". 18 Dec. 2003. ZNet. 16 Nov. 2005. . Caplan, Bryan. "General Equilibrium: The Reality Series". 21 Aug. 2005. The Library of Economics and Liberty. 18 Nov. 2005. . Debreu, Gerard. ""The Mathematization of Economic Theory". American Economic Review. 1991. Quoted in The History of Economic Thought Website. Economics New School. 18 Nov. 2005. . Encyclopedia Britannica. "Welfare Economics". 2005. 18 Nov. 2005. . Harberger, Arnold C. "Microeconomics" 2002. In The Concise Encyclopedia of Economics. The Library of Economics and Liberty. . Henderson, David. R. "Biography of James M. Buchanan". 2002. The Concise Encyclopedia of Economics. The Library of Economics and Liberty. 18 Nov. 2005. . Pareto, Vilfredo. "Manual of Political Economy". 1906. Page 13. Quoted in The History of Economic Thought Website. Economics New School. 18 Nov. 2005. . Wikipedia. "First Welfare Theorem". 6 Nov. 2005a. 17 Nov. 2005. . Wikipedia. "General Equilibrium". 21 Sept. 2005b. 14 Nov. 2005. . Wikipedia. "Kaldor-Hicks Efficiency". 4 Oct. 2005c. 17 Nov. 2005. . Wikipedia. "Microeconomics". 16 Nov. 2005d. 18 Nov. 2005. . Wikipedia. "Pareto Efficiency". 10 Nov. 2005e. 17 Nov. 2005. . Wikipedia. "Say's Law". 13 Nov. 2005f. 18 Nov. 2005. . Wikipedia. "Social Welfare Function". 5 Oct. 2005g. 17 Nov. 2005. . Wikipedia. "Supply and Demand". 12 Nov. 2005h. 14 Nov. 2005. . Wikipedia. "The Two Fundamental Theorems of Welfare Economics". 6 Nov. 2005i. 17 Nov. 2005. . Wikipedia. "Welfare Economics". 16 Nov. 2005j. 17 Nov. 2005. . Read More