25.1 Beyond Partial Equilibrium

Last week we analyzed partial competitive equilibrium — that is, equilibrium in a single perfectly competitive market, holding all factors outside that market constant.

But markets for one good don’t exist in a vacuum: the demand for one good is influenced by the prices of other goods, and the supply of one good depends on outside factors like the prices of inputs and, in the long run, the opportunity cost of switching industries. This week we’ll show how we can use our models of consumer and firm behavior to move beyond the ceteris paribus assumption and start to model how a change in one market affects others. We will end up with a model which takes as exogenous only the resources available to the economy, the technology for transforming those resources into goods, and consumers’ preferences over goods: in short, the same basic ingredients as in the model of Chuck in “autarky” that we spent the first four weeks of class on. This model, in which we solve for equilibrium in all markets in the economy at once is called the model of general competitive equilbrium.

Perhaps remarkably, we will show that markets, made of thousands of firms and millions or even billions of consumers, “choose” to produce at the same point along the PPF as a single omniscient, benevolent “social planner” would.

Today we will focus on the supply side of the market: how firms respond to prices by collectively choosing the point along the PPF that maximizes the monetary value of their combined output, even though each firm is only concerned with its own profit. On Wednesday we will bring the demand side of the equation back into it, and solve for our final model of the class: the one model that everything we’ve been doing has been leading up to.