Chapter Outline

General equilibrium can be explored most easily with a simple two-person exchange model.
An Edgeworth exchange box shows the initial endowment of goods and the distribution of those goods.
1. If marginal rates of substitution of the two goods differ for the two people, both people can improve their lot by exchange.
2. Pareto optimality and a location on the contract curve results when exchange cannot improve one person’s position without reducing that of the other person.
3. The location on the contract curve, although efficient, may not be fair if the initial endowments were not equitable.
4. The actual trading process is enhanced by the fluctuation of the prices of the goods until supply equals demand in each market.
5. The invisible hand theorem summarizes this action, by stating that the equilibrium in competitive markets is Pareto optimal.
An Edgeworth production box shows the initial resource endowments and how they are allocated among the two production processes.
1. If the marginal rates of technical substitution differ, there will be incentive for the firms to exchange inputs until they reach the contract curve of production, where the MRTS are identical.
2. The contract curve of production is efficient because one firm could not increase its output without the other firm losing output.
Efficiency in production and consumption could exist in an economy that produced the wrong mix of goods.
1. Deriving a production possibilities curve from the production contract curve will give a menu of alternative efficient output combinations.
2. The slope of the production possibilities curve shows the rate at which society is able to exchange one good for the other.
3. The slope of the consumer's indifference curve shows the rate at which society would be willing to trade the two goods.
4. When society values goods at the cost of producing the goods, then the right mix of goods exists.
If a country engages in international trade and takes world prices as given, then the world price becomes the cost of acquiring output (imports complement domestic production) rather than the country’s marginal cost of production. Production takes place where the marginal cost of production for goods equals world prices.
1. Firms will be unsuccessful if they try to sell goods that cost more than the world price.
2. Accordingly, each country exports those goods for which it has a cost advantage and buys goods that would be more costly to produce themselves, resulting in gains from trade.
Market intrusions alter the ideal outcomes.
1. Taxes that affect relative prices destroy the efficiency of the system, unlike head taxes that do not alter relative price ratios.
2. Monopoly pricing above the marginal cost leads to the wrong product mix.
3. Externalities distort the true costs and benefits of decision making, unless public policy offsets the distortion.
4. Public goods cannot be efficiently supplied by markets because of their nondiminishability and nonexcludability.

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