Question

Q1.In general equilibrium, can we have an excess demand of all goods? Show your argument in a two goods case.

Q2.

a.Explain why perfectly competitive markets are efficient.

b.If the Canadian government levies a 10% tax on beer, is the Canadian economy( otherwise perfectly competitive) still efficient? Explain.

Answer 1

1. No we can not have an excess demand of all goods in general equilibrium.

Lets take a two goods economy. Lets say the 2 goods are Oranges and Leather. If the demand of Oranges increases, the income spend on Oranges will also increase. Since the income is constant, the income spent on leather will decrease, resulting in lesser demand for Leather. Hence the increase in demand of Oranges will be nullified by the decrease in demand of Leather. This, when used in general sense, is called Walras's law- the total value of excess demand of different goods must be zero.

2. Perfectly competitive markets are efficient because they not only hold productive efficiency, but also allocative efficiency.

• Productive Efficiency- Productive efficiency happens when the production is on the production possibility frontier. The company is neither overproducing nor underproducing.
• Allocative Efficiency- When the firm chooses such a point of the production possibility frontier that Price=Marginal Cost, the firm is choosing the price where the benefit to the society is being maximized. This is called allocative efficiency.

If the price is greater than the marginal cost, the benefit to the society is lessened as a whole. If the price is lesser than the marginal cost, the cost of producig the good is exceeding the benefit to the society as a whole.

At P=MC, the societal benefit is being maximized and hencce perfectly competitive markets are efficient.

3. No it isnt. When a tax is introduced in a perfectly competitive economy, it creates a diffrence between demand price and supply price, which were equal till now. This tax will mostly be paid by both the buyers and by the sellers. This reduces the consumer and producer surplus, which was being maximized till now, and results in an inefficient economy.