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Competitive equilibrium

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Competitive market equilibrium is the traditional concept of economic equilibrium,
appropriate for the analysis of commodity markets with flexible prices and many
traders, and serving as the benchmark of efficiency in economic analysis. It relies
crucially on the assumption of a competitive environment where each trader decides
upon a quantity that is so small compared to the total quantity traded in the market
that their individual transactions have no influence on the prices. Competitive
markets are an ideal, a standard that other market structures are evaluated by.
A competitive equilibrium is a vector of prices and an allocation such that given the
prices, each trader by maximizing his objective function (profit, preferences) subject
to his technological possibilities and resource constraints plans to trade into his part
of the proposed allocation, and such that the prices make all net trades compatible
with one another ('clear the market') by equating aggregate supply and demand for
the commodities which are traded.
A simple example is a society where there are only two products, bananas and
apples, and 2 individuals, Jane and Kelvin. The price of bananas is P b, and the price
of apples is P a.

The indifference curves J1 of Jane and K 1 of Kelvin first intersect at point X, where
Jane has more apples than Kelvin does, Kelvin has more bananas than Jane does,
and they are willing to trade with each other at the prices P b and Pa. After trading
both Jane and Kelvin move to an indifference curve which depicts a higher level of
utility, J2 and K2. The new indifference curves intersect at point E. The slope of the
tangent of both curves equals -Pb/Pa.
And the MRSJane=Pb/Pa; MRSKelvin=Pb/Pa. The marginal rate of substitution of Jane
equals that of Kelvin. Therefore the 2 individuals society reaches Pareto efficiency,
where there is no way to make Jane or Kelvin better off without making the other
worse off.

The competitive equilibrium and allocative efficiency [edit]

At the competitive equilibrium, the value society places on a good is equivalent to
the value of the resources given up to produce it (marginal benefit equals marginal
cost). By definition, this ensures allocative efficiency (the additional value society
places on another unit of the good is equal to what society must give up in resources
to produce it).[1]

Note that microeconomic analysis does NOT assume additive utility nor does it
assume any interpersonal utility tradeoffs. Efficiency therefore refers to the absence
of Pareto improvements. It does not in any way opine on the fairness of the
allocation (in the sense of distributive justice or equity). An 'efficient' equilibrium
could be one where one player has all the goods and other players have none (in an
extreme example). This is efficient in the sense that one may not be able to find a
Pareto improvement - which makes all players (including the one with everything in
this case) better off (for a strict Pareto improvement), or not worse off.

References [edit]
1. ^ Callan, S.J & Thomas, J.M. (2007). 'Modelling the
Market Process: A Review of the Basics', Chapter 2
in Environmental Economics and Management: Theory,
Politics and Applications, 4th ed., Thompson
Southwestern, Mason, OH, USA

See also [edit]

Economic equilibrium

Allocative efficiency


Markets (customer bases)

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This page was last modified on 13 October 2012 at 09:23.

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