Chapter 10, Problem 1RQ

To determine

To ascertain:The necessity of general equilibrium analysis if there is an alteration in prices of goods by using mentioned diagram.

Answer to Problem 1RQ

Using the general equilibrium analysis will express more than the simple supply-demand diagram.A simple supply-demand diagram can only describe that if there is an alteration in demand, then given thesupply there can only be upward pressure on prices. The necessity is to apply general equilibriumanalysis to check changes in demand to calculate efficient outcomes that increase the welfare of society.

Explanation of Solution

The rise in demand will increase a goodprice, and the decline in demand will reduce it.This can beassumed from partial equilibrium analysis,but this is not sufficient to understand theworkings of the economy.Various markets are interconnected, and theyperform and respond in suchways that they influence each other. Rise in demand for a product will raise price, but itsinfluence may be different through the collaboration with other factors influencing the price of theproduct.The rise in demand calls for an increase in labour in industry. Increased labour demands morewages. It raises the cost of manufacture and production declines. Prices increase further andsupply comes down.Such interconnected influences can be analysed with the help of generalequilibrium analysis.Perfect competition brings about equilibrium in the market.Arbitrarily determined price andquantity move toward equilibrium price and quantity.

The diagram is given below:

Excess demand has been shown by the difference between X’1, and X1. This excess demand willput upward pressure on the price of good X. If it would have been partial equilibrium analysis,this would have sufficed. However, in general, equilibrium analysis, along with excess demand forgood X, there will also be an excess supply of good Y.

The excess supply is shown by thedifference between Y, and Y'₁. This excess supply will put downward pressure on the price of goodY. The combined effect of this can be traced by clockwise rotation of the budget constraint. Thenew budget constraint C*C* is steeper than the old budget constraint CC. The steepness ofthe budget constraint C*C* indicates that price of good X has increased and price of good Yhas fallen.Hence, the new equilibrium is designated by point E which is arrived at by the interaction ofthe purchasers and the suppliers in the general equilibrium set up.

The new equilibrium, E, is theefficiency point where society's welfare is increased if markets function perfectly.Hence, truly using the general equilibrium analysis will express more than the simple supply-demand diagram.A simple supply-demand diagram can only describe that if there is alteration in demand, then given thesupply there can only be upward pressure on prices.

But, in an integrated market set upwhich reflects more real world this will not suffice. The necessity is to apply general equilibriumanalysis to check changes in demand tocalculate efficient outcomes that increasethe welfare of society.

Economics Concept Introduction

Introduction: General equilibrium analysis is referring to the equilibrium of complete organisation in the economy purchaser, manufacture, resource owner, services and industries.General equilibrium succeeds when both good and factor markets are in equilibrium in relation to each other.