General Equilibrium


Market Equilibrium is a point that is both optimal and feasible:

  1. Optimality: HHs, firms, govn’t are maximally happy; , maximized, government plan is in place
  2. Feasibility: Budget/Resource Constraints are in action


  1. Labor Market:
  2. Goods Market: ←“Resource Constraint”
  3. HH income: ←”Consumer Budget Constraint”
  4. Government ←”Government Budget Constraint”

⇒ If the two of three budget constraints are satisfied, the other one is automatically satisfied

Deriving the Equilibrium

1. Production Possibility Frontier


  • PPF indicates current level of technology, levels of govn’t spending
  • Gradient of the PPF is the Marginal Rate of Transformation () of the economy; i.e. opportunity cost of transforming between consumption and leisure. This is equivalent to wage.
  • Government speding is indicated by a downward shift of the PPF

2. Household Optimization


  • Consider: even if households do not work, they will get amount of income

1+2: Market Equilibrium


At Point :

  • Firms produce maximally, HHs maximize utility
  • Is feasible [=inside PPF, inside HH budget constraint]

Examples of Disequilibrium

→ The left case: but is infeasible household indifference curve is outside → The right case: feasible, but household utility is not maximized


Changes in Equilibrium

  1. Changes in Government Spending [= ], normally due to war, or infrastructure projects


Government can crowd out private consumption, because it reduces HH income (income effect):

Taxes↑ ⇒ HH income ↓ ⇒ ↓ ⇒ ↓ ⇒ likely increases