Question

Illustrate and explain how a representative consumer’s decisions and a representative firm’s decisions contribute to equilibrium in a competitive market for a particular good or service. Is the equilibrium socially efficient?

Answer 1

In a competitive market for equilibrium to exist, both consumers and producers must meet on a common ground.

The producers produce one good at the cost of another, also known as the marginal rate of technical substitution. This is calculated as the slope of the production possiblities frontier which equals the marginal product of labor to marginal product of capital.

The consumers consume two goods which are represented in their indifference curves. The slope of the indifference curve is the ratio of the prices of the goods consumed.

At the optimal point, the PPF is tangent to the indifference curve, which means

PL/PK = MPL/MPK

This equilibrium is socially efficient as it involves best optimal allocation of resources between producers and consumers. Both producers and consumers are equally better off and no one can be made better off without making the other one worse off.