Summary
Chapter 2 summary
- Course
- EKN 310
- Institution
- University Of Pretoria (UP)
Summary of 11 pages for the course EKN 310 at UP (Chapter 2 summary)
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Chapter 2Benchmark model of the economy: Positive and normative
approaches
Benchmark model:
Describes a stable economy in which all resources are used optimally → can help us
understand and appreciate real world problems better as a result.
Depicts how the economy should run in the ideal economy → does not provide an
accurate picture of the real world.
It is a general equilibrium model (all markets are in equilibrium at the same time) that is
used to determine the “ideal situation” with relation to economic efficiency (a country’s
ability to achieve economic growth)
Model assumption: (relates to normative economics)
1. 2x2x2 model
- 2 producers of commodities, 2 consumers, 2 suppliers of factors of production
- Labour and capital are used to produce goods X and Y that are both
consumed by an individual.
2. No external influences
- All parties are fully informed about the economy.
- All parties are unaffected by the actions of other consumers and producers.
- Consumers have fixed tastes.
- No external effects associated with consumption.
3. Production processes have:
- Unlimited factor substitutability → labour and capital can be instantly moved
from one sector to another.
- Diminishing marginal productivities
- Constant returns to scale → rules out diseconomies of scale
4. Consumers maximise utility and producers maximise profits.
5. Commodity and factor markets are perfectly competitive → both markets clear
and there is neither a surplus nor deficit.
These assumptions are unrealistic → we start with them in this model and then relax certain
assumptions → see what outcome there is on the model.
The assumptions ensure the existence, uniqueness, and stability of the general equilibrium.
Notes by Georgia Taylor EKN 310 1
, Benchmark model and allocative efficiency: (relates to normative economics)
Economic efficiency → consists of allocative efficiency and technical efficiency (X-
efficiency) → a country’s ability to achieve economic growth.
Achieving perfect economic efficiency ensures the ability to achieve optimal economic
growth → want to achieve economic efficiency so that we ca achieve optimal economic
growth.
Government should intervene to help the economy improve its economic efficiency and
societal welfare an diminish it → government should help achieve economic efficiency
and not hamper it.
Allocative efficiency
Describes the situation where a country’s limited resources are allocated according to the
wishes of its consumers → results in the optimal mix of products.
Optimal mix of products → involves economic actions by both consumers and producers
to be achieved.
Allocative efficiency in the general equilibrium context will only exist when:
- There is no public sector in the economy → therefore no government intervention.
- There are no production and consumption externalities → everything received by
one party is paid to another → no extra cost of benefit to the rest of society (e.g
pollution)
- The economy achieves the following three conditions at the same time.
o Pareto-optimal production solution
o Pareto-optimal consumption solution
o Simultaneous consumer and producer equilibrium
Pareto-optimal consumption solution → when it is no longer possible to increase one
consumer’s utility position any further without negatively affecting those of the other
consumers.
- Optimality is only achieved when you succeed to improve the welfare experience
in your society experienced by the last individual without taking away from your
other individual in the society.
- Consider:
o Two-person, two-commodity exchange economy in which the total supply
of two commodities is fixed.
o Consumers (A and B) each have an initial allocation of good X and Y → they
exchange these goods if it is mutually beneficial for both A and B.
o Rate at which they are willing to exchange one good for another →
marginal rate of substitution (MRSxy) → if MRSxy differs between A and B
there is room for beneficial exchange.
o MRSxy is equal for A and B → all mutually beneficial exchange opportunities
have been exhausted → pareto-optimal allocation has been reached.
- Movement from initial allocation to efficient allocation = Pareto improvement
𝑎 𝑏
𝑀𝑅𝑆𝑥𝑦 = 𝑀𝑅𝑆𝑥𝑦
Notes by Georgia Taylor EKN 310 2
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