Households make constrained choices in both input and output markets. In parts 9 to 24, we discussed an individual household demand curve for a single good or service. Then in parts 25 to 29, we went behind the demand curve and saw how income, wealth, and prices define the budget constraints within which households exercise their tastes and preferences. We soon discovered, however, that we cannot look at household decisions and output markets without thinking about the decisions made simultaneously in input markets. Household income, for example, depends on choices made in input markets: whether to work, how much to work, what skills to acquire, and so forth. Input market choices are constrained by such factors as current wage rates, the availability of jobs, and interest rates.
Firms are the primary producing units in a market economy. Profit-maximizing firms, to which we have limited our discussion, earn their profits by selling products and services for more than it costs to produce them. With firms, as with households, output markets and input markets cannot be analyzed separately. All firms make three specific decisions simultaneously: (1) how much output to supply, (2) how to produce that output---that is, which technology to use, and (3) how much of each input to demand.
 In parts 30 to 44 of this analysis, we explored these three decisions from the viewpoint of output markets. We saw that the portion of the marginal cost curve that lies above a firm's average variable cost curve is the supply curve of a perfectly competitive firm in the short run. Implicit in the marginal cost curve is a choice of technology and a set of input demands. In parts 45 to 54, we looked at the perfectly competitive firm's three basic decisions from the viewpoint of input markets.
Output and input markets are connected because firms and households make simultaneous choices in both arenas, but there are other connections among markets as well. Firms buy in both capital and labor markets, for example, and they can substitute capital for labor and vice versa. A change in the price of one factor can easily change the demand for other factors. Buying more capital, for instance, usually changes the marginal revenue product of labor and shifts the labor demand curve. Similarly, a change in the price of a single good or service usually affects household demand for other goods and services, as when a price decrease makes one good more attractive than other close substitutes. The same change also makes households better off when they find that the same amount of income will buy more. Such additional "real income" can be spent on any of the other goods and services that the household buys.
The point is simple: input and output markets cannot be considered separately or as if they operated independently. While it is important to understand the decisions of individual firms and households in the functioning of individual markets, we now need to add it all up, to look at the operation of the system as a whole.
You have seen the concept of equilibrium applied both to markets and to individual decision-making units. In individual markets, supply and demand determine an equilibrium price. Perfectly competitive firms [Pure or perfect competition is a theoretical market structure in which the following criteria are met: All firms sell an identical product (the product is a "commodity" or "homogeneous"). All firms are price takers (they cannot influence the market price of their product). Market share has no influence on prices (investopedia.com).] are in short-run equilibrium when price and marginal cost are equal (P = MC). In the long run, however, equilibrium in a competitive market is achieved only when economic profits are eliminated. Households are in equilibrium when they have equated the marginal utility per dollar spent on each good to the marginal utility per dollar spent on all other goods. This process of examining the equilibrium conditions in individual markets and for individual households and firms separately is called partial equilibrium analysis.
A general equilibrium exists when all markets in an economy are in simultaneous equilibrium. An event that disturbs the equilibrium in one market may disturb the equilibrium in many other markets as well. The ultimate impact of the event depends on the way all markets adjust to it. Thus, partial equilibrium analysis, which looks at adjustments in one isolated market, may be misleading.
Thinking in terms of a general equilibrium leads to some important questions. Is it possible for all households and firms in all markets to be in equilibrium simultaneously? Are the equilibrium conditions that we have discussed separately compatible with one another? Why is an event that disturbs an equilibrium in one market likely to disturb many others simultaneously?
In talking about general equilibrium, we continue our exercise in positive economics---that is, we seek to understand how systems operate without making value judgments about outcomes. In later posts, we turn from positive economics to normative economics as we begin to judge the economic system. Are its results good or bad? Can we make them better?
In judging the performance of any economic system, you will recall, it is essential first to establish specific criteria to judge by. In the next several posts we use two such criteria: efficiency and equity (fairness). First, we demonstrate the efficiency of the allocation of resources---that is, the system produces what people want and does so at the least possible cost if all the assumptions that we have made thus far hold. When we begin to relax some of our assumptions, however, it will become apparent that free markets may not be efficient. Several sources of inefficiency naturally occur within an unregulated market system. Then, we will cover the potential role of government in correcting market inefficiencies and achieving fairness.
*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 233-235*
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