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In the last lecture, we put together the last piece of the circular flow diagram: capital markets. Since we now understand each piece of the circular flow diagram, we are in a position to understand the diagram as a whole. This chapter examines the arrows that connect each piece of the circular flow diagram. We will put the input and the output markets together to create a picture of general equilibrium in the economy. We explain why a perfectly competitive market has certain socially desirable features. We will conclude by noting some of the conditions under which markets do not work properly. By the end of this chapter, you should be able to answer the following questions: 1. What is the difference between general equilibrium and partial equilibrium? 2. Are markets always in a general equilibrium? 3. How can one tell if an allocation is Pareto efficient? 4. Is a perfectly competitive firm Pareto efficient in the long run? Explain. 5. How do resources get efficiently allocated among firms? 6. How do we know if a market is producing the socially optimal quantity of each output? 7. What is a market failure and what are some of the reasons for market failure? 8. Why do we study the efficiency properties of perfect competition?
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