The difference between partial and general equilibrium models

  1. Explain the difference between partial and general equilibrium models.
    Give an example of an economic issue that would be better studied
    in the context of a general equilibrium model. Explain why a partial
    equilibrium approach would not be appropriate in your example.
    Comment: Do not use the example of the housing crash and financial
    crisis of 2007-2008, as this was given in the notes. Instead, you should
    come up with your own example. [3 points]
  2. In the static general equilibrium model with production, the first order
    conditions for the household are:
    u2(C, l) = u1(C, l) · w and,
    C = w · (h − l) + π − T.
    Explain in words what each of these conditions says and explain why
    each must be satisfied at an optimal choice. [3 points]
  3. Consider a version of the static general equilibrium model with production. Suppose that the government want to finance an exogenous
    stream of government expenditures, given by G. For simplicity, you
    can assume that these government expenditures enter neither the utility function nor the production function (i.e. they are useless).
    The government chooses between two possible tax schemes in order
    to finance its spending. Option 1 is to impose a lump sum tax on
    households (as seen in the notes). Option 2 is to impose a proportional
    tax on employment that will be paid by firms.
    Assume that the government balances its budget.
    Evaluate the following claim in the context of the above model: “Households will be better off under option 2, because in that case the firms
    will pay the tax whereas in option 1 the households will have to pay
    the tax.” [3 points]

Sample Solution