EKN 310
Chapter 2 – Benchmark model of the economy:
Positive and Normative approaches
Introduction
What is the benchmark model?
• The benchmark model is the neoclassical theory of general equilibrium.
• It is a benchmark because it is not an accurate description of the real
world but rather used to determine the ‘ideal situation’ with respect to
economic e?iciency.
Benchmark model assumptions:
The benchmark model is based on a host of unrealistic assumptions that include…
1. 2x2x2 Model
o There are only 2 people in the economy, A and B
o They own the 2 factors of production, capital (K) and labour (L)
o They produce 2 goods, X and Y
o And they consume both goods.
o Their amounts of capital and labour are fixed (don’t change)
2. No External Influences
o One’s consumption of something does not aOects anyone else’s
o Production does not creates external costs or benefits
o Everything aOects only the buyer and seller involved
o No consumption or production externalities
3. Tastes are Fixed
o People’s preferences do not change
o IndiOerence curves are smooth and ‘well behaved’, they don’t cross and
they show diminishing marginal rate of substitution
o Aka you receive less and less of one good to get more of another.
o Remember: indiOerence curves show diOerent combinations of goods
that yield the same level of utility).
, 4. Production Process has perfect factor suitability
o Inputs (capital and labour) can be substituted for each other
o As you use more of one input, its extra output eventually decreases
(diminishing marginal productivity)
o There can also be constant returns to scale – if you double inputs, output
doubles
o There are no economies or diseconomies of scale
o Isoquants are smooth and regular
5. Everyone maximized something
o Consumers maximize utility
o Producers maximize profit
6. Commodity and factor markets are perfectly competitive
o There are many buyers and many sellers
o No single person can influence prices
o So everyone is a price-taker
o No public sector
These assumptions together ensure the existence, uniqueness and stability of a general
equilibrium.
Economic E-iciency
Economic e?iciency consists of both:
- Allocative e?iciency
- Technical e?iciency (or X-e?iciency)
NB: Achieving perfect economic e?iciency, ensure that ability to achieve optimal
economic growth for a country.
Allocative E-iciency
• Allocative e?iciency describes the situation where a country’s limited
resources are allocated according to the wishes of its consumers.
• Thus creating an optimal mix of products/ consumables.
• The optimal mix of products involves economic actions by both
consumers and producers.
Chapter 2 – Benchmark model of the economy:
Positive and Normative approaches
Introduction
What is the benchmark model?
• The benchmark model is the neoclassical theory of general equilibrium.
• It is a benchmark because it is not an accurate description of the real
world but rather used to determine the ‘ideal situation’ with respect to
economic e?iciency.
Benchmark model assumptions:
The benchmark model is based on a host of unrealistic assumptions that include…
1. 2x2x2 Model
o There are only 2 people in the economy, A and B
o They own the 2 factors of production, capital (K) and labour (L)
o They produce 2 goods, X and Y
o And they consume both goods.
o Their amounts of capital and labour are fixed (don’t change)
2. No External Influences
o One’s consumption of something does not aOects anyone else’s
o Production does not creates external costs or benefits
o Everything aOects only the buyer and seller involved
o No consumption or production externalities
3. Tastes are Fixed
o People’s preferences do not change
o IndiOerence curves are smooth and ‘well behaved’, they don’t cross and
they show diminishing marginal rate of substitution
o Aka you receive less and less of one good to get more of another.
o Remember: indiOerence curves show diOerent combinations of goods
that yield the same level of utility).
, 4. Production Process has perfect factor suitability
o Inputs (capital and labour) can be substituted for each other
o As you use more of one input, its extra output eventually decreases
(diminishing marginal productivity)
o There can also be constant returns to scale – if you double inputs, output
doubles
o There are no economies or diseconomies of scale
o Isoquants are smooth and regular
5. Everyone maximized something
o Consumers maximize utility
o Producers maximize profit
6. Commodity and factor markets are perfectly competitive
o There are many buyers and many sellers
o No single person can influence prices
o So everyone is a price-taker
o No public sector
These assumptions together ensure the existence, uniqueness and stability of a general
equilibrium.
Economic E-iciency
Economic e?iciency consists of both:
- Allocative e?iciency
- Technical e?iciency (or X-e?iciency)
NB: Achieving perfect economic e?iciency, ensure that ability to achieve optimal
economic growth for a country.
Allocative E-iciency
• Allocative e?iciency describes the situation where a country’s limited
resources are allocated according to the wishes of its consumers.
• Thus creating an optimal mix of products/ consumables.
• The optimal mix of products involves economic actions by both
consumers and producers.
