1

Part III:
Walrasian Theory
Literature
Geoffrey A. Jehle, Philip J. Reny: Advanced
Microeconomic Theory, 2nd Ed., Pearson
International, 2001.
2
Hall R. Varian: Microeconomic Analysis, 3rd
Ed., W. W. Norton & Company, 1992.
Andreu Mas-Colell, Micheal D. Whinston und
Jerry R. Green: Microeconomic Theory,
Oxford University Press, 1995.
Overview
1. Introduction
2. Model
3. Normative Analysis
First Welfare Theorem
3
First Welfare Theorem
Second Welfare Theorem
4. Positive Analysis
Existence
Structural characteristics
Introduction
In Part II of this lecture series we looked at
partial analysis, where makets were
considered in isolation.
Where the income effect and repercussions
4
Where the income effect and repercussions
in other markets are important, partial
analysis can yield false results.
The following example from Mas-Colell et al.
(1995, pp. 538540) makes this evident:
Introduction
Who bears the tax burden?
1 country, N identical towns, N identical firms
Production of a homogeneous good, price normalized
5
Production of a homogeneous good, price normalized
to 1
One firm per town
Production function, with z = labor input:
( ) ( ) ( )
mit ' 0 und '' 0 f z f z f z > <
with
and
Introduction
Total supply of labor is M; and supply is
inelastic.
There is total factor mobility.
6
There is total factor mobility.
w
n
is the wage in town n
Complete factor mobility implies that
1
.....
n
w w w = = =
Introduction
Each firm employs M/N units of labor.
The following wage is the product of the optimization
condition for firms:
( )
' w f =
7
Town 1 decides to tax its firm.

( )
Marginal Cost
Marginal Revenue
'
M
N
w f =

Introduction
Owing to tax t, the optimization condition for
firm 1 in town 1 is new.

( )
Marginal Cost
'
M
N
w t f + =

8
Who will actually pay the tax? The worker or
the firm?
Marginal Cost
Marginal Revenue

Introduction
Partial analysis
Partial analysis investigates this question
under the assumption that wages remain
constant in all the other towns; i.e.,
9
constant in all the other towns; i.e.,
Because of complete factor mobility, the
wage in town 1 cannot fall, thus
2
.....
n
w w w = = =
1
w w =
Introduction
Therefore, the whole tax must be carried by
firm 1.
10
Introduction
General analysis
We now look at the general equilibrium across the
labor markets of all the towns. As a result of
competition, the equilibrium wage rate must be such
as
11
as
where the wage w(t) depends on taxation in town 1.
The firms in towns 2, ... ,N respectively employ z(t)
and firm 1, z
1
(t) units of labor.
( )
1 2
.....
n
w w w w t = = = =
Introduction
The following equilibrium conditions hold:
( ) ( ) ( )
1
1 N z t z t M + =

12

Labor supply
Labor demand

( ) ( ) ( )
( ) ( ) ( )
1
'
'
f z t w t
f z t w t t
=
= +
Introduction
How does the wage w(t) react when the tax t
changes?
If we differentiate all three equations with
13
If we differentiate all three equations with
respect to t, we obtain:
( ) ( ) ( )
( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
1
1 1
1 ' ' 0 (1)
'' ' ' 0 (2)
'' ' ' 1 0 (3)
N z t z t
f z t z t w t
f z t z t w t
+ =
=
=
Introduction
We can now substitute from(2) for z'(t) and
from (3) for z
1
'(t) in (1).
( )
( )
( ) ( )
( )
( ) ( )
1
' ' 1
1 0 (4)
'' ''
w t w t
N
f z t f z t
+
+ =
14
If we now evaluate (4) at t = 0, we obtain
since z(0) = z
1
(0) = M/N.
( ) ( ) ( ) ( )
1
'' '' f z t f z t
( ) ( ) ( )
1 ' 0 ' 0 1 0 (5) N w w + + =
Introduction
Solving equation (5) for w'(0) gives
( )
1
' 0
N
w =
15
The equilibrium wage thus falls in all N towns.
The reduction is smaller, the more towns
there are.
Introduction
Now we still do not know who will pay the tax.
We only know that the workers carry a portion
of the tax burden.
( )
16
Let a firms profit function be .
Then aggregate profit is:
( )
w
( ) ( ) ( ) ( ) ( )
1 N w t w t t + +
Introduction
The change in the aggregate profit is
If we evaluate this change when t = 0, we
obtain
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
1 ' ' ' ' 1 N w t w t w t t w t + + +
17
obtain
Aggregate profits do not change!
Only the workers pay!
( ) ( )
1 1
' 0 1 0
N
w
N N

| |
| |
+ + =
| |
\
\
Introduction
Although the partial equilibrium approximation
is correct, as far as getting prices and wages
about right, it errs by just enough and in just
such a direction that the conclusion of the tax
incidence analysis based on it is completely
18
incidence analysis based on it is completely
reversed.
Introduction
This example has shown that it is often
important to undertake a total analysis of the
markets.
19
That is, we have to investigate all markets and
their mutual dependencies simultaneously.
This is the aim and purpose of general
equilibrium theory (Walrasian Theory).
Introduction
Use of the theory
General equilibrium analysis offers a framework for
investigating the effects of exogenous changes such
as taxation, preferences, endowments, technologies
20
as taxation, preferences, endowments, technologies
or politics on quantities and prices in all markets.
It is particularly important that general equilibrium
effects are also taken into consideration when
evaluating fiscal or structural policy measures.
Introduction
Examples
Effects of an eco-tax
Effects of labor market policies
21
Effects of labor market policies
Effects of a oil price shock
Introduction
Areas of application
Public Finance
22
Macroeconomics
Finance
Trade theory
Introduction
Historical description of general equilibrium
theory in a nutshell
In 1776 Adam Smith established the theory
23
In 1776 Adam Smith established the theory
that the wealth of the nation was based on
the division of labor and the achievement of
economic subjects individual interests .
The price mechanism directed by an invisible
hand brought about intelligent coordination.
Introduction
Adam Smiths book, An Inquiry into the
Nature and Causes of the Wealth of Nations
(1776), founded economic liberalism.
His central thesis was that self-interest
24
His central thesis was that self-interest
created (state) welfare: It is not from the
benevolence of the butcher, the brewer or the
baker that we expect our dinner, ... We
address ourselves not to their humanity but to
their self-love, and never talk to them of our
own necessities but of their advantages.
Introduction
L. Walras (1886) was the first to formulate a
mathematic model taking up Adam Smiths
ideas of the invisible hand.
25
According to Walras an equilibrium is a price
vector p that brings supply and demand in all
markets into balance.
Introduction
Kenneth Arrow and Gerard Debreu applied
Kakutanis fixed-point theorem in the 1950s
in order to prove the existence of a Walrasian
equilibrium subject to certain assumptions.
26
Already before they were able to substantiate
the existence of Walrasian equilibria, they
proofed the first and second fundamental
theorems of welfare theory.
The Model
These two fundamental theorems of welfare
theory constitute the theoretical foundation of
the social market economy.
27
the social market economy.
We shall give a short introduction to the
general equilibrium model according to
Debreu (Theory of Value, 1959).
The Model
Important assumptions of the model as presented here
The number of goods is given.
Firms have an exogenously-given technology.
28
Firms have an exogenously-given technology.
Household preferences are given.
The allocation of property rights is given (i.e., they are
uniquely defined, implicitly assuming there is an efficient
legal system).
The Model
The agents exchange goods at prices that
they regard as given.
29
Exchange is central and there are no
transaction or information costs (frictionless
economy).
Prices are constituted such that all markets
are cleared.
The Model
Goods
There are j = 1,, N goods.
30
Goods are perfectly divisible.
There is a market for every good (complete
markets).
The Model
Prices
Let p
j
be the price of good j.
31
We then call a price
vector.
( )
1
,....,
N
N
p p p
+
=
The Model
Producers (firms)
There are f = 1,, F producers.
The technological possibilities of producer f are
32
The technological possibilities of producer f are
determined by the technology .
The following sign convention applies for the
production plans :
Inputs are negative, outputs are positive.
N
f
Y
( )
1
,...,
f f fN f
y y y Y =
The Model
We assume that producer f maximizes his
profit , given his technological
possibilities.
( )
f
p
33
That is, he solves the following problem.
( )
fi
N
i
i
Y y
f
Y y
f
Y y
y p y p p
f f f f f f

=

= =
1
max max max
The Model
Consumers (Households)
There are h = 1,,H households.
Household h starts with the initial endowment:
34
Household h starts with the initial endowment:
The sum of initial allocations
is the total allocation for the economy.
( )
1
,...,
N
h h hN
e e e
+
=
1
H
h
h
e e
=
=

The Model
The set is the set of all feasible
consumption bundles of consumer h.
A goods bundle of consumer h is a vector
N
h
X

35
A goods bundle of consumer h is a vector
Each household possesses a utility function.
( )
1
,...,
h h hN h
x x x X =
:
h h
u X
The Model
Firms belong to the consumers and the profits from
production are split among the consumers.
Let
hf
be the portion of the h-th consumers share of
profit from the f-th firm.
36
profit from the f-th firm.
It holds that:
Let the vector of the profit shares of the h-th
consumer be
[ ]
1
0,1 und 1
H
hf hf
h

=
=

( )
1
,...,
h h hF
=
The Model
Each individual households budget is
composed of the value of their initial
endowment as well as their shares from
companies profits:
37
companies profits:
( )
1
F
h h hf f
f
p x p e p
=
= +

The Model
Households maximize their utility subject to their
budget constraint.
The decision problem is thus:
38
The decision problem is thus:
( ) ( )
1
max s.t.
h h
F
h h h h hf f
x X
f
U x p x p e p

=
= +

The Model
Definition (Allocation): A list
of consumption plans and production plans is
called an allocation if
( ) ( )
1 1
, ,.., ; ,..,
H F
x y x x y y =
39
called an allocation if
( )
( )
1
1
,.., for all 1,..,
,.., for all 1,..,
h h hN h
f f fN f
x x x X h H
y y y Y f F
= =
= =
The Model
Definition: An allocation is feasible, if the
following holds:
40

= = =
+
F
f
f
H
h
h
H
h
h
y e x
1 1 1
The Model
Feasibility simply means that for each
good the quantity consumed cannot be
larger than the total quantity available.
41
larger than the total quantity available.
The Model
Definition (Walrasian equilibrium). An
allocation (x*; y*) with price vector p* is a
Walrasian equilibrium if the following holds:
* *
1. arg max 1,...,
f f
y Y
y p y f F

=
42
( )
( )
*
* * * *
1
* * *
1 1 1
1. arg max 1,...,
2. arg max s.t.
1,...,
3.
f f
h h
f f
y Y
h h h
x X
F
h h hf f
f
H H F
h h f
h h f
y p y f F
x u x
p x p e p y h H
x e y

=
= = =
=

+ =
= +

The Model
In words
In a Walrasian equilibrium all decision makers
take the price vector as given.
43
Firms maximize their profits and households
their utility.
The price vector is such that for each good
supply = demand.
The Model
Questions
Normative: What welfare characteristics does a
Walrasian equilibrium have (was Adam Smith
44
Walrasian equilibrium have (was Adam Smith
right?)
Positive: Existence and characteristics
Empirical: Which real markets fit this model?
The Model
Questions
Normative: Welfare properties
45
Positive: Existence and comparative statics
Empirical: does the model fit the data
Overview
Behavioral
hyothesis
Exogenous
data
Endogenous
data
46
Households
Utility
maximization
Endowment
Preferences
Prices
Firms
Profit
maximization
Technology Prices
The Model
Example: Barter economy
We will now calculate the Walrasian
equilibrium for a barter economy in which
there are only 2 goods x and x and 2
47
there are only 2 goods x
1
and x
2
and 2
households.
The Model
Example: Barter economy
Initial endowment
( ) ( ) ( ) ( )
1 11 12 2 21 22
, 1, 0 and , 0,1 e e e e e e = = = =
48
Utility functions
( ) ( )
( )
1 1
1 11 12 11 12 2 21 22 21 22
, and , ,
, 0,1
u x x x x u x x x x



= =

( ) ( ) ( ) ( )
1 11 12 2 21 22
, 1, 0 and , 0,1 e e e e e e = = = =
The Model
Example: Edgeworth-Box with endowment e
x
12
x
21
2
ee
21
= e
1
- ee
11
49
x
11
1
x
22
ee
11
ee
22
= e
2
- ee
12
ee
12
~
2
~
1
The Model
Calculation of individual demand functions
Household 1 solves the following problem:
( )
1
, Max u x x x x

=
50
( )
11 12
1
1 11 12 11 12
,
1 11 2 12 1
1 1 11 2 12
,
s.t.
where
x x
Max u x x x x
p x p x b
b p e p e

=
+ =
= +
The Model
Lagrange:
First order conditions
( )
1
11 12 1 1 11 2 12
L x x b p x p x

= +
51
First order conditions
( )
1 1
11 12 1
11
11 12 2
12
1 1 11 2 12
0
1 0
0
L
x x p
x
L
x x p
x
L
b p x p x

= =

= =

= =

The Model
Marginal rate of substitution is equal to the
relative price
12 1
1
11 2
1
x p
MRS
x p

= =

52
The same optimization principle applies to the
other household.
11 2
1 x p
22 1
2
21 2
1
x p
MRS
x p

= =

The Model
We obtain individual demands via the budget
constraint:
( )
[ ]
( )
( )[ ]
1 11 2 12
11 1 2
1
,
1
p e p e
x p p
p
p e p e

+
=
+
53
For the other household we obtain:
( )
( )[ ]
1 11 2 12
12 1 2
2
1
,
p e p e
x p p
p
+
=
( )
[ ]
( )
( )[ ]
1 21 2 22
21 1 2
1
1 21 2 22
22 1 2
2
,
1
,
p e p e
x p p
p
p e p e
x p p
p

+
=
+
=
The Model
Calculation of equilibrium prices
Aggregate demand = aggregate supply
( ) ( )
[ ] [ ]
11 1 2 21 1 2 11 21
, , x p p x p p e e
p e p e p e p e
+ = +
+ + +
54
Aggregate demand is homogeneous of degree zero. We can
therefore normalize a price.
I choose p
1
= 1:
[ ] [ ]
1 11 2 12 1 21 2 22
11 21
1
2
1
1
p e p e p e p e
e e
p
p
p


+ + +
= +
+ =
2
1 p + =
The Model
Equilibrium prices are thus:
1 2
1
1, p p

| |
= =
|
\
55
Equilibrium consumption is thus:
( ) ( )
( ) ( )
11 1 2 12 1 2
21 1 2 22 1 2
, ; ,
, 1 ; , 1
x p p x p p
x p p x p p


= =
= =
56
NORMATIVE ANALYSIS
Normative Analysis
Normative analysis is concerned with the
question of how allocations should be
evaluated.
57
Here, we investigate the welfare properties of
Walrasian equilibria.
Welfare evaluations are always based on
subjective judgments.
Normative Analysis
A central question of economics is: How
should goods be allocated among
households?
58
We now consider 3 alternatives
Welfare functions
Voting
Pareto Criterion
Normative Analysis
Alternative 1: Welfare functions
We define a welfare function:
W = W(u ,,u ) R
59
W = W(u
1
,,u
H
) R
and look for the allocation that maximizes
welfare.
Normative Analysis
Examples of welfare functions W(u
1
, u
2
)
1. The utilitarian welfare function:
W(u
1
, u
2
) = u
1
+ u
2
60
Characteristics:
(a) Symmetry: W(u
1
, u
2
) = W(u
2
, u
1
)
Symmetry has the advantage that welfare does not
depend on the name of the consumer, but rather on
everyone being considered in the same way.
Normative Analysis
(b) Always give the most to the individual with the greatest
marginal utility. This function awards something to the
individual who can produce greater utility with the
goods.
2. Rawls welfare function:
61
2. Rawls welfare function:
W(u
1
, u
2
) = min{u
1
, u
2
}
Characteristics:
(a) Symmetry: W(u
1
, u
2
) = W(u
2
, u
1
)
(b) Give to the one with the least utility.
Normative Analysis
Criticism of welfare functions
Who chooses W(u
1
,, u
H
)?
62
An interpersonal comparison of utility is required.
Individuals have an incentive to hide their true
preferences if they see an advantage in doing so.
Normative Analysis
Interpersonal comparison of utility requires a
cardinal utility concept. The possibility of this,
however, is questionable and is the reason why an
ordinal utility concept has become accepted.
63
Normative Analysis
Alternative 2: Voting
Derivation of a welfare function based on individual
household preferences decided by means of majority
voting choices.
64
Condorcet Paradox
Arrows Impossibility Theorem
Normative Analysis
Condorcet Paradox
Condorcets paradox illustrates that the familiar
method of majority voting can fail to satisfy the
transitivity requirement.
65
transitivity requirement.
Let there be 3 social states a, b, c:
Player 1
a b c
Player 2
b c a
Player 3
c a b
( ) ( ) ( ) c u b u a u
1 1 1
> >
( ) ( ) ( ) a u c u b u
2 2 2
> >
( ) ( ) ( ) b u a u c u
3 3 3
> >
Normative Analysis
Voting:
a vs. b: Players 1 and 3 find a better.
Thus W(a) > W(b)
b vs. c: Players 1 and 2 find b better.
66
b vs. c: Players 1 and 2 find b better.
Thus W(b) > W(c)
a vs. c: Players 2 and 3 find c better.
Thus W(c) > W(a)
Thus W(a) > W(b) > W(c) > W(a) which is a
contradiction.
Normative Analysis
Arrows Impossibility Theorem
Arrows impossibility theorem shows the impossibility
of aggregating individual preferences (finding a voting
rule) so as to establish a social preference order that
is free of contradictions.
67
rule) so as to establish a social preference order that
is free of contradictions.
It states that:
If there are at least three social states, then there is
no social welfare function that satisfies the precisely
specified minimal requirements for a reasonable
social welfare function.
Normative Analysis
Minimal requirements for a
reasonable social welfare function
Unrestricted Domain: The social preference order
that is derived from individual preferences must be
complete, reflexive and transitive.
68
complete, reflexive and transitive.
Independence of irrelevant alternatives: The
assessment of two alternatives should be
independent of that of other alternatives.
Weak Pareto Principle
Nondictatorship: The preference of any one
individual may not be declared the social preference.
Normative Analysis
Kenneth Arrow (1963) has shown that no social
decision mechanism exists that can satisfy these
conditions.
69
The result is sobering; it shows that no guarantee for
rational decisions exists in politics.
It also explains why collective decisions can be
arbitrary.
Pareto Efficiency
Alternative 3: Pareto Criterion
Definition: Given an allocation x. A feasible allocation y
is strictly Pareto-better if all agents prefer y.
70
is strictly Pareto-better if all agents prefer y.
Definition: Given an allocation x. An feasible allocation
y is weakly Pareto-better if all agents do not find y
less preferable to x, and at least one agent prefers y.
Pareto Efficiency
Definition (Pareto-efficiency): an allocation x is
Pareto-efficient if it does not allow any weak
Pareto-improvement.
71
An allocation is Pareto-efficient if it is
impossible to make someone better off
without making someone worse off.
Pareto Efficiency
Remarks:
This criterion gives every economic subject a veto
right.
72
Efficiency has nothing to do with justice (whatever its
definition): An allocation in which an agent consumes
all goods is Pareto-efficient.
In general there are many Pareto-efficient allocations.
Pareto Efficiency
Example: Barter economy
2 agents, 2 goods x
1
and x
2
Initial allocation
1 2
1 and 1 e e = =
73
Initial allocation
Utility functions
( ) ( )
( )
1 1
1 11 12 11 12 2 21 22 21 22
, und , ,
, 0,1
u x x x x u x x x x



= =

1 2
1 and 1 e e = =
and
Pareto Efficiency
Calculation of Pareto-efficient allocations:
( )
11 12 21 22
1
1 11 12 11 12
, , ,
,
x x x x
Max u x x x x

=
74
( )
11 12 21 22
, , ,
1
2 21 22 21 22 2
11 21
12 22
s.t. ,
1
1
x x x x
u x x x x u
x x
x x

= =
+ =
+ =
Pareto Efficiency
Lagrange:
FOCs:
( ) ( )
( )
1
1
11 12 2 11 12
1 1 L x x u x x

=
75
FOCs:
( ) ( )
( ) ( )( ) ( )
( ) ( )
1 1
1 1
11 12 11 12
11
11 12 11 12
12
1
2 11 12
1 1 0
1 1 1 1 0
1 1 0
L
x x x x
x
L
x x x x
x
L
u x x

= =

= =

= =

Pareto Efficiency
Marginal rates of substitution:
( ) ( )
12 12
1 2
11 11
1
1 1 1
x x
MRS MRS
x x

= = =

76
Solve for x
12
(contract curve):
( )
( )
( )
11
12
11
1
where
1 1 1
x
x
x

= =

Pareto Efficiency
Edgeworth-Box: Contract curve
x
12
x
21
2
xx
21
= e
1
- xx
11
11
x
x

=
77
The contract curve is the set of all Pareto-efficient
allocations.
x
11
1
x
22
xx
11
xx
22
= e
2
- xx
12
xx
12
~
2
~
1
( )
11
12
11
1 1
x
x
x

=

Pareto Efficiency
How does a contract curve look like?
( )
12
2
11
11
0
1 1
dx
dx
x

= >
(

( ) ( )
( )
2
11
12
4 2
11
11
2 1 1 1
1 1
x
d x
dx
x

(

=
(

( )

78
( )
( )
( )
( )
( )
( )
2
12
2
11
2
12
2
11
2
12
2
11
1
If 1, then 0.
1
1
If 1, then 0.
1
1
If 1, then 0.
1
d x
dx
d x
dx
d x
dx

= > <

= = =

= < >

Pareto Efficiency
The example demonstrates that an allocation
is only Pareto-efficient if the marginal rate of
substitution between two goods is identical
for both households.
79
for both households.
This statement can be extended to any
number of goods and households: An
allocation is only then Pareto-efficient if the
marginal rate of substitution between any
two goods is the same for all individuals.
Pareto Efficiency
Edgeworth-Box: Inefficient allocation
x
12
x
21
2
xx
21
= e
1
- xx
11
xx = e - xx xx
80
x
11
1
x
22
xx
11
xx
22
= e
2
- xx
12
xx
12
~
2
~
1
Pareto Efficiency
Edgeworth-Box: Efficient allocation
x
21
2
xx
21
= e
1
- xx
11
81
x
11
1
x
22
xx
11
xx
22
= e
2
- xx
12
xx
12
~
2
~
1
Slopes of the indifference curves are
identical.
Pareto Efficiency
Example: Production economy
Consider the following allocation problem: Player 1
produces q
B
bananas and player 2, q
O
oranges.
82
Let the cost functions be c(q
i
) = q
i
, i = B,O.
Let the utility functions of both players for bananas
and oranges be u
1
(q
O
) and u
2
(q
B
) where
' ''
0 und 0, 1, 2.
i i
u u i > < =
and
Pareto Efficiency
Payoff to both players:
u
1
(q
O
) q
B
for player 1
u
2
(q
B
) q
O
for player 2
83
Calculate the Pareto-efficient allocations:
( ) ( )
( )
1 2 1
,
2 2
max
s.t.
O B
O B
q q
B O
S S u q q
u q q S
=
=
Pareto Efficiency
Lagrange function:
First-order condition:
( )
1 2 2
L S
B B
u u q q = (

84
First-order condition:
Pareto-efficient production and consumption
given S
2
[ ] ( )
1 2
' ' 1 0
O B
u q u q =
( ) ( )
* *
2 2
,
B O
q S q S
Pareto Efficiency
Curve of the Pareto-efficient allocations
Calculation of the slopes curve (apply the
( )
{ }
( )
* *
1 1 2 2 2 2
S S S S
B B
u u q q ( =

85
Calculation of the slopes curve (apply the
envelope theorem):
The curve is concave:
1
1
2
S
' 0
S
u

= <

2
1
1
2
2
S
- '' 0
S
u

= >

Pareto Efficiency
The curve of Pareto-efficient allocations:
S
1
Pareto-efficient
allocations
86
S
2
allocations
Pareto-
inefficient
allocations
S
1
(S
2
)
Pareto Efficiency
In order to get an initial idea of the relationship
between Walrasian equilibrium and Pareto-efficiency,
let us once again look at the first-order conditions of a
barter economy with two households (h = 1,2) and
two goods (i = 1,2).
87
two goods (i = 1,2).
( )
( )
11 12 21 22
1 11 12
, , ,
2 2
2 21, 22 2
1 1
max ,
s.t. and
x x x x
h h
h h
u x x
x e u x x u
= =
=

Pareto Efficiency
Lagrange:
First order conditions:
( ) ( ) ( )
2 2 2
1 11 12 2 2 21 22 2
1 1 1
, ,
i hi hi
i h h
L u x x e x u x x u
= = =
| |
= + +
|
\

88
First order conditions:

i
Multipliers
( )
( )
1 11 12
1 1
2 21 22
2
2 2
,
0, 1, 2
,
0, 1, 2
i
i i
i
i i
u x x
L
i
x x
u x x
L
i
x x

= = =

= = =

Pareto Efficiency
Identical marginal rates of substitution:
( )
( )
( )
( )
1 11 12 2 21 22
11 1 21 1
1 2
1 11 12 2 21 22
2 2
, ,
,
, ,
u x x u x x
x x
MRS MRS
u x x u x x




= = = =

89
The multipliers can be interpreted as the
prices p
1
and p
2
.
( ) ( )
1 11 12 2 21 22
2 2
12 22
, , u x x u x x
x x



Pareto Efficiency
The optimality conditions of the previous the
maximization problems are identical with the
optimality conditions of a Walrasian
equilibrium!
90
In a Walrasian equilibrium, the following
holds:
1 1
1 2
2 2
und
p p
MRS MRS
p p
= = and
Pareto Efficiency
The multipliers
i
reflect the fact that the endowment
of goods is scarce.
If we differentiate the Lagrange function with respect
to the endowment e
i
we get
i
.
Thus,
i
measures how much additional utility agent 1
91
Thus,
i
measures how much additional utility agent 1
could get if we had a bit more of good i.
Since we have just seen that the multipliers and
prices enter in the same way into the first-order
conditions of the two problems, it is clear that prices
also reflect scarcity of goods.
Pareto Efficiency
Edgeworth-Box: Walrasian equilibrium
x
12
x
21
2
xx
21
= e
1
- xx
11
92
x
11
1
x
22
xx
11
xx
22
= e
2
- xx
12
xx
12
~
2
~
1
x
*
e
*
Pareto Efficiency
We have just seen that there is a close
relationship between Pareto efficiency and
Walrasian equilibrium.
93
This relationship is investigated in the
following welfare theorems.
Normative Analysis
94
The Welfare Theorems
First Welfare Theorem
Theorem (First Welfare Theorem).
Consider a general equilibrium model with
local non-satiated preferences. Furthermore,
95
local non-satiated preferences. Furthermore,
let (p*, x*, y*) be a Walrasian equilibrium.
Then the allocation (x*, y*) is Pareto-efficient.
First Welfare Theorem
Proof (indirect):
Let (p*, x*, y*) be a Walrasian equilibrium and
(x, y) an allocation that is Pareto-better.
Pareto-better means without loss in generality
96
Pareto-better means without loss in generality
that
*
1 1
*
for household 1
2,...,
h h
x x
x x h H =

First Welfare Theorem

Why has household 1 not chosen x
1
with
prices p*?
Goods bundle x
1
must be more expensive
97
Goods bundle x
1
must be more expensive
than x
1
* with prices p*, otherwise household
1 would not have maximized its utility:
1 1
* * * p x p x >
First Welfare Theorem
For all other households,
must hold owing to local nonsatiation.
* * *
h h
p x p x
98
Summing across all households yields:
* * *
1 1

H H
h h
h h
p x p x
= =
>

First Welfare Theorem
Owing to local non-satiation, a utility-
maximizing consumption bundle must
exhaust the budget; i.e.,
( )
* * * * *

H H H F
p x p e p y = +

99
( )
( )
( ) ( )
* * * * *
1 1 1 1
* * *
1 1 1
1
* * * * *
1 1 1 1


h h hf f
h h h f
H F H
h hf f
h f h
H F H F
h f h f
h f h f
p x p e p y
p e p y
p e p y p e p y

= = = =
= = =
=
= = = =
= +
| |
= +
|
\
= + +



First Welfare Theorem
The last inequality is an implication of the
firms profit maximization.
But this then gives
( ) + >

H F
f h
H
h
H
h
y p e p x p x p
* * * * *
100
A contradiction of the assumption that the
proposed allocation is feasible; that is
1 1 1
H H F
h h f
h h f
x e y
= = =
+

( )
|
|

\
|
+ >


= = = =
= = = =
H
h
F
f
f h
H
h
h
H
h
h
h f
f h
h
h
h
h
y e p x p x p
1 1
*
1
* *
1
*
1 1 1 1
!
First Welfare Theorem
"To say it in words"
An allocation B, which is Pareto-better
than competition allocation A, must
cost more than A, since, otherwise, the
latter would not represent the
competition equilibrium. In order to
101
competition equilibrium. In order to
afford B, household incomes would have
to rise. However, with the given
allocation this would only be possible
if profits were to rise. Since firms
behave in a profit-maximizing manner,
Bs profit is lower than that of A.
Thus, B is not viable.
First Welfare Theorem
The first welfare theorem shows that the market
mechanism achieves an efficient allocation.
The market mechanism is a very simple mechanism:
Economic agents only have to know prices and their
102
Economic agents only have to know prices and their
own preferences and production technology.
However, the question of who sets prices when all
economic agents are price takers remains
unanswered.
First Welfare Theorem
Conditions for the first theorem to hold:
No external effects
The utility of a consumer depends only on the
goods bundle that he, himself, consumes.
103
goods bundle that he, himself, consumes.
Opposite example: cigarette consumption
Local nonsatiation.
Convexity is no condition.
First Welfare Theorem
Definition (local nonsatiation): The property of local nonsatiation of
consumer preferences states that for any bundle of goods there is
always another bundle of goods arbitrarily close that is preferred to it.
Notes (Definition and comments are from wikipedia):
1. Local nonsatiation is implied by monotonicity of preferences, but not vice
versa. Hence it is a weaker condition. versa. Hence it is a weaker condition.
2. There is no requirement that the preferred bundle y contain more of any
good - hence, some goods can be "bads" and preferences can be non-
monotone.
3. It rules out the extreme case where all goods are "bads", since then the
point x = 0 would be a bliss point.
4. The consumption set must be either unbounded or open (in other words,
it cannot be compact). If it were compact it would necessarily have a
bliss point, which local nonsatiation rules out.
Local Nonsatiation
To illustrate that local nonsatiation is a
necessary condition for the first welfare
theorem, we consider an economy with two
households and two goods in which this
characteristic is absent.
105
characteristic is absent.
Local Nonsatiation
Edgeworth-Box: Local nonsatiation
x
12
x
21
2
Thick indifference
106
x
11
1
x
22
~
2
x
*
e
~
2
~
1
Thick indifference
curve
x
Local Nonsatiation
The allocation x* is a Walrasian equilibrium,
but it is not Pareto-efficient!
Reason:
107
Reason:
Player 1 has local non-satiated preferences;
i.e., he has thick indifference curves.
He is therefore indifferent to x and x*, but x is
strictly preferable for consumer 2!
Second Welfare Theorem
Theorem (Second Welfare Theorem):
Under certain conditions every Pareto-
efficient allocation can be sustained as a
108
efficient allocation can be sustained as a
Walrasian equilibrium by means of a suitable
selection of property rights.
Second Welfare Theorem
Idea of the second welfare theorem
2
The Pareto-efficient allocation x should be realized.
Initial endowment is e.
109
x
1
2
e
Second Welfare Theorem
Step 1: Look for price vector p, such that the budget constraint that
passes through e, has the same slope as the tangent to the two
indifferent curves at point x.
2
110
1
e
x
Second Welfare Theorem
Step 2: Redistribution (by means of taxes and transfers) of the
initial allocation e to e'.
2
111
1
e'
x e
Second Welfare Theorem
We now discuss the qualifier certain
conditions in the statement of the theorem.
They are
112
They are
Convexity
Local nonsatiation
Second Welfare Theorem
Convexity (Households)
Preference ordering must be convex.
113
Preference ordering must be convex.
Remarks: If a preference ordering is convex,
then the upper contour set is convex.
Second Welfare Theorem
x
2
x
{y: y x}
Upper contour set of x
114
x
1
1
~
1
x
Remark:
{y: y x} is called the upper contour set of x.
{y: y > x} is called the strict upper contour set of x.
Second Welfare Theorem
Example with non-convex preferences:
x
12
x
21
2
xx
21
= e
1
- xx
11
115
x
11
1
x
22
xx
11
xx
22
= e
2
- xx
12
xx
12
~
2
~
1
p
x
y
Second Welfare Theorem
Allocation x is Pareto-efficient, however not
feasible as a Walrasian equilibrium.
Although consumer 2 would demand
116
Although consumer 2 would demand
consumption bundle x
2
= (x
21,
x
22
) on the
budget constraint line, consumer 1 would
prefer the allocation y
1
= (y
11,
y
12
).
Second Welfare Theorem
Convexity (Firms)
Every production set Y
f
is convex:
117
No increasing economies of scale
No indivisibility
No fixed costs
Second Welfare Theorem
Examples of non-convex technologies:
Fixed costs
Indivisibility
Increasing
economies of
118
economies of
scale
0
0
0
Second Welfare Theorem
Example of fixed costs
An economy is assumed to consist of a consumer, h = 1,
and two goods n = 2, the work of the consumer and the
consumption goods produced by his labor. ("Robinson
Crusoe-economy").
119
Crusoe-economy").
The production function is characterized by fixed costs.
Pareto-efficiency requires that the marginal rate of
substitution is equal to the technical rate of substitution
(MRS = TRS).
Second Welfare Theorem
Decentralization is possible
y
2
~
1
120
y
1
0
p
x
Y
f

Second Welfare Theorem

Decentralization is not possible
y
2
~
1
121
y
1
p
x
Y
f

Second Welfare Theorem

Allocation x is Pareto-efficient, but not
achievable as a Walrasian equilibrium, since
it does not maximize the producers profit!
122
Problem: Technology Y
f
is not convex. The
firm makes losses.
Interpretation of the Welfare Theorems
Until now we have discussed the welfare theorems from
a theoretical point of view. On the next few slides
well point out some difficulties arising from adapting
these findings to the real-world.
123
Our focus will be on the following issues:
1. Market Economy vs. Planned Economy
2. Redistribution of the initial allocation
3. Market Failure as a real-word problem
Market Economy vs. Planned Economy
From Wikipedia:
The first theorem is often taken to be an analytical
confirmation of Adam Smith's "invisible hand"
hypothesis, namely that competitive markets tend
124
hypothesis, namely that competitive markets tend
toward the efficient allocation of resources.
The theorem supports a case for non-intervention in
ideal conditions: let the markets do the work and the
outcome will be Pareto efficient.
Market Economy vs. Planned Economy
Statement: The economic policy maker only has to
determine property rights in a market economy and can
leave efficient allocation to the market. The market
economy is thus better than a planned economy.
125
This is a fallacious statement, as in a centrally planned
economy with perfect information exactly the same
solution can be achieved. Both systems are equivalent
in this respect.
Market Economy vs. Planned Economy
What can be said if the assumption of complete
information by the planner is dropped?
- With a planned economy the likelihood of arriving at a
targeted goal is virtually nil. The actual solution is
126
targeted goal is virtually nil. The actual solution is
thus almost always inefficient.
- With a market economy an efficient allocation is
guaranteed (first welfare theorem). But it is very
improbable that the realized allocation coincides with
the targeted allocation.
Redistribution of the initial allocation
2. Redistribution of the initial allocation
To reach the target allocation, the policy maker has
two fundamental ways to influence the initial
allocation:
a) Per capita-/fix-rate tax
127
a) Per capita-/fix-rate tax
Since reallocation occurs independently of the
demand behavior of economic subjects on the
markets, the marginal conditions remain intact.
Thus, this type of reallocation is efficient.
Redistribution of the initial allocation
b) Commodity-/consumption-/income taxes
These reallocations are dependent on the
transactions and the behavior of market subjects. A
difference arises between the purchase and sales
price.
128
price.
The second welfare theorem only holds for a
reallocation of type a. In the real world, however, a
reallocation of type b is almost always the case
observed.
Market Failure as a real-word problem
3. Market Failure as a real-word problem
The fundamental theorems indicate why markets might fail to
provide efficient allocations.
Reasons for market failures:
property rights are not well defined
129
property rights are not well defined
incomplete markets
incomplete information
transaction costs
Non-convexities
Markets may also fail if the utility- and production functions of
the agents are dependent on the consumption or production of
the other economic subjects (external effects).
POSITIVE ANALYSIS
130
POSITIVE ANALYSIS
Positive Analysis
Literature: Varian, H., Microeconomic Analysis
(Chapter 17)
In this section we shall look at
131
Walrass Law,
Relative and absolute prices
Existence of Walrasian equilibrium.
Walrass Law
We consider a barter economy.
A consumers demand is defined as
132
( )
( )
( )
1
,
,
,
h h
h h
hN h
x p e
x p e
x p e
| |
|

|
=
|

|
|
\
Walrass Law
The consumers excess demand (net
demand) is
( ) ( )
,
h h h h
z p x p e e =
133
Aggregate excess demand is then
( ) ( ) ( ) ( )
1 1
,
H H
h h h h
h h
z p z p x p e e
= =
= =

Walrass Law
Theorem (Walrass law). For every price vector p, the
value of aggregate excess demand is equal to zero;
i.e.,
134
( )
0 p z p =
Walrass Law
Proof
Owing to monotonicity, every households demand
satisfies the budget constraint
( )
, p x p e p e =
135
Thus it follows that
Aggregate
( ) ( )
1
0
H
h
h
p z p p z p
=
= =

( )
,
h h h
p x p e p e =
( ) ( ) ( )
, 0
h h h h
p z p p x p e e = =
Walrass Law
Remarks:
The value of excess demand is always zero.
136
The law implies that if N-1 markets are in
equilibrium, the N
th
market will also be in
equilibrium.
Relative Prices
Demand is homogeneous of degree zero for
prices:
*Homogenittsgrad Degree of homogeneity
137
Interpretation: If one multiplies all prices by
the factor , demand does not change (no
money illusion!).
( )

( ) ( )
*
0
, , ,
h h h h h h
x p e x p e x p e = =
Relative Prices
Cobb-Douglas example:
For a barter economy with two goods we get
the following demand:
( ) ( )
( )
1
1
1
, and ,
b
b
x p e x p e

= =
138
The budget constraint is
Demand for good 1 is homogeneous:
( ) ( )
( )
1
1
1 2
1 2
1
, and ,
h h h h
b
b
x p e x p e
p p

= =
1 1 1 2 2 h h
b p e p e = +
( )
( ) ( )
( )
1 1 2 2 1 1 2 2
1 1
1 1
, ,
h h h h
h h h h
p e p e p e p e
x p e x p e
p p

+ +
= = =
Relative Prices
An important implication is that only relative
prices are relevant to demand.
We are thus always able to choose a price
139
We are thus always able to choose a price
freely.
The price of the first good is often given as
numraire...
Relative Prices
The prices then have to be changed using the
formula
1
, 1,..,
i
i
p
p i N
p
= =
140
The price of good 1 is thus normalized to .
Every price is thus measured in the units of the first
good.
1
1 p =
Existence of a
141
Existence of a
Walrasian Equilibrium
Existence
It is often important to know whether the
objects that are being discussed actually
exist.
142
exist.
If one assumes that certain things exist even
though they do not in fact exist, this can result
in funny conclusions.
"Raelians" believe that
extraterrestials brought
life to the each 25,000
years ago.
143
years ago.
Existence
27.10.07 7:56 Kantonal police of the Valais
In the Valais paintball guns are used to shoot at
Raelians.
Sitten. SDA/baz. A masked man broke in on a party
144
Sitten. SDA/baz. A masked man broke in on a party
being held by the Raelian sect on Friday evening in
the lower Valais village of Mige and shot around
with a paintball gun. Two people were slightly injured.
According to the Valais police report, approximately
40 members of the UFO-sect were conducting a
meeting in a large hall in Mige when the unknown
person intruded on the crowd and fired. The culprit
then took flight.
Existence
Proposition (Humbug): The largest integer number is 1.
Proof: Let us suppose that a finitely large integer
number exists and let it be called N. Then,
2
N N
145
since N is the largest number. Thus
But since N is the largest number,
QED.
N N
1 N
1 N =
Existence
We have only arrived at this nonsense
because we have assumed the existence of a
largest integer number.
146
But there is no such number and therefore
the proof is humbug.
Existence
In order to investigate the existence of a Walrasian
equilibrium, we will assume that every good has a
positive excess demand when its price is equal to
zero; i.e.,
( )
0 0 for all 0,.., p z p i N = > =
147
Then a Walrasian equilibrium is a price vector p*,
such that aggregate excess demand is z(p*) = 0.
This means that supply = demand for every good.
( )
0 0 for all 0,..,
i i
p z p i N = > =
Existence
Proof of existence
In order to prove its existence, it must be shown that
there is a price vector p*, such that z(p*) = 0; i.e.,
( )
0 z p =
148
We thus have an equilibrium system with N equations
and N unknowns.
( )
( )
1
0
0
0
0
N
z p
z p
=
=
=
=
Existence
These equations are, however, not independent of
one another.
Walrass Law implies that
149
Thus the system of equations consists of N-1
independent equations and N unknown prices.
( ) ( )
j j i i
i j
p z p p z p

Existence
However, since z(p) is homogeneous of degree zero
in prices, we are free to select a price.
Thus the system of equations which we would like to
solve consists of N-1 independent equations and
150
solve consists of N-1 independent equations and
N-1 unknown prices:
( )
( )
1
1
0
0
0
0
N
z p
z p

=
=
=
=
Existence
A Walrasian equilibrium exists if we can find a
solution to this system of equations.
Such a proof is typically done by application
151
Such a proof is typically done by application
of a fixed-point theorem.
The simplest fixed-point theorem is Brouwers
fixed-point theorem.
Existence
Digression: Brouwers Fixed-Point Theorem
Theorem. If is a continuous
function, then an x exists with f(x) = x.
1 1
:

N N
S S f
152
Proof (for N = 2):
Consider a continuous function .
The theorem states that this function has a
fixpoint; i.e., such that
:[0,1] [0,1] f
[ ]
0,1 x ( )
. f x x =
Existence
Define the function .
The function g measures the distance between f(x)
and the diagonal:
( ) ( )
g x f x x =
f(x)
153
0
1
1
x
Existence
A fixpoint x* of the function f thus satisfies
g(x*) = 0.
Since f(0) [0,1], it holds that
g(0) = f(0)-0 0.
1
f(x)
154
g(0) = f(0)-0 0.
Since f(1) [0,1], it holds that
g(1) = f(1)-1 0.
Since the function f is continuous, it follows at an
x* [0,1] exists, such that g(x*) = 0 = f(x*) - x*.
End of digression.
0 1
x
Existence
Proof of existence (continuation):
We allow that excess demand z(p*) can be negative
in a Walrasian equilibrium (Demand < Supply).
155
A Walrasian equilibrium is then a price vector p*,
such that aggregate demand z(p*) 0.
The proof of existence involves to show that a price
vector p* exists, such that z(p*) 0.
Existence
We normalize the prices p
1
,...,p
N
as follows
for the proof of existence:
1
1,..,
i
i
N
j
j
p
p i N
p
=
= =

156
Normalized prices have the characteristic that
The set of all normalized price vectors lies in
the unity simplex S
N-1
.
1 j =

1
1
N
i
i
p
=
=

Existence
Unity simplex of
1
1
1
N
N N
i
i
S p p

+
=

= =
`
)

N
+

157
S
1
S
2
2
p
2
p
1
p
1
p
3
p
Existence
The proof of existence involves to show that
a normalized price vector p S
N-1
exists such
that z(p) 0.
158
The proof uses Brouwers fixed-point
theorem.
Existence
Theorem (Existence): If excess demand
is continuous, then a price
vector p* S
N-1
exists such that z(p*) 0.
1
:
N N
z S

159
Proof:
Consider the function
1 1
:

N N
S S g
( )
( ) ( )
( )
( )
1
max 0,
1,...,
1 max 0,
i i
i
N
j
j
p z p
g p i N
z p
=
+
= =
+

Existence
Since z(p) and max(...) are continuous
functions, then g(p) is also continuous.
Since , the range of this function is
( )
1
N
i
g p =

160
Since , the range of this function is
the simplex S
N-1
.
Interpretation of g: If there is a surplus
demand for good i ; i.e., z
i
(p) > 0, then the
price of this good will rise.
( )
1
1
i
i
g p
=
=

Existence
The function g thus has the properties that we
need in order to apply Brouwers fixed-point
theorem.
161
It follows from Brouwers fixed-point theorem
that a p* exists such that p* = g(p*); and
( ) ( )
( )
( )
*
*
1
max 0, *
(*) 1
1 max 0, *
i i
i
N
j
j
p z p
p i ,..., N
z p
=
+
= =
+

Existence
It still needs to be proved that the fixpoint p*
is a Walrasian equilibrium; i.e., z(p*) 0.
Crosswise multiplication of (*) gives
162
Crosswise multiplication of (*) gives
( )
( )
( ) ( )
*
1
max 0, * max 0, * 1
N
i j i
j
p z p z p i ,..., N
=
= =

Existence
Multiplication of the equation with z
i
(p*)
Summing over all equations, we get
( ) ( ) ( ) ( ) ( ) ( ) ,...,N i p z p z p z p p z
i i
N
j
j i i
1 * , 0 max * * , 0 max *
1
*
= =

=
163
Summing over all equations, we get
Walrass law thus implies
( ) ( ) ( ) ( ) ( ) ( )
*
1 1 1
0
* max 0, * * max 0, *
N N N
i i j i i
i j i
z p p z p z p z p
= = =
=
=

( ) ( ) ( )
1
0 * max 0, *
N
i i
i
z p z p
=
=

Existence
Each term
is greater than or equal to zero:
( ) ( ) ( )
* max 0, * 1,...,
i i
z p z p i N =
164
is greater than or equal to zero:
( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( )
2
If * 0, then * max 0, * 0
If * 0, then * max 0, * *
i i i
i i i i
z p z p z p
z p z p z p z p
=
> =
Existence
If one term were indeed greater than zero,
could not be satisfied.
( ) ( ) ( )
1
0 * max 0, *
N
i i
i
z p z p
=
=

165
Thus it holds that z
i
(p*) 0 i = 1,..,N.
Therefore p* is a Walrasian equilibrium.
QED