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Walrasian Equilibrium Theory
The foundation of modern mathematical microeconomics
Marcus Pivato
Department of Mathematics, Trent University

Peterborough, Ontario, Canada
marcuspivato@trentu.ca
November 8, 2006
Introduction
Walrasian Equilibria in Pure Exchange Economies
Walrasian Equilibria in Production Economies
Price Adjustment Dynamics
Proof of Sonnenschein-Mantel-Debreu Theorem
Conclusion
Supply and Demand
Quantity
Demand: total quantity
ly
pp bought by all consumers.
Su
nt m
ua iu
ity
Q libr
ui
Eq
De
ma
nd
Equilibrium Price
Price
Supply and Demand
Quantity
ly
Su
Decreasing function of price.
nt m
ua iu
ity
Q libr
ui
Eq
De
ma
nd
Equilibrium Price
Price
Supply and Demand
Quantity
ly
Su
nt m
ua iu
ity
Supply: total quantity pro-

Q libr
ui
Eq
De duced by labourers, farmers, ar-

ma
nd tisans, factories, etc.
Equilibrium Price
Price
Supply and Demand
Quantity
ly
Su
nt m
ua iu
ity

Q libr
ui
Eq

ma
Increasing function of price.
Equilibrium Price
Price
Supply and Demand
Quantity
ly
Su
nt m
ua iu
ity

Q libr
ui
Eq

ma
Equilibrium Price
Price
At the equilibrium price, supply = demand.

Thus, there is neither excess nor shortage. The market clears.
Supply and Demand
Quantity
ly
Su
nt m
ua iu
ity

Q libr
ui
Eq

ma
Equilibrium Price
Price
At the equilibrium price, supply = demand.

Thus, there is neither excess nor shortage. The market clears.
Fundamental assumption of microeconomics:
Markets rapidly converge to equilibrium, and stay there.
Demand curve
Why is demand a decreasing function of price?
30 consumers want the product

Quantity
very much.
They are willing to pay $100 for
it.
De
ma
nd
30
Price
00
$1
Demand curve
21 more consumers want the

Quantity
product slightly less.

They would buy it for $90
De
ma
nd
51
30
Price
$1 0
00
$9
Demand curve

Quantity
product slightly less

They would buy it for $80
De
ma
nd
70
51
30
Price
0
$1 0
00
$8
$9
Demand curve

Quantity
product slightly less

They would buy it for $70.
Also, 12 out of the first 70
would be willing to buy two
De
100
ma
nd units at this price...
70
51
30
Price
0
0
$1 0
00
$7
$8
$9
Demand curve
....If the price was $30, then 200

Quantity
consumers would buy one, 60

would buy two, and 10 would
350 buy three.
De
ma
100 nd
70
51
30
Price
0
0
0
0
0
0
$1 0
00
$3
$4
$5
$6
$7
$8
$9
Demand curve
In this way, the demand curve

Quantity
emerges from the aggregate

purchasing behaviour of mil-
lions of consumers.
De
ma
nd
Price
Supply curve
Why is supply an increasing function of price?
Quantity
40 producers are very efficient.

ply
Su
p They can make the commodity
for $30/unit.
40
Price
0
$3
Supply curve
Quantity
9 more producers are slightly

ply
Su
p less efficient.
They can make it for $40/unit.
49
40 (They produce nothing if price
is lower, because they would
lose money)
Price
0
0
$3
$4
Supply curve
Quantity
7 more producers are even less

ply
Su
p efficient.
56 They will make the commodity
49
40
if the price is at least $50/unit.
Price
0
0
0
$3
$4
$5
Supply curve
Quantity
In this way, the supply curve

ply
Su
p emerges from the aggregate
production behaviour of hun-
dreds or thousands of produc-
ers.
Price
Why does market converge to equilibrium?
Quantity
Suppose the market price was
ly
less than the equilibrium price...
pp
ge and t
or dem arke
Su
M
ta
Sh
De
pl t
ma
pp ke
nd
y
su ar
M
Market Equilibrium Price

price Price
Quantity
ly
pp
ge and t
or dem arke
Su
Then demand would exceed
M
supply...
ta
Sh
There would be a shortage.

De
pl t
ma
pp ke
nd
y
su ar
M

price Price
Quantity
ly
pp
ge and t
or dem arke
Su
M
supply...
ta
Sh

De
pl t
ma
pp ke
nd
y
su ar
M

price Price
Some buyers would be willing to pay more than market price for the scarce
commodity.
Quantity
ly
pp
ge nd t
or em rke
Su
d a
M
a
supply...
ta
Sh

De
pl t
pp ke
ma
y
su ar
nd
M

price Price
Some buyers would be willing to pay more than market price for the scarce
commodity.
They would bid up the price until it was at equilibrium.
Quantity
p ly more than the equilibrium
Sup
ge and t
ke
price...
de ar
M
ta
or m
Sh
pl t
pp ke
De
y
su ar
ma
M
nd
Equilibrium Market Price

Price price
Quantity
Sup
pl t
price...
pp ke
y
su ar
M
Glut
Then supply would exceed de-
mand....
an t
m ke
There would be a glut.

d
de ar
De
M
ma
nd

Price price
Quantity
Sup
pl t
price...
pp ke
y
su ar
M
Glut
mand....
an t
m ke

d
de ar
De
M
ma
nd

Price price
Some retailers will sell at lower price to clear excess stock.

Quantity
Sup
pl t
price...
pp ke
y
su ar
M
Glut
mand....
an t
m ke

d
de ar
De
M
ma
nd

Price price

Less efficient producers will cut back production (or go out of business).
Quantity
Sup
pl t
price...
pp ke
y
su ar
M
Glut
mand....
an t
m ke

d
de ar
De
M
ma
nd

Price price

Less efficient producers will cut back production (or go out of business).
This would drive down the price until it was at equilibrium.
Problems and complications
Complementarities and substitution in commodity prices
Consumption of commodity X can affect the demand for commodity Y .


Some goods are complements (e.g. bread & butter)
If people eat more bread, they will also want more butter.

Some goods are substitutes (e.g. margarine & butter)
If people consume more margarine, they will consume less butter.

Some goods are substitutes (e.g. margarine & butter)
If people consume more margarine, they will consume less butter.
Thus, the price (and hence, consumption) of bread and margarine can
affect the demand (and hence, the price) of butter.
A full economic model must account for this.
Factor price interactions in commodity prices
Consumption of commodity X can affect the supply for commodity Y , if X

and Y require common factors of production.

Example: Wheat is a production factor for both bread and pasta.

Suppose demand for pasta increases.
Then pasta makers will purchase more wheat.

This increases demand (and hence, price) for wheat.

This makes baking more expensive.
This decreases supply (equivalently, raises price) of bread.

This makes baking more expensive.
This decreases supply (equivalently, raises price) of bread.
Thus, demand for pasta affects supply (and hence, price) for bread.
A full economic model must account for this.
Wealth effects: Perverse supply curves
Quantity
pp
ly Supply should be in-
Su
creasing function of price.
Price
Quantity
pl
y Labour Supply should be in-
sup
ur creasing function of wage.
bo
La
Wage
Quantity
pl
sup
bo
La
But consider a highly paid pro-
fessional (e.g. a computer pro-
grammer).
Wage
Quantity
pl
sup
bo
La
grammer).
If wage is high enough, then
Wage
programmer might work less.
Quantity
pl
sup
bo
La
grammer).
Wage
She feels rich, so she spends
more time on leisure.
Labour Supply should be in-

Quantity
ly
up
p creasing function of wage.
rs
bou
La But consider a highly paid pro-
grammer).
Wage
Thus, labour supply curve turns down, due to a wealth effect.
Labour Supply should be in-

Quantity
ly
up
p creasing function of wage.
rs
bou
La But consider a highly paid pro-
grammer).
Wage
Thus, labour supply curve turns down, due to a wealth effect.
A proper economic model must account for this.
The Law of One Price
Why should there be a single global price for commodity X ?
This model assumes the Law of One Price (LOP):

Each commodity c has a single global price, which constant
across the whole market. All sales of c occur at this price.

Why? Let A and B be two marketplaces for commodity c.
pA := price of c at A. What if pA > pB ?
pB := price of c at B.

Arbitrage: Buy c for pB at B, and sell c for pA at A.
Make easy profit (pA pB ).

Make easy profit (pA pB ). If enough arbitrageurs do this, then....

...demand for c will increase at B, so pB will increase, and

...supply of c will increase at A, so pA will decrease...

...until pA = pB , and the arbitrage opportunity disappears.

...until pA = pB , and the arbitrage opportunity disappears.
Thus, (Law of One Price) (Assumption of Zero Arbitrage).
Caveats with the Law of One Price
Zero Arbitrage holds in markets with perfect information, zero

transportation costs, and zero transaction costs. (Not the real world).

Partial solution: the definition of commodity c must include location,
convenience, information vs. uncertainty level, and experience qualities
(e.g. ambience, marketing, branding). For example:

Price(Montreal coffee) > Price(Peterborough coffee):

Different location = different commodity.

Price(Retail) > Price(Wholesale):

Retail has greater convenience, better information, lower risk, etc.

Price(Guess jeans) > Price(Levis) > Price(Truly jeans):

Guess experience has more branding than Truly experience.

Price(Starbucks coffee) > Price(Second Cup coffee):

Starbucks experience has nicer ambience (music, decor, etc.).

Starbucks experience has nicer ambience (music, decor, etc.).
A proper economic model must represent such product differentiation.
Goal: A more general model
A pure exchange economy has two components:
A set C of commodities (goods, services, etc.). Each commodity...
....has a market price.
...can be traded for other commodities at this price.
A set of consumers. Each consumer...
...begins with with an endowment of commodities (e.g. personal
property, labour, etc.)
....has preferences over these commodities.
...obtains consumption bundle she most prefers, by buying/selling from
her endowment at market prices.
A production economy has commodities and consumers, and also has
producers, called firms (e.g. megacorporations, small businesses, farmers,
artisans, freelance consultants, contractors...).
Each firm...
Each firm...
....has technology to convert some (bundles of) commodities into others.
Each firm...
....chooses production strategy which maximizes profit at market prices.
Each firm...
First we will consider pure-exchange economies.
Each firm...
First we will consider pure-exchange economies.
Then we will consider production economies.
Commodities: endowments, prices, and trade
Let C be the set of commodities.
Bananas
Endowment: a point e RC .
e = (e1 , e2 , . . . , eC ) means
50 e=(20,50) e1 units of commodity 1
e2 units of commodity 2, etc.
You have:
20 apples.
50 bananas.
20 Apples
Bananas
Price(apple) = $3
Price(banana)= $2 Endowment: a point e RC .
e = (e1 , e2 , . . . , eC ) means
Value(e) = 3x20 + 2x50
50 e = 60+100 e1 units of commodity 1
= 160
Market yields price vectorXp RC .
2 p=(3,2)
Value of of e is p e = pc ec .
cC
20 3 Apples
Bananas
Price(apple) Endowment: a point e RC .

= 1.5 x Price(banana) e = (e , e , . . . , e ) means
1 2 C
50 e
You can trade
e1 units of commodity 1
3 bananas e2 units of commodity 2, etc.
for 2 apples
2 p=(3,2)
Value of of e is p e = pc ec .
cC
20 3 Apples Can trade p1 units of c2 for p2 units
of c1 (both bundles worth p1 p2 ).
Bananas
e=(10,65) Endowment: a point e RC .

e = (e1 , e2 , . . . , eC ) means
50 e e1 units of commodity 1
Impossible e2 units of commodity 2, etc.
Foolish Market yields price vectorXp RC .
2 p e=(40,20) Value of of e is p e = pc ec .
cC
20 3 Apples Can trade p1 units of c2 for p2 units
of c1 (both bundles worth p1 p2 ).
Can trade e for e iff p e = p e.
Bananas
Endowment: a point e RC .
e = (e1 , e2 , . . . , eC ) means
p e1 units of commodity 1
e
Be,p Value of of e is p e = pc ec .
cC
Can trade p1 units of c2 for p2 units
Apples of c1 (both bundles worth p1 p2 ).
Can trade e for e iff p e = p e.

The set Be,p := e RC ; p e = p e is budget hyperplane through e
(orthogonal to p). All trades must occur along Be,p .
The Consumer: Utility functions and indifference curves
Each consumer i has a (continuous, concave) utility function ui : RC R,

such that
ui (e ) > ui (e) i prefers bundle e to bundle e .

such that
Rational Maximizer Assumption: i always tries to maximize ui .


such that
Rational Maximizer Assumption: i always tries to maximize ui .

For all r R, we define the indifference set:

Sr := e RC ; ui (e) = r .
(usually a smooth hypersurface).

The geometry of the indifference sets encodes substitute/complement rela-
tionships between commodities.

such that

Indifference sets: Sr := e RC ; ui (e) = r ( r R).
Commodities c and d are perfect substitutes

Esso Gasoline
u =i
2.
6
u =i
(c, d) indifference curves are straight lines.

2.
u =i
4
2.
2
u =i
Example: Esso gasoline vs. Shell gasoline.

2.
0
u =i
1.
u =i
Formal model: u is linear function

1.
6
u =i
1.
4
u =i
1.
2
u =i
u(ec , ed ) = kc ec + kd ed .
1.
0
Shell Gasoline
for some constants kc , kd > 0.


such that

Commodities c and d are good substitutes
Margarine

u =i
2.
(c, d) indifference curves are almost linear.

6
u =i
2.
4
u =i
2.
Example: Butter vs. margarine.

2
u =i
2.
0
u =i
Formal model: u is CES function:

1. 6
u =i 1.4
8
1.
u =i
u =i
(ec + ed )1/ .
1. 0
u =i
u(ec , ed ) =
2
1.
Butter
for some constant 0 < 1.


such that

Commodities c and d are complements

Butter
ui=2.4
(c, d) indifference curves are almost square.
ui=2.2
Example: Bread vs. butter.
ui=2.0
ui=1.8 Formal model: Cobb-Douglas function:
ui=1.6
ui=1.4
ui=1.2
ui=1.0 u(ec , ed ) = ecc edd .
Bread
for some constants c , d > 0


such that

c and d are perfect complements
Left Shoes

ui=2.4 (c, d) indifference curves are square.
ui=2.2
ui=2.0
Example: Left shoes vs. right shoes.
ui=1.8
ui=1.6
ui=1.4
Formal model: u(ec , ed ) = min{ec , ed }.
ui=1.2
ui=1.0
Right Shoes
The Consumer: Utility maximization through trade
Bananas
Consumer i will trade ei for any x such
that ui (x) > ui (ei ).
ei
Apples

Bananas
Be,p
xi
Ideal: trade ei for the xi in budget
hyperplane Be,p maximizing ui (xi ).
p
xi is the point where Be,p is
tangent to an indifference surface.
ei
Apples

Be,p
xi
Ideal: trade ei for the xi in budget
hyperplane Be,p maximizing ui (xi ).
Buy 45 bananas
zi xi is the point where Be,p is

p
tangent to an indifference surface.
xi = xi (p) is i s consumption plan.
ei
Sell 30 apples
zi (p) := xi ei is i s excess demand. It encodes how much of each

commodity i must buy or sell to maximize her utility at the market price p.
Aggregate excess demand
Let C be the set of commodities. Let I be the set of consumers.

A pure exchange economy is thus described by the following data:

A set of initial endowments {ei }i I (where ei RC for all i I).

A set of utility functions {ui }i I (where ui : RC R for all i I).

Let p RC be a price vector.

Given p, each i I chooses utility-maximizing consumption plan xi (p)
in her budget set Bi (p).

Given p, each i I chooses utility-maximizing consumption plan xi (p)
in her budget set Bi (p).
The aggregate excess demand of the market (at price p) is defined:
X
z(p) := xi (p) ei .
i I
z(p) encodes the net quantity of every commodity which the entire
market demands (or supplies) at price p.
Aggregate excess demand & Walrasian Equilibrium
Recall: the aggregate excess demand (at price p) is defined,

X
z(p) := xi (p) ei .
i I
Suppose z(p) = (z1 , z2 , . . . , zC ) RC . Let c C.


X
z(p) := xi (p) ei .
i I

If zc > 0, then there is a net shortage of commodity c.

X
z(p) := xi (p) ei .
i I

If zc < 0, then there is a net glut of commodity c.

X
z(p) := xi (p) ei .
i I

If zc = 0, then supply of commodity c exactly matches demand.

X
z(p) := xi (p) ei .
i I

Thus, the market is in equilibrium if and only if zc = 0 for all c C.

X
z(p) := xi (p) ei .
i I

Definition: The price vector p is a Walrasian equilibrium if z(p) = 0.
If p is a Walrasian equilibrium, then supply exactly matches demand
(i.e. the market clears) for every commodity, simultaneously.
Existence of Walrasian Equilibria
Theorem: (Arrow and Debreu, 1954)

For all i I, suppose that the utility function ui : RC R is:

Differentiable.

Differentiable.
Strictly concave. (i.e. no commodity is a perfect substitute for any
other commodity, for any consumer).

Differentiable.
Strictly monotonic.
(i.e. every consumer always prefers more of every commodity
i.e. c ui > 0 for every i I and c C).

Differentiable.
Strictly monotonic.
X
Also, for all c C, suppose that eic > 0.
i I
(i.e. There is a nonzero amount of every commodity).

Differentiable.
Strictly monotonic.
X
Also, for all c C, suppose that eic > 0.
i I
(i.e. There is a nonzero amount of every commodity).
Then a Walrasian equilibrium exists in this economy.
Proof idea:
Proof: Aggregate excess demand function z has following properties:
Proof idea:
Homogeneous of degree 0:
For all p RC+ , and r > 0,
z(r p) = z(p).
Proof idea:
Homogeneous of degree 0:
z(r p) = z(p).
Reason: It doesnt matter whether we measure prices in dollars (r = 1) or

in cents (r = 100). Demand for each commodity is the same.
Proof idea:
(0,0,1) Homogeneous of degree 0:

z(r p) = z(p).
)
(0,1,0
(1,0,0)
Reason: It doesnt matter whether we measure prices in dollars (r = 1) or

in cents (r = 100). Demand for each commodity is the same.
Consequence:
( We can always)normalize p to lie on the price semisphere
X
S+ := p RC+ ; pc2 = 1 .
cC
Proof idea:
(0,0,1) p 0-Homogeneous: Can assume

p S+ (price semisphere).
z(p p
) Walras Law: For any p RC+ ,
z(p) is orthogonal to p (thus,
z(p tangent to S+ ).
)
)
p (0,1,0
)
z(p
(1,0,0)
Proof idea:

z(p p
)
)
p (0,1,0
)
z(p
(1,0,0)

Reason: For every i I, xi (p) ei is orthogonal to p because it lies in
i s budget hyperplane Bi (p) (which is orthogonal to p by definition).
X
Thus, z(p) = xi (p) ei is also orthogonal to p.
i I
Proof idea:

z(p p
)
)
p (0,1,0
)
z(p
(1,0,0)

Reason: For every i I, xi (p) ei is orthogonal to p because it lies in
i s budget hyperplane Bi (p) (which is orthogonal to p by definition).
X
Thus, z(p) = xi (p) ei is also orthogonal to p.
i I
Consequence: z is a tangent vector field on S+ .
Proof idea:

z(p p
) Walras: z is tangent vector field
on S+ .
z(p
) Liquidation sale effect: c C,
)
p (0,1,0 if pc 0, then zc (p).
)
z(p
(1,0,0)
Proof idea:

z(p p
) Walras: z is tangent vector field
on S+ .
z(p
) Liquidation sale effect: c C,
)
p (0,1,0 if pc 0, then zc (p).
)
z(p
(1,0,0)
Reason: Every good is desirable to everyone (ui is monotone and convex).

If a good is cheap enough, people will buy arbitrarily large quantities.
Proof idea:
(0,0,1) 0-Homogeneous: Can assume

Walras: z is tangent vector field
on S+ .
Liquidation sale effect: c C,
)
(0,1,0 if pc 0, then zc (p).
(1,0,0)
Reason: Every good is desirable to everyone (ui is monotone and convex).

If a good is cheap enough, people will buy arbitrarily large quantities.
Consequence: Tangent vector field z points inwards at boundaries of S+ .
Proof idea:
(0,0,1) Walrasian 0-Homogeneous: Can assume

Equilibrium:
z(p)=0 p S+ (price semisphere).
z vector Walras: z is tangent vector field
field
on S+ .
Liquidation sale effect: z points
)
(0,1,0 inwards at the boundaries of S+ .
(1,0,0)
These properties, combined with Brouwers Fixed Point Theorem, imply that
z(p ) = 0 for some p S+ .
This p is a Walrasian equilibrium. .
The Firm: Technology
Flour Labour Energy

Each firm has a technology,
Yeast which eats a bundle of
Water
Salt commodities (factors) and
Sugar yields bundle of some other
Bakery Bread commodity (merchandise).
Technology
3 Energy 3 Water 10 Energy 3 Water

5 Labour 1 Salt 2 Labour 1 Salt
10 Flour 1 Sugar 3 Bread 10 Flour 1 Sugar 3 Bread
1 Yeast 1 Yeast
6 Energy 6 Water
10 Labour 2 Salt
20 Flour 2 Sugar 5 Bread
2 Yeast
Flour Labour Energy

Water
Technology
Different combinations of
factors yield different output
3 Energy 3 Water
1 Salt
10 Energy 3 Water
1 Salt
quantities of merchandise.
5 Labour 2 Labour
1 Yeast 1 Yeast
6 Energy 6 Water
10 Labour 2 Salt
20 Flour 2 Sugar 5 Bread
2 Yeast
Flour Labour Energy

Water
Technology
Different combinations of
factors yield different output
3 Energy 3 Water
1 Salt
10 Energy 3 Water
1 Salt
quantities of merchandise.
5 Labour 2 Labour
1 Yeast 1 Yeast We describe this with
6 Energy 6 Water (nonlinear) function
10 Labour 2 Salt
20 Flour 2 Sugar 5 Bread f : RC RC+ .
2 Yeast
Suppose i = (i1 , . . . , iC ) RC+ , and f (i) = o = (o1 , . . . , oC ) RC+ .

This means: if the input is i1 units of factor 1, i2 units of factor 2, etc....
then output is o1 units of merchandise 1, o2 units of merchandise 2, etc.
(Note: Factor inputs are measured in negative units.)
The Firm: Single-factor, single-output technology
f : R R. If f (i ) = o, then i units of input yield o units of output.
Assume f (0) 0 (No Free Lunch). Define production possibility set:

Y := (i , o) R2 ; o f (i )
The geometry of Y describes the scale economies of the technology:

Y := (i , o) R2 ; o f (i )
o If Y is convex (e.g. f is decreasing),

then get diminishing returns to scale.
f Ubiquitous assumption in most
economic models.
Y Reasonable model of a single
factory.
Perhaps applies to long-term
-i (0,0)
global economy? (Fundamental
resource constraints).

Y := (i , o) R2 ; o f (i )
o If Y is a cone (e.g. f is linear), then

get constant returns to scale.
f Reasonable assumption for model
of an entire industry, due to
Y replication argument.
(0,0)
-i

Y := (i , o) R2 ; o f (i )
o If Y is concave (e.g. f is increasing)

then get increasing returns to scale.
f Intellectual property industries
(zero marginal cost of
production).
Y Network effects (e.g.
transport/communication
(0,0)
-i networks, software standards).
Leads to natural monopolies
(e.g. telephone, electricity).

Y := (i , o) R2 ; o f (i )
o Suppose i < 0 such that f (i ) = 0

for all i > i . Then get startup costs.
f Firm must invest minimal

amount to produce anything.
Y Increasing returns on small scale.
Startup Complete shutdown is possible.
cost
(0,0)
-i i* Example: Electricity for factory light-
ing.

Y := (i , o) R2 ; o f (i )
o Suppose exists i < 0 such that f (i ) =

for all i > i . Then get sunk costs.
f
Firm must invest minimal
amount just to exist.
Y Increasing returns on small scale.
Sunk Complete shutdown is impossible.
cost
(0,0)
-i i* Example: Construction of factory.
Rental of land and equipment.
The Firm: Multi-factor, single-output technology
f : RC R. If f (i) = o, then input vector i yields o units of output.

Geometry of f describes substitution or complementarity between factors:
Corn Oil Brown sugar
1
2
m
gr
ca
uf ns
ee
m
ke
3
fin
n
uf
gr
3
on
fi
m
ee
4
io
uf fins
n
4
gr
fin
on
m
ee
ca
uf
io
s
5
5
ke
n
gr
on
m
s
ca
ee
uf
io
6
ke
6
fin
n
m
gr
s
on
ca
s
uf
ee
io
ke
7
fin
n
7
s
gr
on
s
ca
m
Saflower Oil
ee
io
ke
uf
n
fin
s
on
8
ca
Molasess
m
s
io
ke
uf
n
fin
ca
ke
s
s
Perfect Substitutes Substitutes

Green Onions Sugar
1 green
2 g
on
3 gr reen 1 muffin
io
een
n cake s
on
4 gre 2 muffins
io
on
e
5 gre n
n
io
3 muffins
cak
n
e
on
6 gre n
cak
e
io n cak es
en 4 muffins
on
es
cak
io n cak
7 gre 5 muffins
on
en
es
io
8 green
on
6 muffins
es
io
n
on
7 muffins
Potatoes
cakes
io
n cake
Salt
s
Complements Perfect Complements

The Firm: Profit maximization
A production plan is vector y := f (i) i RC (for some i RC ).
Y
y=(-i,o) o=f(-i)
-i
Let p RC be market price vec-

tor.
Y
y=(-i,o) o
po=1
,1)
i
(p
-i p= pi

tor.
Y
The output o := f (i) has a
y=(-i,o) po o resale value of p o.
po=1
,1)
i
(p
-i p= pi

tor.
Y
po=1
,1)
The input i costs p i.
i
(p
-i p= pi
-pi i

tor.
Y
- pii
The input i costs p i.
Profit = poo - pii = p y Thus, plan y yields a profit of
-i - pii pi p o p i = p y.

o
y*
tor.
Y
resale value of p o.
Maximal p
profit The input i costs p i.
Thus, plan y yields a profit of
-i p o p i = p y.
Assume firm chooses production plan y which maximizes profit.

At y , boundary of production possibility set Y is orthogonal to p.
Shareholders & Dividends
Let J be the set of firms. Let I be the set of consumers.
Each firm j J is owned by one or more consumers in I.
For all j J and i I, let ij be the share of firm j owned by
consumer i . Thus,
X
ij = 1, for each j J .
i I
consumer i . Thus,
X
i I
If firm j chooses profit-maximizing production plan yj Yj and makes

profit p yj , then consumer i receives the dividend ij p yj .
X
Thus, i s total dividend income is ij p yj .
jJ
consumer i . Thus,
X
i I
If firm j chooses profit-maximizing production plan yj Yj and makes

profit p yj , then consumer i receives the dividend ij p yj .
X
Thus, i s total dividend income is ij p yj .
jJ
If i had initial endowment ei C
R , then i s effective budget set is now

X
Bi (p) := x RC ; p x = p ei + ij p yj .

jJ
A production economy is thus described by the following data:
A set of production sets {Yj }jJ . (where Yj RC , j J ).
X
An allocation of shares {ij }i I,jJ . ( ij = 1, j J ).
i I
X
i I
X
i I
Given p, each j J then chooses profit-maximizing production plan
yj (p) in its production set Yj .
X
i I
Given p (and dividend income from {yj }jJ ), each i I then chooses
utility-maximizing consumption plan xi (p) in her budget set Bi (p).
X
i I
Given p (and dividend income from {yj }jJ ), each i I then chooses
utility-maximizing consumption plan xi (p) in her budget set Bi (p).
The aggregate excess demand of the market (at price p) is defined:
X X
z(p) := xi (p) ei yj (p).
i I jJ

X X
i I jJ


X X
i I jJ


X X
i I jJ


X X
i I jJ


X X
i I jJ


X X
i I jJ

Definition: The price vector p is a Walrasian equilibrium if z(p) = 0.
If p is a Walrasian equilibrium, then supply exactly matches demand
(i.e. the market clears) for every commodity.
Theorem: (Arrow and Debreu, 1954) Suppose:


RC R
For all i I, the utility function ui : is continuous, concave,
and locally nonsatiated (i.e. ui is never 0).

RC R
For all j J , the production
set Yj RC isclosed,convex, includes 0,
and has free disposal: y y and y Yj = y Yj

RC R
The set of feasible resource allocations

Y Y X X
(x, y) RC Yj ; (xi ei ) yi is compact.

i I jJ i I jJ

RC R
The set of feasible resource allocations

Y Y X X
(x, y) RC Yj ; (xi ei ) yi is compact.

i I jJ i I jJ
Then a Walrasian equilibrium exists in this economy.

Proof idea:
Proof idea: Represent economy as game with I + J + 1 players:
Proof idea:
Each firm j J is a player, whose action is a choice of production
plan yj Yj , and whose goal is to maximize profit.
Proof idea:
Each consumer i I is a player, whose action is a choice of excess
demand xi in her budget set, and whose goal is to maximize her utility.
Proof idea:
The extra player is a fictitious price setter, whose action is a choice
price vector p RC , and whose goal is to maximize p z (where z is
excess demand generated by other players).
Proof idea:
Fact: This game has a Nash equilibrium, p , where each players action is
her best response to the actions of all other players.
Proof idea:
her best response to the actions of all other players. If z = z(p), then
z p = 0. Thus, c C, either zc = 0 or pc = 0 (excess goods are free).
Proof idea:
From p , derive p with z(p) = 0 i.e. p is a Walrasian equilibrium.
Proof idea:
From p , derive p with z(p) = 0 i.e. p is a Walrasian equilibrium.
Remark: The tangent field strategy from pure exchange economy is
inapplicable, because Walras Law (p z(p)) is false.
In general z(p) p < 0 because yj (p) p 0 for each j J
(i.e. the profit-maximizing production of firms creates value in economy.)
Significance of Walrasian equilibria
Fundamental Assumption of Neoclassical Microeconomics:
The market is always at a Walrasian equilibrium.
Most models in modern microeconomics take the following form:
Define a set C of commodities.
Define utility functions {ui }i I and production sets {Yj }jJ .
Locate the Walrasian equilibrium of this economy.
Predict that the real economy is similar/identical to this equilibrium.
For example, to predict how economy responds to exogenous shock (e.g.
introduction of new technology, natural disaster, change in consumers
tastes), do this:
tastes), do this:
Compute Walrasian equilibrium before the shock.
tastes), do this:
Compute Walrasian equilibrium after the shock.
tastes), do this:
Observe how the equilibrium has moved.
tastes), do this:
Predict that the real economy will respond similarly.
tastes), do this:
Predict that the real economy will respond similarly.
This is called comparative statics.
Problems with Walrasian equilibria #1: Nonuniqueness
(0,0,1) Multiple Nonuniqueness problem: Even in a

Equilibria
pure exchange economy it is possible
that many Walrasian equilibria exist.
0)
(0,1,
(1,0,0)

Equilibria
Thus, the Fundamental Assumption is
0) not sufficient to predict a unique out-
come of the market.
(0,1,
(1,0,0)

Equilibria
come of the market.
(0,1,
For example, comparative statics

(1,0,0)
cannot predict a unique response to
a shock.

Equilibria
come of the market.
(0,1,
For example, comparative statics

(1,0,0)
cannot predict a unique response to
a shock.
Depending on initial conditions, market might choose different equilibria.
This is called path-dependence or lock-in.
Walras Problem #2: LOP & Monopolistic Competition
The Walrasian model assumes the Law of One Price (LOP):
Recall: To justify the LOP, the definition of a commodity must include its
location, convenience, information vs. risk level, and experience qualities:
Montreal coffee 6= Peterborough coffee . . . . . . . . . . . . . . . . . . . (location).
Montreal coffee 6= Peterborough coffee . . . . . . . . . . . . . . . . . . . (location).
Retail product 6= Wholesale product . . . . . . (convenience, information).
Retail product 6= Wholesale product . . . . . . (convenience, information).
Guess jeans 6= Levis jeans 6= Truly jeans . . . . . . (branding & marketing).
Guess jeans 6= Levis jeans 6= Truly jeans . . . . . . (branding & marketing).
Starbucks coffee 6= Second Cup coffee . . . . . . . . . . . . . . . . . (ambience).
Consequence: Same product, sold in different stores, or different locations,
or with a different brand, is considered a different commodity in model.
Thus, each firm has a monopoly over its version of the commodity.
Firms still compete: their products are (imperfect) substitutes for one
another. But each firm has some monopoly power because of its unique
brand or location, or because it provides a unique customer experience.
Firms still compete: their products are (imperfect) substitutes for one
another. But each firm has some monopoly power because of its unique
brand or location, or because it provides a unique customer experience.
In such a monopolistic competition, each firm is a price setter for its
product, not a price taker. This contradicts the price-taker assumption of
Walrasian model.
Problems with Walrasian equilibria #3: Price Setting?
Price setting problem: Walras model assumes each consumer and firm is a
price taker, who treats market prices as exogenous and fixed, and simply
chooses her own individual best response to these prices. That is:
No consumer or firm can set or influence prices.
But if nobody can influence prices, then how do prices ever change? How
do prices get to the equilibrium in the first place?
For example, in comparative statics, how exactly does the price find the
new equilibrium after the shock ?
Also, how rapidly does market find equilibrium? Presumably, in the extreme
long run, the market will find an equilibrium, but....
Also, how rapidly does market find equilibrium? Presumably, in the extreme
long run, the market will find an equilibrium, but....
In the long run, we are all dead. J.M. Keynes
Extreme long run predictions are irrelevant for crafting economic policy.
Tatonnement dynamics
Suppose p is not a Walrasian equilibrium i.e. z(p) 6= 0.
Then there is a scarcity of some goods, and an excess of others.
Presumably, for every commodity c C:
If c is scarce, then its price pc should rise.
If c is scarce, then its price pc should rise.
If c is in excess, then its price pc should fall.

If c is scarce, then its price pc should
rise.

dpc
zc (p) > 0 = > 0 .
dt
rise.

dpc
zc (p) > 0 = > 0 .
dt
If c is in excess, then its price pc should
fall.

dpc
zc (p) < 0 = < 0 .
dt
rise.

dpc
zc (p) > 0 = > 0 .
dt

dpc
zc (p) < 0 = < 0 .
dt
Thus, Paul Samuelson (1947) proposed that nonequilibrium price vector
obeys tatonnement differential equation:

p(t) = (z [p(t)]),
where price adjustment vector field : RC+ RC is such that:
For all c C, sign[c (z)] = sign[zc ].
rise.

dpc
zc (p) > 0 = > 0 .
dt

dpc
zc (p) < 0 = < 0 .
dt
Thus, Paul Samuelson (1947) proposed that nonequilibrium price vector
obeys tatonnement differential equation:

p(t) = (z [p(t)]),
where price adjustment vector field : RC+ RC is such that:
For all c C, sign[c (z)] = sign[zc ].
Simplest choice: (z) = z.
Problems with Tatonnement #1: Anything goes
Recall: In a pure exchange economy, we can assume p S+ (the price
semisphere), because z is homogeneous of degree zero.
Then z(p) is tangent to S+ (by Walras law).
Thus, z : S+ RC is a tangent vector field.
Thus, tatonnement equation p = z(p) defines a smooth flow on S+ .
Sonnenschein-Mantel-Debreu Theorem (1974)
Suppose |I| |C|. Let > 0. Let S := {p S+ ; pc , c C}.
C
Let V : S R be any crazy tangent vector field you want.
C
There exist reasonable utility functions ui : RC R and initial
endowments ei RC (for i I) such that, if z : S+ RC is the resulting
excess demand vector field, then z|S V.
C
Consequence: Given any chaotic dynamical system you want on S , there
exists a pure-exchange economy whose t atonnement dynamics mimic this
dynamical system. (In particular, it will never converge to equilibrium).
C
Introducing production into economy does not fix the problem.
C
Introducing production into economy does not fix the problem.
Generalizing p = z(p) to p = [z(p)] also doesnt work, for
reasonable choices of .
Tatonnement Problems #2: Nonfeasibility & Rationing
The real economy cant obey t atonnement dynamics for another reason:
If p is not a Walrasian equilibrium, and z(p) 6= 0, then:
There are scarcities. This means consumers overconsume substitutes
for the scarce goods, while firms experience production shortfalls due
to lack of inputs. This leads to further scarcities, and so on....
There are gluts, so not all merchandise can be sold. This means
shortfalls in revenue, which means shortfalls in purchases, which means
further lost sales, and so on....
In short, the whole Walrasian model falls apart outside of equilibrium.
In short, the whole Walrasian model falls apart outside of equilibrium.
A proper disequilibrium model must describes how scarce goods are
rationed in the market, and must describe how consumers and firms react
when their consumption/production plans are not feasible.
Tatonnement Problems #3: One price or many?
Like Walras, the tatonnement model assumes the Law of One Price (LOP):
However, if market is not at equilibrium, there is no justification for LOP.

In disequilibrium, nobody knows what the right price is for commodity c.
Different firms and consumers will make different guesses, resulting a
distribution of price offers.
However, if market is not at equilibrium, there is no justification for LOP.

In disequilibrium, nobody knows what the right price is for commodity c.
Different firms and consumers will make different guesses, resulting a
distribution of price offers.
A proper disequilibrium model must allow each market agent to assign her
own price to each good, and evolve these individual prices over time.
(Presumably they eventually converge to a common value.)
The Hahn-Negishi price-adjustment model [Skip to SMD proof]
Hahn and Negishis (1962) model somewhat obviates these problems.

As before, assume tatonnement price adjustment:

p(t) = [p(t)],
for some sign-preserving adjustment rule : RC RC .


p(t) = [p(t)],
Also assume disequilibrium trade: Consumer i s endowment ei (t) evolves in
time according to:
e i (t) = i e1 (t), . . . , eI (t); p(t) ,
for some trading rule i : RCI S+ RC .


p(t) = [p(t)],
time according to:
e i (t) = i e1 (t), . . . , eI (t); p(t) ,
for some trading rule i : RCI S+ RC . We assume:
Dawn of time: All trading and price adjustment occurs before any
consumption occurs. (No consumption before equilibrium.)


p(t) = [p(t)],
time according to:
e i (t) = i e1 (t), . . . , eI (t); p(t) ,
Explanation: Assume consumers trade (perhaps in virtual units) and prices

adjust in primordial epoch.
Consumption only begins after we reach Walrasian equilibrium.


p(t) = [p(t)],
time according to:
e i (t) = i e1 (t), . . . , eI (t); p(t) ,
P
Pure exchange: For all t R+ ,
i I e i (t) = 0.
Explanation: Assume consumers trade (perhaps in virtual units) and prices
adjust in primordial epoch.
Consumption only begins after we reach Walrasian equilibrium.


p(t) = [p(t)],
time according to:
e i (t) = i e1 (t), . . . , eI (t); p(t) ,
P
i I e i (t) = 0.
Explanation: This is pure-exchange economy with no production.


p(t) = [p(t)],
time according to:
e i (t) = i e1 (t), . . . , eI (t); p(t) ,
P
i I e i (t) = 0.
No swindling: For all t R+ , p(t) e i (t) = 0, for all i I.
Explanation: This is pure-exchange economy with no production.



p(t) = [p(t)],
time according to:
e i (t) = i e1 (t), . . . , eI (t); p(t) ,
P
i I e i (t) = 0.
Explanation: All trades are revenue neutral.

Nobody can swindle another person and buy something by selling something
else of lesser market value.


p(t) = [p(t)],
time according to:
e i (t) = i e1 (t), . . . , eI (t); p(t) ,
Indecomposability: c, d C, write c et d if i I such that
eci (t) 6= 0 6= edi (t). Then (C, et ) is a connected graph for all t R+ .
Explanation: All trades are revenue neutral.
Nobody can swindle another person and buy something by selling something
else of lesser market value.


p(t) = [p(t)],
time according to:
e i (t) = i e1 (t), . . . , eI (t); p(t) ,
Indecomposability: c, d C, write c et d if i I such that
Explanation: c et d means that some consumer owns nonzero amounts

both of c and d. Economy doesnt decompose into subeconomies with
disjoint commodities held by disjoint populations. Thus, price comparisons
between commodities are meaningful, because they all trade in same market.
The Hahn-Negishi price-adjustment model
Each i I also has optimal consumption plan xi (t) (which changes as

ei (t) and p(t) change).

Let zi (t) := xi (t) ei (t) be i s excess demand at time t.

Let zi (t) := X
xi (t) ei (t) be i s excess demand at time t.
Let Z(t) := zi (t) be aggregate excess demand of the market at time t.
i I

Let zi (t) := X
i I
Finally, the key assumption in Hahn-Negishi models is:

Let zi (t) := X
i I
Orderly
i markets:
For all i I and c C, if zci (t) 6= 0, then
sign zc (t) = sign [Zc (t)].

Let zi (t) := X
i I
Orderly
i markets:
Explanation: We are assuming it is impossible for zcj (t) < 0 < zcj (t) for
some i 6= j.

Let zi (t) := X
i I
Orderly
i markets:
some i 6= j. Why? Because in an orderly market, i and j would meet
and trade until at least one of them was satisfied.

Let zi (t) := X
i I
Orderly
i markets:
and trade until at least one of them was satisfied. In other words,
Every buyer can always find a seller, if one exists.
(And vice versa).

Let zi (t) := X
i I
Orderly
i markets:
and trade until at least one of them was satisfied. In other words,
Every buyer can always find a seller, if one exists.
(And vice versa).
Consequence: If p is a Walrasian equilibrium, then not only is Z(p) = 0,

but zi (p) = 0 for all i I.
The Hahn-Negishi Stability Theorem
Assumptions:
(a) Law of One Price.
(b) Tatonnement price adjustment: p(t) = [p(t)].

(c) Disequilibrium trade: e i (t) = i e1 (t), . . . , eI (t); p(t) .
(d) Dawn of time: No consumption before equilibrium.
P
(e) Pure exchange: For all t R+ , i I e i (t) = 0.
(f) No swindling: For all t R+ , p(t) e i (t) = 0, for all i I.
(g) Indecomposability: c, d C, write c et d if i I such that
(h) Orderly
i markets:
The Hahn-Negishi Stability Theorem
Assumptions:
(a) Law of One Price.
(b) Tatonnement price adjustment: p(t) = [p(t)].

(c) Disequilibrium trade: e i (t) = i e1 (t), . . . , eI (t); p(t) .
(d) Dawn of time: No consumption before equilibrium.
P
(e) Pure exchange: For all t R+ , i I e i (t) = 0.
(f) No swindling: For all t R+ , p(t) e i (t) = 0, for all i I.
(g) Indecomposability: c, d C, write c et d if i I such that
(h) Orderly
i markets:
Stability Theorem: (Hahn & Negishi, 1962)
Under assumptions (a)-(h), the economy will converge to some Walrasian
equilibrium from any initial conditions.
Proof idea for Hahn-Negishi theorem
Stability Theorem: (Hahn & Negishi, 1962) Under assumptions (a)-(h),

the economy will converge to some Walrasian equilibrium from any initial
conditions.

conditions.
Proof idea: Prices are out of equilibrium because the optimal consumption
plans xi (t) of all consumers are not simultaneously feasible.

conditions.
That is: some consumers expectations are unreasonably optimistic.

conditions.
As prices adjust, each consumer must adjust her expectations downwards....

conditions.
The things she wants to buy become more expensive....
The things she wants to sell become cheaper....

conditions.
Thus, her projected optimal utility ui (xi (t)) is nonincreasing in time.

conditions.
Thus, her projectedX optimal utility ui (xi (t)) is nonincreasing in time.
Thus, U(t) := ui (xi (t)) decreasing over time.
i I

conditions.
i I
In other words, U(t) is a Lyapunov function for dynamics.

conditions.
i I
In other words, U(t) is a Lyapunov function for dynamics.
This guarantees convergence to a local minimum of U(t). This will be an
equilibrium.
Fishers extension of Hahn-Negishi model
Franklin M. Fisher generalized HN and relaxed unrealistic assumptions.
First (1974), he introduced firms, by replacing assumption (d) (Pure
exchange) with (technical) assumptions about firm behaviour.
Fisher thus changed assumption (c) (Dawn of Time) to say:
No consumption or production before equilibrium.
Money and liquidity are important in Fishers model.
For example, he distinguishes between an agents target demand vector zi
(what she would like to get if all markets clear) and her active demand
vector ai (the one she has the money to actually realize).
Both demand vectors evolve over time, but Orderly Markets assumption
only applies to active demands:

If aci (t) 6= 0, then sign aci (t) = sign [Zc (t)].
Both demand vectors evolve over time, but Orderly Markets assumption
only applies to active demands:

If aci (t) 6= 0, then sign aci (t) = sign [Zc (t)].
With additional technical assumptions, Fisher proved a Stability Theorem

for this more general model.
Later, Fisher (1983) removed Dawn of time assumption altogether, with

complex model of consumption and production in disequilibrium.

He explicitly tracks each agents intertemporal choice between present and
future consumption, production, and/or trade.

Using dynamic programming, each agent constantly revises a detailed plan
of all her future consumption, production and trade, as prices change.

Finally, Fisher relaxed the Law of One Price by allowing agents to make
individual price offers when confronted with nonclearing markets.

Fishers key assumption is No favourable surprise: as market conditions
evolve, agents are never pleasantly surprised: instead, they always discover
that their future projections were either accurate, or overly optimistic.

This allows Fisher to generalize the strategy of the Hahn-Negishi theorem,
and once again use projected utility as a Lyapunov function.

This allows Fisher to generalize the strategy of the Hahn-Negishi theorem,
and once again use projected utility as a Lyapunov function.
With this and several additional technical assumptions, Fisher proved a
Stability Theorem for his most general model.
Problems with Fisher-Hahn-Negishi model
Problems:
Problems:
Fisher-Hahn-Negishi model depends heavily on Orderly Market
hypothesis. (every buyer can always find a seller, if one exists.).
This is not realistic, especially in on short time scales.
Problems:
Fisher removes unrealistic assumptions like Dawn of Time and Law
of One Price, but he requires No Favourable Surprise instead.
Problems:
Model says nothing about which equilibrium the market will converge
to (if there are many), or the speed of this convergence. (Because it
imposes few restrictions on the adjustment function ).
Problems:
Model also makes few predictions about disequilibrium trading
behaviour. (Because it imposes few restrictions on the trading rules
function i , except for assumptions (e,f,g)).
Problems:
Model also makes few predictions about disequilibrium trading
behaviour. (Because it imposes few restrictions on the trading rules
function i , except for assumptions (e,f,g)).
Other disequilibrium models include Uzawas (1962) Edgeworth trading
model and Benassys (1984, 2002) quantity-constrained rationing model.
Sonnenschein-Mantel-Debreu Theorem




Let V : S RC be any crazy tangent vector field you want.

Let V : S RC be any crazy tangent vector field you want.
There exist utility functions ui : RC R and initial endowments ei RC
(for i I) such that, if z : S+ RC is the resulting excess demand vector
field, then z|S V.
Proof background for SMD Theorem [Skip to end]
Let z : S+ RC be some tangent vector field on S+ .


Question: Does there exist e RC and u : RC R, such that z is excess
demand function for consumer with utility function u and endowment e?

Lemma 1: Suppose z is the excess

demand function for u and e.


p p demand function for u and e.
Let p, p S+ be two price vectors.
e


p p demand function for u and e.
e z(p)
Let x = z(p) + e and x := z(p ) + e.
x
z(p) x


p demand function for u and e.
p z(p
thus, u ) < 0 Let x = z(p) + e and x := z(p ) + e.
(x) > u x
(x)
z(p)
x (a) If p z(p ) 0, then u(x) > u(x ).
(c)


p z(p
thus, u ) < 0 z(p) p Let x = z(p) + e and x := z(p ) + e.
(x) > u x
(x)
z(p)
p
z(p (b) If p z(p) 0, then u(x ) > u(x).
)>
0
(c)


p z(p
thus, u ) < 0 z(p) p Let x = z(p) + e and x := z(p ) + e.
(x) > u x
(x)
z(p)
p
z(p (b) If p z(p) 0, then u(x ) > u(x).
)>
0
(c) Only one of (a) or (b) can occur.


Let x = z(p) + e and x := z(p ) + e.
z(p)
Affordable
from e at price
vector p.
(b) If p z(p) 0, then u(x ) > u(x).
Proof: (a) If p z(p ) 0, then consumer i can afford to trade e for x at

market price p.


z(p) Let x = z(p) + e and x := z(p ) + e.
x
Affordable z(p)
from e at price
vector p.

market price p. But i s optimal consumption bundle at price p is x (not x ).


p Let p, p S+ be two price vectors.
e z(p)
Let x = z(p) + e and x := z(p ) + e.
x u(x)
z(p) x (a) If p z(p ) 0, then u(x) > u(x ).
u(x)
u(e)

Thus, i must prefer x to x . Thus, u(x) > u(x ).


e z(p)
Let x = z(p) + e and x := z(p ) + e.
x u(x)
u(x)
u(e)

(b) Symmetric argument.


e z(p)
Let x = z(p) + e and x := z(p ) + e.
x u(x)
u(x)
u(e)

(b) Symmetric argument. (c) Clearly either u(x) > u(x ) or u(x ) > u(x),
but not both.
If p z(p ) 0, then say p is revealed prefered to p , and write p p .

e z(p)
Let x = z(p) + e and x := z(p ) + e.
x u(x)
u(x)
u(e)

but not both.

Why revealed prefered ? In this notation, Lemma can be rewritten:

e z(p)
Let x = z(p) + e and x := z(p ) + e.
x u(x)
u(x)
u(e)

but not both.


e z(p)
Let x = z(p) + e and x := z(p ) + e.
x u(x)
z(p) x (a) If p p , then u(x) > u(x ).
u(x)
(b) If p p, then u(x ) > u(x).
u(e)
(c) p p , p p cant both occur.


e z(p)
Let x = z(p) + e and x := z(p ) + e.
x u(x)
u(x)
u(e)
In other words, if p p , then i has better optimal consumption plan at price
p than at p .
....Hence i prefers price vector p to p .


e z(p)
Let x = z(p) + e and x := z(p ) + e.
x u(x)
u(x)
u(e)
In other words, if p p , then i has better optimal consumption plan at price
p than at p .
....Hence i prefers price vector p to p .
Note: Part (c) says that the relation is asymmetric.
Proof background for SMD Theorem
Let z : S+ RC be tangent field on S+ . Let p, p S+ be price vectors.

Recall: p is revealed prefered to p (p p ) if p z(p ) 0.

We say p is indirectly revealed prefered to p if
p p1 p 2 p n p
for some price vectors p1 , . . . , pn . We then write p p .


p p1 p 2 p n p

z satisfies the Strong Axiom of Revealed Preference (SARP) if the relation
is asymmetric. That is we cannot have both p p and p p.

p p1 p 2 p n p

Thus, part (c) of the Lemma 1 says:
If z is the excess demand vector field for some utility function

u and endowment e, then z satisfies SARP.

p p1 p 2 p n p

Thus, part (c) of the Lemma 1 says:
This can be strengthened to....
If z is the excess demand vector field for some utility function
u and endowment e, then z satisfies SARP.

p p1 p 2 p n p

This can be strengthened to....

SARP Theorem: z is the excess demand vector field for some utility
function u and endowment e if and only if z satisfies SARP.
Let z : S+ RC be tangent vector field on S+ . Recall:

SARP
Theorem:
z is excess demand field for some u and e z satisfies SARP.

SARP
Theorem:
Say z is proportionally injective (PI) if, for all p, p S+ ,

p 6= p = z(p) and z(p ) are linearly independent.

SARP
Theorem:

Clearly, if z is PI and r : S+ R+ is any function, then z := r z is also PI.


SARP
Theorem:


Less clearly...
Lemma 2: If z is PI and satisfies SARP, and r : S+ R+ is any
continuous positive function, then z := r z also satisfies SARP.

SARP
Theorem:


Less clearly...
Lemma 2: If z is PI and satisfies SARP, and r : S+ R+ is any
continuous positive function, then z := r z also satisfies SARP.
Corollary: z is also the excess demand field for some u and e .
(because of SARP Theorem.)
Proof of SMD Theorem
Claim 1: c [1...C ], let ec := (0, 0, . . . , 1, 0, . . . , 0) be cth unit vector.


For every p = (p1 , p2 , . . . , pC ) S , define zc (p) := ec pc p.

This yields a tangent vector field zc : S RC which is proportionally
injective and satisfies SARP.

(The vector fields z1 , . . . , zC span tangent space of S+ at each point.)

Now, let z : S RC be any vector field....
We want a set of C consumers whose aggregate demand vector field is z.

Claim 2: There exist continuous, positive scalar functions
r1 , r2 , . . . , rC : S R+ such that, for all p S ,
z(p) = r1 (p)z1 (p) + + rC (p)zC (p).

z(p) = r1 (p)z1 (p) + + rC (p)zC (p).
For all c [1...C ], vector field rc zc satisfies SARP (by Lemma 2).

z(p) = r1 (p)z1 (p) + + rC (p)zC (p).
Thus, rc zc is excess demand for some consumer (by SARP Theorem).

z(p) = r1 (p)z1 (p) + + rC (p)zC (p).
Thus, rc zc is excess demand for some consumer (by SARP Theorem).
Thus, z = r1 z1 + + rC zC is the aggregate excess demand field for
this set of consumers, as desired.
Proof of Claim 1

Proof of Claim 1

Proof of Claim 1: For all c C, let consumer c have utility function
uc : RC R defined
uc (x) := 1/kx ec k2 . (inverse Euclidean distance)
Proof of Claim 1

uc : RC R defined
uc (x) := 1/kx eC c k2 . (inverse Euclidean distance)
Let p S . Let Bp := z R ; z p be the budget plane orthogonal to
p through endowment 0.
Proof of Claim 1

uc : RC R defined
The uc -maximizing element zc (p) of Bp is the element of minimal distance
from ec namely the orthogonal projection of ec onto Bp .
Proof of Claim 1

uc : RC R defined
Thus, if p = (p1 , p2 , . . . , pC ), then zc (p) := ec pc p.
Proof of Claim 1

uc : RC R defined
Lemma 1 says zc satisfies SARP (zc (p) is uc -maximizing choice for all p).
Proof of Claim 1

uc : RC R defined
Lemma 1 says zc satisfies SARP (zc (p) is uc -maximizing choice for all p).
Also, zc is proportionally injective (exercise). Claim 1 .
Proof of Claim 2
Claim 2: There exist continuous, scalar functions r1 , r2 , . . . , rC : S R+

such that, for all p S , z(p) = r1 (p)z1 (p) + + rC (p)zC (p).
Proof of Claim 2

Proof: S is compact, so c C, zc is bounded (because continuous).
Proof of Claim 2

Thus, R > 0 such that, for all c C and p S , zc (p) + Rpc > 0.
Proof of Claim 2

For
Xall c C, define X rc : S R+ by rc (p) := zc (p) + Rpc > 0. Then:
rc zc (p) = (zc (p) + Rpc ) (ec pc p)
cC X cC X X X
= zc (p)ec + Rpc ec zc (p)pc p Rpc pc p
cC cC cC cC
= z(p) + Rp (z(p) p) p R kpk2 2 p
| {z } | {z }
=0 (Walras) =1 (pS)
= z(p) + Rp Rp = z(p).
as desired. Claim 2 .
Proof of Claim 2

For
Xall c C, define X rc : S R+ by rc (p) := zc (p) + Rpc > 0. Then:
rc zc (p) = (zc (p) + Rpc ) (ec pc p)
cC X cC X X X
= zc (p)ec + Rpc ec zc (p)pc p Rpc pc p
cC cC cC cC
= z(p) + Rp (z(p) p) p R kpk2 2 p
| {z } | {z }
=0 (Walras) =1 (pS)
= z(p) + Rp Rp = z(p).
as desired. Claim 2 .
This completes the proof of the Sonnenschein-Mantel-Debreu Theorem. .
Conclusion
The Walrasian model was the first mathematically rigorous,
all-encompassing model of equilibrium in an entire economy.
It underpins almost all of modern mathematical microeconomics.
Conclusion
However, the Walrasian model is an inadequate (or misleading, or even

incoherent) description of economies not in equilibrium.
It cannot predict which equilibrium will be chosen, how the economy will
get to this equilibrium, how long this process might take, and how the
economy will function in the mean time.
Conclusion

This is a major shortcoming.

Real economies are subjected to constant shocks.
Thus, real economies are often (usually? always?) in disequilibrium.
Conclusion

This is a major shortcoming.

Real economies are subjected to constant shocks.
Thus, real economies are often (usually? always?) in disequilibrium.
Needed: A mathematically rigorous, all-encompassing model of

disequilibrium dynamics in microeconomics.
Further reading
These slides: http://xaravve.trentu.ca/pivato/Teaching/walras.pdf
Microeconomics (Walrasian Equilibria, etc.)

Andreu Mas-Colell, Michaeal D. Whinston, and Jerry R. Green,
Microeconomic Theory. (1995, Oxford UP).
Hal Varian, Microeconomic Analysis, 3rd edition. (1992, W.H.Norton).
T
atonnement and Sonnenschein-Mantel-Debreu Theorem
17.F of Mas-Colell, Whinston & Green.
Donald Saari, Mathematical complexity of simple economics, Notices
of the American Mathematical Society 42(#2) (February, 1995).
Disequilibrium dynamics (price-adjustment models, Hahn-Negishi, etc.)
Jean-Pascal Benassy, The economics of market disequilibrium. (1982,
Academic Press).
Franklin M. Fisher, Disequilibrium foundations of equilibrium
economics. (1983, Cambridge UP).
Jean-Pascal Benassy, The macroeconomics of imperfect competition
and nonclearing markets. (2002, MIT Press).
Introduction
Supply and Demand
Demand Curves
Supply Curves
Why equilibrium?
Problems
Complementarities and substitution
Factor price interactions
Walrasian Equilibria in Pure Exchange Economies
Goal
Commodities
Consumers
Utility functions
Trade and optimal consumption
Walrasian Equilibrium
Definition
Existence Theorem
Proof idea
Walrasian Equilibria in Production Economies
The Firm
Technology
Profit Maximization
Walrasian Equilibrium
Definition
Existence Theorem
Proof idea
Significance
Problems with Walrasian equilibria
Nonuniqueness
LOP & Monopolistic Competition
Price Setting?
Price Adjustment Dynamics
Tatonnement
Definition
Problem: The Sonnenschein-Mantel-Debreu Theorem
Problem: Nonfeasibility & Rationing
Problem: One price or many?
The Hahn-Negishi model
Description
Hahn-Negishi Stability Theorem
The Fisher model
Description
Problems
Proof of Sonnenschein-Mantel-Debreu Theorem
Background
Revealed Preference
Strong Axiom of Revealed Preference
SARP and proportional injectivity
The proof
Main proof
Proof of Claim 2
Proof of Claim 2
Conclusion

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Department of Mathematics, Trent University

Walrasian Equilibria in Pure Exchange Economies

Walrasian Equilibria in Production Economies

Price Adjustment Dynamics

Proof of Sonnenschein-Mantel-Debreu Theorem

Supply: total quantity pro-

De duced by labourers, farmers, ar-

Supply: total quantity pro-

De duced by labourers, farmers, ar-

Supply: total quantity pro-

De duced by labourers, farmers, ar-

At the equilibrium price, supply = demand.

Supply: total quantity pro-

De duced by labourers, farmers, ar-

At the equilibrium price, supply = demand.

30 consumers want the product

21 more consumers want the

product slightly less.

19 more consumers want the

product slightly less

18 more consumers want the

product slightly less

....If the price was $30, then 200

consumers would buy one, 60

In this way, the demand curve

emerges from the aggregate

40 producers are very efficient.

9 more producers are slightly

7 more producers are even less

In this way, the supply curve

Market Equilibrium Price

There would be a shortage.

Market Equilibrium Price

There would be a shortage.

Market Equilibrium Price

There would be a shortage.

Market Equilibrium Price

Equilibrium Market Price

There would be a glut.

Equilibrium Market Price

There would be a glut.

Equilibrium Market Price

Some retailers will sell at lower price to clear excess stock.

There would be a glut.

Equilibrium Market Price

Some retailers will sell at lower price to clear excess stock.

There would be a glut.

Equilibrium Market Price

Some retailers will sell at lower price to clear excess stock.

Consumption of commodity X can affect the demand for commodity Y .

Consumption of commodity X can affect the demand for commodity Y .

Consumption of commodity X can affect the demand for commodity Y .

Consumption of commodity X can affect the demand for commodity Y .

Consumption of commodity X can affect the supply for commodity Y , if X

Consumption of commodity X can affect the supply for commodity Y , if X

Consumption of commodity X can affect the supply for commodity Y , if X

Consumption of commodity X can affect the supply for commodity Y , if X

Consumption of commodity X can affect the supply for commodity Y , if X

Consumption of commodity X can affect the supply for commodity Y , if X

Labour Supply should be in-