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    1987 Newpalgrave1 PDF

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    Miguel Henriques de Carvalho

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    ‘Arrow-Debreu model of general equilbrum. 1 1xrnoDUCTON; TUTE MODEL EQUILIBRIUM IV PARETO OPTIMALITY, V WHAT Ik isnot easy to separate the significance and influence of the ‘Arrow Debreu model of general equlibrum from that of futhmtiea ccomonies Hass In an extaordinary series of papers (Arrow, 1981; Debreu, 1951; Arrow-Debreu, 1954), fw ofthe oldest and most important questions of neociassical cconomics, the Vablily and elcency of the market ster, were shown to be susceptible to analysis in a model completely Taithul to the neoclassical” methodological premises of individual rationality, market clearing, and rational expects fons, through arguments at least as_clegant as any in ‘economic theory, using the two techniques (convexity and fixed point theory) that are sil, aller thirty years, the most important mathematical devices in mathematical cconomics. Fileen years after its birth (eg. Arrow, 1969), the mode! was still being reinterpreted to yield fresh economic insights, and ‘sven years later the same mode! was sill capable of vielding fnew and fundamental mathematical properties (eg Debreu, 1970, 1974) When we consider thatthe same tWo men who derived the most fundamental properties of the model (along ‘with McKenzie, 1984) also provided the ost significant eco- fnomic interpretations i ho wonder that its invention has helped earn foreach ofits creators, i diferent years, the Nobel Prize for economics. Tn the next fe pages I shall try to summarize the primitive mathematical concepts, and theit economic interpretations, that define the model, i give hint of the arguments used to xablshthe model's conclusions Fall, on the theory that ‘mode is equally well desenbed by what it cannot expla, Uist Several phenontena that the model isnot equipped to handle Commodities and Arrow-Debreu Conomodiies (A.1) Let there be L commodities, [=1,..,L. The amount of & commodity Is described by real suber. A lst of quantities of all commodities is given by a vector in Rt ‘The notion of commodity is the fundamental primitive concept in economic theory, Each commodity is assumed to Ihave an objective, quantifable, and universally agreed upon (le. measurable)" destription. OT course, in Teality” this eseiption is somewhat ambiguous (should two apples. of iferent sizes be consdered two units ofthe same commodity, ‘or two diferent commodities?) but the essential quantitative Sipect of commodity cannot be doubled. Production and consumption are defined in terms. of transformations of commodities that they cause. Conversely, the set_ of ‘commodities isthe minimum coletion of objects necessary to ‘describe production and consumption. Other objects, such a8 Financial asels, may be traded, but they are not commodities. U6 ‘General equilibsium theory is concerned withthe allocation of commodities (between nations of individuals, across ime, oF Cinder "uncertainty ete). The’ Arsow-Detwrew model etiiee thos allocations Which can be achieved through the exchange of commodities at one moment in time Wis easy tose Ut is often naportant to Ue agent at economy to have precise physical desriptions of eommodities, 5 for example when placing an order for a particular grade of Steel or ofl The Jess erude the categonzation of commodities ‘becomes, the more scope there is for agen to Wade, and the ‘greater isthe set of imaginable allocations. Two agents may tach have apples and oranges, There is no point in ‘tchanging one man's frit for the other man's fut, but both ‘ight be made beter off if one could exchange his apples for the other's oranges. Of course there need not be any end fo the ‘stinctions which in principle could ‘be drawn between ‘commodities, but presumably finer details become les and less important. When the descriptions are so precise that further refinement cannot yield imaginable allocations which increase ‘he satisfaction of the ages in the economy, then the commodities are called Artow-Debreu commodities. ‘A field is better allocated to one productive use than another depending upon how much fin has fallen omit bu ts also better allocated depending on how much rain has fallen on other fields, Thit illustrate the apparenty paradoxical Usefulness of including inthe deserption of an Arrow-Debres commodity characteristics of the world, for example the ‘commodity’s geographic location, is temporal locaton (Hicks, ‘ate of nature (Arrow, 198%; Debre, 1989, Radner, \ and. perhaps even thc mame of ils final consumer (Arrow, 1969), which at fst glance do not seem intrinsically ‘connected with the object ill (but which are in principle observable). Ticks, perhaps anticipated by Fisher and Hayek, was the first to Ruggest an elaborate notion of commodity this idea has been developed by others, especially Arrow in connection with uncertainty. Hicks was also the fist to understand “parently complicated transactions, pechaps involving the exchange of paper assets oF other noncommodities, over many lime periods, in terms of commodity tade at ope moment in time. Thus saving. or the lending of money, might be thought fof as the purchase today of pariclar future dated commodity. The second welfare theorem, which we shall Shortly discuss, shows that an ‘optimal’ series of transactions ‘an always be so regarded. By making the distinction between the same physical object depending. for example, on the rate fof nature, the general equim theory of the supply and ‘demand of commodities at one moment in time can incorporate the analysis of the optimal allocation of risk (@ concept which ar removed from the mundane ‘qualitesoffresh fut) with exactly the same apparatus weed to Snalyse' the exchange of apples and oranges. Clasilying physical objects according to ther location likewise allows transportation costs to be handled in the same framework, Distinguishing commodities by who ultmately consumes ther could allow general equilibrium analyss to. systematically ‘nluae esternsities and pubic goods at special Css, hough this has not been much pursed. Tn realty, it i very rare to find a market for a Arrow Debreu commodity. ‘The more finely the commodities fare described, the less likely ae the commodity markets to have many buyers and sellers (ce, to be competitive). More commonly, many groupe of Arrow Debreu commodities are traded together, in unbreakable bundles, at many moments in time, in second bes’ transactions. Nevertheless, this under Handing of the limitations of teal world markets, based on the ‘Arrow-Debreu model of general equim concept of the Arrow-Debreu commodity, is one ofthe mort ppowerfut anya! tools of systematic accounting svaiabe To the general equilibrium theorist. Similars, the. model of ‘Artow-Debret, with it idesiation of a separate market for tach Arow-Debreu commodity, all simultaneously meting is the benchmark ‘against which the eal economy can be measured Consumers. (Act) Let there be H consumers, = I, #.Q ‘Each consume Aven imagine consumption plans xe Re lying in some consumption set 2°, (A.2) Xe a closed subet in BE which is bounded ftom below. a Each consumer also has well defined preferences > hovet very pa (e y)EX"2X% where x py means x i a least as Sesrable ay: Typiealy it ie asumed that (A.3) > ie a ‘complete, transitive, continous ordering, a ‘Notice that 1m geeralequiltrium consumers make choices between entire consumption plans, not betweeen Individual commodiis. A single commodity has sigaieance to the co Sumer only in relation to the other commodities he has consumed, or plans to consume. Together with transitivity and ‘completeness, this hypothesis about consumer preferences em bodies the neolasial ideal of rational choice ‘Rationality has not alvays been a primitive hypothesis in neoclassical economics, It was customary (eg. for Bentham, Jevons, Menger, Walas) to regard satisfaction, or uty, asa ‘measurable primitive; rational choee, when it was thought tO ‘eeur at al, was the consequence ofthe maximization of uti. ‘Rad’ since ‘uty was often thought to. be instantaneously ‘produced, sequential consumer choke on the basis of sequential Inctantancane ality maximiration wae sometimes expity discussed a rational Gee eg Botum-Baverk on saving and the reasons why the fae of interest is always positive) ‘Once utility is taken to be a funewon not of instantaneous consumption, but ofthe elie consumption plan, thea rational choice equivalent to utlty maximization. Debreu (1951) proved that any preference ordering > defined on X¥ xX Saisfes (A.)-(A3) if and only if there is 2 utlity function 8: Xt-oR soch that x Peay exactly when uh) Bu) Under the influence of Pareto (1909), Hicks (1989) and Samuelson (1947), neoclassical economics has come to take ‘aUonalty as prtilive, sal wilt animation ay x logical consequence, This has had a profound effet on welfare eco omic, and pechaps on the scope of economic theory as wel Inthe ist pace, itutity is not dicey measurable, then it can only be deduced from observable chores, asin the proof of ‘Debreu. But at best this wll give an ordinal” wilt, sine if //R—R is any strc increasing function, then represents 24 fad only if vbw? represents, Hence there ean be fo! meaning to inerpersonal wtlity comparisons the Ben- thamite sum EE. us very different from the Bentham sum Eff" Inthe second place, the ideal of rational choice for preterence, feed from the need for measurement, is much tore easly extended 1o domains not directly connected 10 platforms, of ‘social states. The elaboration ofthe nature of {he primitive concepts of commodity and rational choice, veloped av the basis of the theory Of masket equibiun prepared the say for the methodological principles of neo. lassiel economics (ational choice and equlibrium) 10 be applied to questions far beyond those of the market. "Although the rationality principles Is in some respects a weakening of the hypothes® of measurable uility and instan: ‘ancous utility maximization, when coupled with the notion of consumption pln it is also a strengthening ofthis hypothesis, fand avery strong assumption indeed. For example there isnot room in ths theory for the Freudian spt psyche (or sel. Geception), of for Udyscus-ke changes of raft Pethaps mote Importantly, a consumer's preferences fr example how thi hts) donot change according tothe ol he play ia the proce ‘of production (eg on whether hei capitalist or landowner), not do they change depending on other consumere preferences forthe supply of commoditis. As an instance of this last case ote that i follows from the rationality hypothesis that the Surge inthe microcomputer industry influenced consumer choice between typewriters and word processors only through availability (va the price, and not through any learning ee. (Consumers can ‘lear’ in the Arzow-Debrev mode, eg. thet ‘marginal rates of substitution can depend onthe sae of nature, but the rate at which they etn is independent of production for consumption it depende on the exogenous relation of the state. We shall come back to this when we consider information) It for no other reson, the burden of calculation ad attention which rauona! choles: over consumption plane imposes onthe individual sso large that one expects rationality to give way to some Kind of bounded rationality in some future ‘general equilbrium models “Two more assumptions on preferences made inthe model of ‘Acrow-Dsbreu are nonsatiation and convety (For cach x0 tre ina ye wh > eh that y pax and not 2 >a (AS) Fe a eonven set td ys conten, Leg fy ax and Dee et then ly +0 —Oxlmx a ‘The nonsatition hypothesis seems entiely in accordance with human nature, ‘The convexity hypothe implies that ‘cammadiiee are infitely diiibe, and that mintuee are at least a good as extremes. When commodities ae distinguished ‘very finely aceording to date, so that they must be thought of 438 flows, then the convexity hypothesis is untenable. In a Standard example, a man may be indieret between drinking 4 glass of gin or of seotch at a particular moment, but he would ‘bemuch Worse offi he had to drink a pane of half gin-halt ‘otch On the other hand if the commadties were not so finely ated. then they would be more analogous to stocks, and @ consumer ght well be better off with aie of gin and a lite ‘of scotch, than two lites of ether one. In any case, s we shal ema lteycvesy agent ual sia tte het (FE if there are many agens) then the onconvenitis in preferences ace relatively unimportant ‘each agent Mis also characterized by a vector of tial ‘endowments (AQ MeXMERE forall het. A o ‘The endowment vector e* represents the claims thatthe com- sumer has on all commodities, not necessarily commodtie in his physical possession. The fat that ee X* means that the ‘consumer eat ensure his own survival even i hei deprived of Allopportunty to ade. This 4 somewhat strange hypothesis for the modern world, in which individuals often have labour buat few other endearment =e tae Dubin the hypthese could be relaxed; in any cafe survival isnot amiss that i Addressed in the Arrow-Debreu model, {Each individual slao endowed wih an owaciship sha of each of the firms j= os J (A) For all he tesco Hey besocedh dy 20, and for al Fe deced Bvdy =i o Firms. (A.8) Let there be J fms, j= by. a ‘The firm in Arrow-Debrew is characterized by ss initial seibution of owners, and by ils technological capacity Arrow Debreu model of general eulibium ¥,cR! to transform commodities. Any production plan yew, where negative components of y tter to inputs and positive components denote outputs, is Teasible for firm j if Ye, A-customary asumplion made inthe Arrow-Drbert ‘model is ree disposal: f= 1,» L any commodity, and r, i the unt vector in RE, with one in the [th coordinate and 20 chew, then (A9) Fer all Land k>0, —kye¥,, for some Poked o Ahough sts strange, when thinking of nuclear waste ete, to think that any commesdy ca be disposed without cot (fe ‘without the use of any other inputs), a5 we shall remark lates this assumption can be faxed, if megative prices are introduced {ort weak monotonicy t aseimed). "The empirically most vulnerable assumption to the Arrow Debrew model, and one erucsl to ts lop, I (A.10) For each j,¥, i closed, convex set conaining 0. ‘This convexty assumption rules out indvsiblsis in pro duction (half a tunnel) increasing returns to scale, guns from specialization, el. AS with consumption, ifthe indivis: Toes of production are small elativ to the ize of the whole ‘economy, then the conclusions we shal shortly pesent are not ‘uch affected. But when they are large. or when there are Significant increasing return to sae, the model of competitive ‘equilibrium that we are about to examine simply mot appic= thie. Neuerheets, convent consistent withthe traitionally important eases of decreasing and constant returns to scale in production We eoncuue by procting Unee Gal assumptions wed in the Arrow-Debreu mode (AND Leto = Ets BEES (pel zp ay ye Pye hod ti Falperyresiyand 7 i Beer (pe ppetece sm Mm ye, yeF Then FAB. #9 and Ks compact Assumption (Al) requires thatthe leel of productive activity ‘hats possible even if the productive sector appropriates all the resources of the consuming sectors bounded (ts well ascosed) ‘Notice that these asumpuons are conssent with ems ‘owning initia resources, as well as indwiduals In the orginal [Arrow Piven mde (1084), the firme wnte pried fre ‘owning initial resources (they were assigned tothe firm owners, With complete markets there wit ference, but with incom plete markets the eater assumption is restrictive) (A.12) The economy is reducible a We sall not elaborate thi assumption hee. It means that for any twoagents hand the endowment eof agent his postive in some commodity . which (Caking into account the poss Dities of production) agent ’ could use to make hinself Strely better of I certainly seems reasonable that each agent's Inbour poser could be asd to wake abuthes agent lite Uf Tasty, we assume thi (4.13) The commodities are not dutinguished ssoording to Which firm produces them, or who consumes them C) Assumption (A.13) is made simply for the purposes of interpretation. When put together withthe defition of com- petitive equilibrium, it plies that there are no externalities fo Production or consumption, no public goods, ete. Matbe- ‘atcally, however, (A.13) has no content. tm other words if we ‘dropped assumption (A.13), the Arrow-Debreu notion of com petitive equiloum would sil make sense (even im the presence ‘of extraltes and public goods) and it would still have the ‘optimality properties we Shall elaborate in Section ML, but it would require an entirely diferent interpetation. Consumers, Tar example, would be charged diforem price forthe tame physical commodities Game, that, according, to dae, ocation fand state of nature). In more technical language, a Lindahl quilbria i special cae of an (A 1)-(A.12) Artow-Debrew quit, with the commodity space suitably expanded and interpreted, Thus each physial unt of «publi good is replaced by Hf goods, one unit forthe public good indexed by which agent consume it Also the physical technology set describing the production of the public good is replaced by a diferent set, in the Arrow-Debreu model, lying in higher dimensional syace, where the output of the sime amount of ff goods. In a8 ‘Aviom Debreu cqulltriam, consumers wl kely pay aierent Drees for these H goods, Le for what in reality represents the same physical public good. Hence the differential pay principle for the optimal provision of public goods ‘elvtdated by Samuelson, which appeared to point toa qualitative difference between the analytical apparatus mended to describe optimality in public goods and private goods economies, is thus shown (0 beveaplicable by exactly the same apparatus wed for private goods economies, simply by multiplying the number of conn ‘dies. The same device ca also be used for analysing the ‘optimal provision of goods when there are externalities, pro: ‘ded that nopaive prices ae allowed Assumption (A 13) tus Seriously limts the normative conclusions that ea be drawn From the met From a dresnptive unt af oem, however rationality and the price taking behatiout which eqoilibriam implies, make (A.13)nevessry ice ithe Final primitive concept m the Arrow-Debreu mode! Like commodity it is quanifabie and directly measurable. AS ‘Bebreu has remarked, the fundamestal role which mathematics plays in economists party owing tothe quansiable nature of these two primitive concepts, and to the rch mathematical ‘eationship of dual vector spuces, sto Which 1 satura (0 lassi the collections of price values and commodily quan tives Properly speaking, pice only sensible (and measurable) ltsarelaionhipbetmeen two commodiin sc. a0Flatie pie Hence there should be LL teatve pres an the ‘Arrow-Debrev model. But the definivon of Arrow-Debreu ‘equuibcium immediately mptes tat suthees to ge L~ Tot these ratios, and all the ees are determined For mathematical convenience (namely to teat prices and ‘quantities as dual vectors), one pre specified for each unt ‘uaniy of each commodity The relauve prie of two com fhodities can be obiained by taking the rato of the Arrow Debreu prices of these commodities. T shal proceed by specifying the defininon of Arrow-Debreu ‘equilibrium, and thes I make a umber of remarks emphasizing Some of the salient characterises ofthe dfition. The longest remark concerns the dillerences between the historical devel. ‘pment of general equilibrium, up unt the time of Mieks and Simueson and the particular Arrow Debreu model of general "An Arfow-Debreu economy E isan array E = (L, H,J(X, a OD) kale Hyg J). sting assumptions (A.1)-(A.18), An Arrow-Debrew equilibrium san aay (A). (81), (Ft Leh elec HJ leone) stieying For all j= 1... S540 ween pon Arrow Debre model of general equilibrium For all a1... H.S€B%B), where BY) sfreniacedaad ohn Jo and if x €84(9), then not x>43%, Fora f= tanks Eat ‘The most sting feature of general equilbrium is the justapositon of the great diversity im goals and resources it flows. tozether with the supreme coordination it requires. Every desire of each consumer, no fatter how whistal, 5 met precisely by the voluntary supply of some producer. And thio tr forall markats and consumers tmulteneoucly. “There isa symmetry 1 the general equilibrium mode, im the way that all agents enter the model ndvidually motwvated by Seltintrest (aot as members of cstinet clases motivated by class interest), and simultaneously, 0 that no agent acts por to any other on a given markel (eg. by seine price). IT workers” subsistence were not assumed, for example, that ‘would break the symmetry: workers income could have to be fuaranteed fist, otherwise demand would (discontinuous) Sollase. As 5, atthe aggregate level, supply and demand Squall and simuttancousy determine. pices in equilibrium, botn the consumers mana! rates subsulucon and the producers’ marginal rates of transformation are equal t0 Felative pees (assuming. diferentiabilty and. inteority). ‘There are gains fo trade both through exchange and through production This point of view represent 4 sgnifiant break Sith the clascal tradition of Ricardo and Marx. We shall Some (the main diffrence between the classical and ncoeasical approaches shortly. Another diference is that here need not be fixed coefcenls of production in the Mrow-Debreu model = the sets Y are much more general Aso in an Arrow-Debreu equlibrium, there is no reson for here 10 be a uniform rate of prof. Tere is none the less one spect of the model which these authors would have greatly "Pproved, namely the shar d¥ which allow the owners of ‘rss to collet profs even though they have contributed vothng to production. TNouke tat Im generat equilbrum each agent need only concer himsalf with his ova goal (preferences opis) and hie pees. The implicit assumpion that every agent "knows! Ihe peices s highly non-trivial. Ie means that at cach date scl agent capable of forecasting perfectly all Ture prices ‘0 the end. of time It yim thi sense that the Arow Debreu model depends on “rational expectations. Each agent ust also be informed of the “price g of eath firm J, where ‘fa fs}. Fis that produce under constant returns (o le must also discover the level of production, whick cannot < deduced from the pries alone.) Assuming that the “man 1s the spot’ (Hayek's expesson) Knows much better than ryone ise What he wants, of best how his changing vironment is suited to prodorng his prodvet,decenteaied Seison making would seem to be highly desirable, si not ‘eompatible with coordination. Indeed, harmony through versity one ofthe sacred doctrines ofthe liberal tradition. “The greatest triumph ofthe Aerow-Debreu model was to lay ut explicitly the conditions (roughly (A.I)-(A.18) under hich if is possible to claim that a properly chosen price stem mst always exist that, lke the invisible hand can lade diverse and independent agents to make mutually compauble choices. The idea of general equilibrium had bradually developed since the time of Adare Smithy mowly throug the proneering work of Walras (1874), Von Neumann (0937), Wald (1982), Hicks (1939) and Samuelson (1917) BY hele 19905 he definion "of equllbeum, including ‘overs shares n the rms, was wellesablshed, Buti was ‘Arrow-Debreu (1954) that spelled ou precise mcroeconomic sssumplions a the level of the individual agents tht could be ‘sed 10 show the model was consistent, "The axiomatic and rigorous approach that characterized the formulation of general equilrivm by Arrow Debreu has been enormously influential. It is now taken for granted that a ‘models not propery defined unless thas been proved 0 be Jogiclly consistent. Much ofthe clamour for microsconomic foundations to macroeconomics’. for example. i a desire to see an axiomatic clanty sila to that of the Atrow-Debcea model applied to other areas of sconomies. OF course there ‘Riomane and ngorous; one thinks especially of Von ‘Neumana-Morgenste's Theory of Gamer (1944) But game theory was, at the time, on the periphery of economics, Competitive oquiivium is at its heart ‘The central mathematical technigues. convexity. theory (separating hyperplane theorem) and Brouver’s (Kakutan's) fixed point theorem. used in Arcow-Debreu are, thirty years later ‘sll the most importa: tools used sn mathematical economies. Both elements had played a (hidden) role in Von ‘Neumans’s work. Convesity had Been prominent in the work or Koopmans (1951) of acti analyse inthe work of Kuhn fand Tucker (1951) 08 optimieation, and in the papers. of ‘Arrow (1951) and Debrew (1981) on optimally Fed pont ‘Georems fad been used by Von Neumann (1937), by Nash (1950) and especially by MeKenzie (1954), who one month tarler than Atrow-Debrey had published a proof of general fquilbrium using Kakutan' theorem, albeit ina model where the primitive assumptions were made on demand Tunctons, rather than preferences McKenzie (1989) also made a early ontnbution to the notion of an stedieble economy (assumption (4.9) “The frst fruit ofthe more presse formulation of equilibrium that began to emerge in the early 1930s was the transparent Semonsiration af the Fret snd second welfare theorems that ‘Arrow and Debreu simultaneously gave wp 1981. Particularly noteworlby is the proof that every equilbrium is Pareto ‘pal $0 snple ai lating ds demons tat i's no exaggeration to cll jt the most frequently stated Argument inal f neccasical economic theory. ‘Among the confusions Ui were eared away by the careful suiomave treatment of equim was the fekance of the Fest 2, omcing ay. ‘Re poo atte second well here, on the ter band des sje convey of ie pretence td positon st ttioughnct tee foetal norte sry o he ‘Gd allcnion 8) Eventi pnd on Minkowshs theorem, which asserts that between any two disjoint convex see in RY there must be 4 separating hyperplane Tn this connection let us mention one more cemarkable mathemati property of the ArrowPohren model. Let us fppos tht all production takes place under constant returns forsale: if ye Y, then 50 i 4), for 10. We say that a {asile allocation & for the economy E sin the core if there i no coalition of consumers S'= (Ty... Af} such that using ‘only their iil endowments of reources, a8 well as access to all the production technologies, they cannot achieve an llloeation for themselves whch they al prefer to &, The core is meant to reflect those allocations which could be rsitained ‘when Bargaining (he formation of coalitions) is costes. Tn 4 satus quo core allocation, any labour union or cartel of ‘Somers dt tnewtens to miield a goods from the market Knows that another coalition could form and by withholding its goods, prevent some members of the original coalition from being better off than they wore under the satus quo, Is 35) to see that any competiine equilibrium in the core Debreu-Seart (1963) building on eatlier work of Scart showed 6y using the separating hyperplane theorem, that it ‘gents are small relative tothe market n the sense they made precise trough the notion of replication, then the core consists ‘only of competitive alleations. Such @ theorem can also be Dproved even af there are small sonconvexiies tn preferences (oe Aumann (1964) fora diferent formulatuon of tbe stall agen’. [EMSTENCE OF EQUILIANIOM. Suppose that agents’ preferences and fms production ses are srily conven, and that agents fice peter mace of any commadiy to lest (eet mono: tonicity) and that they all have sritly positive endowments, Leta be the st of Lepr vectors all nonnegative, summing tone, Let /'(p) be the commodiy bude mos prefered by grat, given the sctly pose pies pe By +. Similarly (2) be'the profit maximizing choice of fm. give prices PEA, .- Fil, et /(9)= 20. 4p) ~¥, 5p) ~ 6. is {any do show that fis 3 continous function’at all pe A, ‘price Fed, «is an Artow-Debreu equilibria prige if and only 78) 3. Th pera there is no reason o expec a continuous fanction toltaye evo. Tas Weld vould grove ely wir great diielty ina special case that an equllbium necessary exists Now observe thatthe funetion must sais Wala Law, p'f(p) = 0, foe al p80 fs na abivary. ‘Consider the convex, compact se A, of prees ped with 1 3e>0, forall Consider also the continuous enction 408, mapping p to the elses point fi & to fp) +p. By Brouwer's fxed point theorem, there must be some p with (9) =. From strict monotony 1 follows that feanmot be fn the Boundary of 4, if is chosen suficently small. From ‘Walras Law it follows tha iff iin the interior of 4, then {(P)=0. The demonstration of the existence of equilibrium by Arrow and Debrey, as modified later by Debreu (1959), fallow a sila ok "Note the esenta ole of convent in two parts of the above poo. It was used with respect to agents characteristics (0 uarante that thir optozing behaviour is continuous. And {was abo used to ensue thatthe space has the fixed point property. Smale (1976) has given a pathfollowing proof (ce- {ated to Scars (1973) algorthn) tat on closet mspestion does not require convexity ofthe pce space. (Derker (1974) and Bulasto (1986) have given homotopy poof) This not only of computational fmportanse. appears that there may be ‘conomie. problems, dealing with general equilibrium with incomplete markets, im which the price space is intnsclly ‘Arrow-Debreu model of general equlibriam ronconvex, and in which the existence of equibium can only beiproved using pathfalowing methods (ee Dull Shaler, 1385). ‘To weaken the assumption of strict convexity, in the above proof, one can replace Brouwer’ fixed point theorem with Kalulant’s. An important conceptual point aes in connection with set montoniety. Ithat is dropped, and the production sts do not have fee disposal, then in order to gurantee the existence of equlbrium, the’ definition must be revised to require either (9) =0, oP) <0 and f= 0. There may be free goods, like air, in excess supply. One cannot drop meno tonicity and fee disposal without allowing for negative prices. ‘Final, t can be shown that if ter are small nonconvexities in sither preference or production, and ial the agets are small ftlative tothe. market tether in the replication sense of Debreu-Seart, or the measure fo sense of Aumann), then ‘thre wil be prices at which the markets nearly clear. On the other hand, inerensing reluray to sale over a broad range “efntely incompatible with equilbrum LOCAL UNIQUENESS AND COMPARATIVE STATICS. Another prop- centy of the excess demand function f(p) is that iis homog- neous of degree zero. 50 instead of taking ped, lets ft ‘i= L Sinilaey. fet Pip) be the LI vector af exces demands for goods (=2.....£ If Fip)=0, then by Walras’ Law, So) Suppose furthermore that agent characteristics are smooth ‘Then F(P) is diflerentable funtion ID, F(A) bas fll rank av'an equilbriam then ps localy Ungue- Moreover te ‘equilibrium p will ove continuous, given continuous, small changes inthe agents characteristics, such as their endowments TED, F(p) has ful rank at all equilibria then thee are on) 4 Ftd number of equiibria. Debreu (1970) called an economy, EE regular i, Fp) bas fll ank at all oquiiboium P of ‘The problem of trying to give sulicient conditions on prefer ‘noes ete. fo guarantee tit D, Phas ful rank in equilibrium hhas proved intractable (except for restrictive, special cases). But ‘Debreu (1970) solved the problem in classic tye, appealing to the transversality theorem of differential topology (ar Sara's theorem), to thow that Hf one were content with epulriy for most aif economies, then the problem is simple ‘He proved that for almoet all economies Dj hat fall rank at ery ‘quitrium Hence, in almost all eednomies comparative statics (Ghe ckange in equilibrium, given exogenous changes to the economy) i Well dened ‘Observe that excess demand F depends on the agents characterises, ineluding their endowments, 0 we could write Flesp). Now the transversality theorem says that (given some technical conditions) i D, Ft, f) has full ank a all equilibria FB forthe economy Ele) with endowments efor al then for ‘almost all ¢, D,F(e,p) has full rank at all equltsium p of Ee) But its eaby to show that D, Fe, p) always has fll rank ‘Along siniar lines, Debreu proved the "generic regularity" of ui, “There is one unfortunate side fo this comparative sates stor) One wou ke to show not only tha comparative statis are well defined, but also that they have a definite form. In a oncave progeamiing problem, for stamps, a small increase finan input results in'a decrease in that inpat's shadow pace, and an reat n output approximately equa tothe siz of he ‘put inrease multiphed By its orginal shadow price. Given the strong rationality hypothesis ofthe Arrow-Debreu model fone would hope for some sot of analogous result. Following ‘conjecture of Sonnenschein, Debreu proved in 1974 tha gives any function f(p) on 4, satisfying Wares” Law, he could find fn’ Artow-Debreu economy such that /ip) its aggregate ‘excess demand on 4. Thus assumption (A.1)-(A.13) do not petit any a prior predictions about the changes tat must ‘Sccurin equilibrium given exogenous changes tothe economy. ‘An increase inthe aggregate endowment of a pariulat good, for example, might cause ts equiltium price to rie, The Possibility of such pathologies is disappointing. It means that fo make even qualitative predictions, the economist needs ‘denied data on the excess demande F . WAT TIE MODEL DOESNT EXPLA We have already discussed the implications of the notion of, Arron Debreu commodities and the second welfare theorem Tor insurance, namely tht since every Pareto optimal allocation is supportable as an Arrow-Debyeu equilibrium, every optimal allocation. of sk. beating canbe accomplished) by the production and trade of Arrow-Debreu commodiis, Le without recourse 10 additional kinds of insurance markets Specializing in sks. Every Arrow-Debreu commodity is as ‘much a diets in location, oF tims, or physical quality a it [s for risk. This leads toa great simplification and economy of analysis, Buti also means, that from the positive point of view, the Atrow-Debreu economy cannot diel provide an danaljis of insurance markets (except asa benchmark case) In this section T shall uy to point out a few of the ober phenomena which recede into. the background inthe Kreow'Debrev model but "whieh would emerge if the assumption of a nite, but complete set of Arrow-Debres tind ennsimers wae dened four cursenly active lines of research which attempe £9 come to grips in general equilbrium framework With some of thee phenomena, while preserigg the Fundamental neoclassical Arrow-Debrew principles of agent ‘optimization, market clearing, and rational expectations, that | think are paticularly worthy of attention. They are the theory ‘of general equilibrium with incomplete asset markets which fan be traced back to Arrow’s (1953) seminal paper on ‘Scconties: overlapping generations economies, whose study inated by Samuelson (1988) sn his clasic consumption Iban model, the Cournot theory of market eathange mith fem leaders, first. adapted "to general equilibrium by Shapley-Shubik (1977), and the model of rational expectations ‘equlibram, proneeres by Lieas (1972) Let us note Bist of al that in Arrow-Debreu equilbcum ther ismo trade in shares of firms. A stock erties s not an ‘Avrow-Debreu commodity, for its possession entiles the ‘owner to additional commodities which he need not obtain through exchange. Note alo that ia Arrow-Debres equilib: sium, the hypothesis that all prices will remain the same, m0 ‘matter how an individual frm changes it production pan, fzuarantecs that firm overs unanimously agree on the! frm bjetive, to maximize profit. If there were a market for frm es there would not be any trade anyway. Since ownership Of the frm and the income necessary to purchase it would be perfect substitutes. Tn an incomplete markets equiium, Sitorentsourees of revenve. are not nesesarly potest fubsittes, There could be ative trade of the stock market, Of course, such a model would have to specify the firm objectives, since one would aot expet unanimuty. The theory ff stock market equilibrium is stl in its infancy, although Some important work has already ben done. (See Deze, 1974, nd Grossmas-Hart, 1999) Banksuptcy isnot allowed in an Artow-Debrew equilibrium, ‘That follows from the fact thit all agents must meet theit 2 Arrow Debrea model of general equlibium budget constraints. Ina game theoretic formulation of Seofbvium Goch as 1a Satu shony) ie ached frposing an infinite bankrupty pena. Since every Kivu Ewes equsiom i Prete optima thee would be 0 bene in reducing the bankeupc) penalty t0 the point Where someone might choose to" g9 bankrupt But with Tncomplete mast sich a poicy might be Pareto improving. ten allowing for the deadweight lom of imposing, te enti Money docs ot appear in the Arrow-Debres model. Of cours, al ofthe reasons for ts ea fe eine: transactions and, precautionary demand, store of value, unt. of Sounty ete are already taken ear of the Arrow Deb ‘model One could imagine money inthe model at data zero Sexy agent could bouton tnney fun the cea bake At Sry date afterwards he would be required 10 france is purchases out of his stock of money adding to that sack fom ais: atthe lant date ie would berequed fortum othe tunk exactly what be. borrowed (or le face an ininite Tuankraptey pent). In such a model the Arow-Debrea prices would appeat as money prices, The absolute lve of ‘money prices and the aggregate Amount of borrowing would tot be determined, but the alecations of conmodites would ‘the sme atin Arrow Debres. Tere sno point in aking the tole of money exp in the Arrow Debret mode since ‘is no eft on te real allocations, However, one cond the same mode! wth incomplete ase! market, the presence of tanlcly financial secures can be of eeatsnicance tothe ‘al allocasons Ta the Arcow-Debrew model, all ade takes place at the tegoning of tins market more opened st ater dates for {he mame Arrow-Debros commodiicn, thm no. additonal trade would take place anyway. Al the other exteme, one ‘ght consider 8 model in which at every date and ats of ‘ature ony those Avrow-Debreucommoditis could be traded tic were indeed bythe corresponding (dt, stat) pir An Tntemediate case woud so permit the trade of ome (but aot Al) difereniy indexed Arrow-Dbreu commodities. Now the ‘Arto Detrew pools of the existence and Pareto opty ff equilibrium do not apply to such an incomplete markets tconoms, as Hart (1973) fs ponte xt. We have already Soted the exitenoe problem. ‘ar for efowncy. tne Pare plialiy of Atrow-Debreu equa might suggest the fresmpton that, though there might be los 0 hminating Irarkets, rade om the remaining markets would be as een 35 possible. In fact, it can be shown (geserialy) that sgulibeium tages do aot make effeent use of the existing ‘market "The Arrow-Debreu. model of general equilnium is relentlessly neoclassical n fact thas Become the paradigm of the neoclassical approach, This stems in part from its individualistic hypothesis, and its elebrated conclusions about the potential efbeacy of unencumbered markets. (Although ‘Avro, for example, has always mainained that a proper Showing how ‘neffcint is the limited teal world. marke, ‘stem,) But stil more telling is the fact thatthe assumption of 2 lte number of commodities (and hence of dates) forces ‘pon the mode! the interpretation of the economic process as one-way activity of converting given primary resources into final consumption goods IF thee is universal agreement about when the world wil end, there cam be no question about the Teproduction ofthe captl stock. In equity i wil be ru8 own to zo. Similarly when the world has 2 definite ‘beginning, so thatthe fst market transaction takes place after the owneship ofall esoutees and techniques of production, iD and the preferences of all individuals have been determined, fone cannot study’ the evaluon of the social norms of Consumption in tems of the historical development of the ‘lations of prediction One certainly cannot speak about the production ofall commodities by commodities Grafs, 1960) {since at date zero there must be commodities which have not ‘been produced by commodities, i. by piyial objects which are trade). ‘Te seems natural to suppose that as L becomes very large, $0 thatthe end ofthe world's put of unt the distant ature, that ‘this event cannot be of much signifeance to behaviour now. But let us not forget the rationality imposed onthe agents. Fs ‘off as the end of the world might be. te perfcly taken into account. Thus, for example, socal scusty (unde as ts in the US by tases vo the yousy) could wot exit if satonal agents agreed on «nal stopping tine to transactions. Consider a model satsying all the assumptions (ADMALTS), except that Land H ae allowed 10 be init, such as the overlapping generations model. Tecan be shown {hat there is robust collection of economies hich have 4 continuum of equilibria, most of which are Pareto sub optimal, which difer enormously in ime O behaviour. Thus in mode! where time dacs act have a definite end, the ‘optimality and comparative sates properties of equilibria are radically diferent. (For example, there may be a continuum of guile, imdeted by the lve! of penod 0 real wages (versely elated tothe rate of profit) ofthe eve! of output oF employment. The interested reader can eonult the entry on OVERLAPPING GENERATIONS MODELS "A systematic. study of ‘conomies where ony Lis allowed to be infinite was begun by Bowley (1972). Such economist tnd to ve propertia svat 1 thove of Arrow-Debreu) ‘There is no place in. the Arrow-Debreu model for asymmetric information. The second welfare theorem, for ‘example, eles on limp sum redistribution, is edstibutons that occur in advance ofthe market interactions, But if agents fanaot be" distinguished. except through their market, behaviour, then the redistribution must be a function of market beaviour Rational agents, antiipating this wl stort their behaviour and the optimality of the redtbution wl be fost Similay nthe definition of equiirium no agent takes into account what other agents know. for example about the state ff nature. Thus it quite possible in an Arcow-Debvea ‘ulibram Tor some ignorant agents to exchange valuable commodities for commodites indexed by sates that other Sgeats know will not occur. Ths problem received enormous tention in the finance erature, and “some cit (ee Grossman 1981) that i has been solved by extending dl Arrow-Debreu.defiition of equilium to 2 rational ‘expectations equim” (Lucas, 1972; se also Radner, 1979) Bur tis definition i self suspect; in particular, it may not be smplementable ‘Eten if ational expectations equilibrium (REE) were {o ghips with the most fundamental problems of asymmetne intormation. For ike Arrow-Debreu equiltium, in REE all trade is conducted anonymously through the market at given Prices. Implicit in this definition isthe assumption of large hhumbers of traders on both sides of every market. But what has come to be called the incentive problem in economies revolves around individual or frm spec uncertainty, ie trade in commodities indexed by the names of the traders, which by defniuon involves few traders. "This Brings ve to another major riddle: how are agents supposed to get to equilibrium i the Arrow-Debreu mode? Arrow-Debreu model of general equa “The pioneers of general equibrium never imagined thatthe sconomy ses neveear in equilibrium: Walrar, for example, Proposed "an "expliitttomnement procedure which he onjectured converged to equibrum. But that idea is awed In two respets: in general, It can be shown not to converEe, find more importaaly, ii an imaginary process which no fachange is permited_ until equilibrium is reached. This, itustrates a grave shortcoming of any equilibrium theory, ramely that it cannot bepin to specify outtomes out of quilbvium. The major ers of labour market clearing inthe 19805, and again recently, argues strongly that thre are limits to the applicabilty of equilibrium analysis. ‘One is led naturally 10 consider market games, in which the ‘outcomes are well-specifed even when apents do not make their equilibrium moves The most fam market game f ‘Courno’sduopaly ode, which has been extended to general equilium by Shapley-Shubik (1977). When there are large fnumber of agents of each type, the Nash equilbna of the Shapley-Shubik game give ney igetical allocations to the competitive allocations of Artow-Debreu. This jusiies (0 fist. approximation) the price taking behaviour of the Acrow-Debreu agents. But note thatthe informational equiements of Nash equilibrium are at last twice that of ‘Arrow-Debreu competiive equiltrium (each agent must ‘know the aggregates of bids and ofers on each marke). ts abo extremely interesting. that trade takes place inthe ‘Shapley-Shubik game even if there is only one trader on each side of the market. Hence many problems in asymmetic ‘nformaton wi have wo pave i ie Atsow-Debreu del, frecause they involve 100. fine a specifeation of the commodities to be consistent with price taking, might be Sone in market game context. Finally, can be shown that REE isnot consistent with the Shapley-Shubsk game, oF sndeed wth any continuous game. ‘We have indicated some ofthe ways in which itis possible vo extend general equiltrium analysis to phenomena outside the Seope of the Arrow-Debrew model, while at the same time preserving the neoclassical methodological premises of agent Optimzation, rational expectations, and equilibrium. Tt is Important t note that thee variations have extended the

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