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Exchange Economies

Barter/ Exchange Economies

• We will start with equilibrium allocations in

economies without production (so-called "barter

equilibrium” for pure exchange economies)

• Let consumer 1 be initially endowed with

units of good 1 and 2, respectively.

– Similarly, consumer 2’s endowment.

• We depict the initial endowment and any

other allocation thru the Edgeworth box.

Explain orientation of axis for each consumer, Indifference curves

and endowment e

General Equilibrium in an exchange

economy

• Movement from the initial endowment e to

allocation A cannot be a barter equilibrium, since

consumer 1 is worse off at A, thus being able to

block allocation A.

• Only points in the lens-shaped area

can be accepted as equilibria by both consumers

• This lens shaped area (later to be called the core

of the economy) is:

– ff condition holds:

Edgeworth Box

Other points in the lens/ core

• Q: Is point B, which belongs to

this lens-shaped area, a barter

equilibrium?

would still make both consumers

better off (i.e. higher IC) than at B.

be an equilibrium (no Pareto

improvements are possible).

curve"

Some Definitions

• Feasible allocation – an allocation x=(x1,

x2,…xI) for I consumers is said to be feasible if

allocation in which there is no other feasible

allocation yi which is w.p. by all consumers iεI

over xi (i.e. yi w.p. xi), and at least strictly

preferred by one consumer (i.e. yi s.p. xi)

Some definitions

• Blocking coalitions – A subset S of I

consumers will block a feasible allocation x if

there is an allocation y that is:

1. Feasible:

individual also a member of S yi s.p. xi

Equilibrium and the Core

• An equilibrium in an exchange economy is

therefore a feasible allocation x, given

endowment e, such that no coalition of consumer

blocks x

unblocked allocations given e, i.e. set of equilibria

points defined earlier

– This is the lens shaped area around e (see previous

slide)

Some notes on the Equilibrium in a

Pure Exchange Economy

• Equilibrium is represented by the tangency of

the indifference curves of the two consumers

• All points in the contract curve are pareto

optimal (they are also non-comparable)

• If the local non-satiation condition is not

satisfied, the equilibrium allocation

represented by point D may not be Pareto

optimal, say, for the case of thick indifference

curves

Some notes on the Equilibrium in a

Pure Exchange Economy

• Because point D is a tangency between two

indifference curves then it satisfies two

conditions:

Some notes on the Equilibrium in a

Pure Exchange Economy

• Condition (a) is a necessary condition for

equilibrium

• Condition (a) is also a sufficient condition with

our assumption of strict quasiconcavity (i.e.

unique solution)

General Equilibrium in Competitive

Exchange Economies

Assumptions about Consumers

• Consumer utility function is continuous,

stritctly increasing, and strictly quasiconcave

• Max Ui s.t. pxi l.e. pei for al p>>0 (i.e. strictly

positive prices)

• Has a unique solution x(p, pei) which is

continuous in p

– Walrasian demand correspondence

Excess Demand Function

• Given x(p, pei) we can define the excess

demand function for good k zk(p) as:

– (write on board)

• zk(p)>0, implies that aggregate demand for

good k exceeds the aggregated endowment for

good k

• zk(p)<0, implies that aggregate demand for

good k is smaller the aggregated endowment

for good k, i.e. excess supply of good k

Properties of zk(p)

• z(p) is continuous in p

• Homogeneity z(ap)=z(p) for all a>0

– Follows from homogeneity in Walrasian demand

in p

• Walra’s Law: pz(p)=0

– (Write proof on board)

• Implications of Walra’s law in a two good

economy:

– p1z1(p)+p2z2(p)=0

– p1z1(p)=-p2z2(p)

• if there is excess demand in market 1, z1(p) > 0,

there must be excess supply in market 2, z2(p) < 0

• Similarly, if market 1 is in equilibrium, z1(p) =0,

then market 2 is also in equilibrium, z2(p)=0

• For n markets, if markets of n-1 goods are in

equilibrium, then so is the nth market, i.e. you

only need to look at n-1 markets.

Walrasian equilibrium and conditions

for it’s existence

• Is a vector of prices p* in Rn++ is a walrasian

equilibrium if z(p*)=0, i.e. the aggregate excess

demand is zero at p*

• The walrasian equilibrium exists if

1. z(p) is continuous for all p>>0 in Rn++

2. pz(p)=0; i.e. Walra’s law holds for all p>>0 in Rn++

3. If {pm} is a sequence of strictly positive price vectors,

pm in Rn++, converging to pbar not equal to 0, and pbark = 0

for some good k, then for some good k’ with price pbark’ =

0, the associated sequence of excess demands in the

market for good k’, {zk’(pm)}, is unbounded above

What the conditions say?

• First two conditions follow from the

assumptions we imposed on consumer’s utility

functions

• Third condition intuitively says that, if the

prices of some but not all goods are arbitrarily

close to zero, then the excess demand for at

least one of those goods is arbitrarily high

– Use to prove that p*>>0

Proof of Existence of WEA

• Use Brouwer’s fixed point theorem

– For a compact, convex and non-empty set S, Let f:

S->S (i.e. f maps S unto itself). Then there exist at

least one x* in S such that f(x*)=x* and x* is

called the fixed point of f

• Proof .. Write on board

WEA in the Edgeworth box

Alternative Graphical Interpretation

• Another way to see CE is through the

concept of the offer curve

consumption for varying prices (red

for consumer 1; blue for consumer 2)

consumer intersect

initial endowment point e

endowment point is the CE point

Some Unusual Cases and Non-

Existence of Equilibria

• Linear Indifference

curves ( perfect

substitutes)

• There would still be

a competitive

equilibria but

marginal rates of

substitutions will not

be equal

Some Unusual Cases and Non-

Existence of Equilibria

• Consumer 1’s preferences

have nonconvex portions

• As a consequence there is a

break in his offer curve

(see blue line)

will not meet aside from

that at the initial

endowment therefore no

equilibria

WEA and the Core

Relationship between WEA and the

Core

• If each consumer’s utility function is strictly

increasing, then every WEA is in the Core C(e)

• Proof: (by contradiction)

Some implications

• The Core C(e) will always be non-empty, it

should contain at least the WEA

• Since all core allocations are Pareto optimal

(i.e. no blocking coalition will form), then all

WEA that are part of C(e) is pareto optimal

(First Welfare Theorem)

• Previous proof is also a proof of the First

Welfare Theorem

Second Welfare Theorem

Suppose you have the following

situation:

associated WEA is x’. Note x’ is

pareto optimal because it is in the

core C(e)

is outside the C(e)

endowments to e”; such that

p*e”=p*xbar

After “transfers” let the market

work and would lead to new WEA

xbar

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