General Equilibrium Theory: Examples

3 examples of GE:
I pure exchange (Edgeworth box)
I 1 producer - 1 consumer
I several producers
and an example illustrating the limits of the partial equilibrium
approach
First example: Edgeworth Box

A pure exchange economy (no production possibilities):

2 consumers i = A, B
2 commodities l = 1, 2
individual endowments ωi = (ωi1 , ωi2 )
global endowment $ = ωA + ωB
allocation x = (xA , xB ) with xi = (xi1 , xi2 ), xi ≥ 0
price p = (p1 , p2 )

Edgeworth box = allocations such that xA + xB = $

Endogenous wealth: wi = p.ωi
The budget line splits the box into the 2 budget sets
Individual Preferences
represented by a utility function ui
I continuous (the representation of preferences by a utility
function ”requires” transitive, complete, continuous
preferences)
I strictly quasi-concave (unique optimum)
I strictly monotonic (stronger than locally non satiated)
Offer curve of i = optima of i (parameterized by p)
Definition : a Walrasian equilibrium is (x ∗ , p) such that
1. individual optimality : ∀i, xi∗ solves

max ui (x) ,
p.x≤p.ωi

2. market clearing X
xi = $
i

= intersection points of the two offer curves (other than the

endowment point)
GE determines the relative price only (→ one defines a numeraire,
a good with price 1, without loss of generality)
Uniqueness is not guaranteed

Examples : Cobb-Douglas, linear, Leontief preferences

Two examples of non existence:
1. An important one: non convexity of one ui : no intersection of
the offer curves because of a discontinuity
2. A more subtle one: non strict monotonicity of one ui :
impossible to clear the markets by adjusting the prices
Illustration of the 2 Welfare Theorems

Th 1 : The allocation x ∗ of an equilibrium (x ∗ , p) is Pareto-optimal

Definition : Equilibrium with nominal transfers = (x ∗ , p, tA , tB ) s.t.

1. tA + tB = 0 (tA , tB ∈ IR )
2. ∀i, xi∗ maximizes ui (xi ) under p.xi ≤ p.ωi + ti
3. xA + xB = $
Th 2 : If x is a PO allocation, then x is the allocation of an
equilibrium with transfers

(compute the relative price p2 /p1 = MRS, then define the transfer:
ti = p.xi∗ − p.ωi )

Th 2 requires the convexity of preferences (not Th 1)

real transfers can be considered as well (example:
p.xi ≤ p.ωi + p1 ti , transfer of good 1)
Second example: 1 consumer + 1 producer

2 commodities: leisure (price w ), consumption good (price p)

firm:
I production function q = f (z) (f 0 > 0 > f 00 )
I max pq − wz
consumer:
I utility u (l, x)
I endowment (L, 0)
I owns the firm
Definition: A Walrasian equilibrium is (l ∗ , x ∗ ),(q ∗ , z ∗ ),(w , p)
1. individual optimality: (q ∗ , z ∗ ) solves

max pq − wz
q=f (z)

(l ∗ , x ∗ ) solves

max u (l, x) , with π = pq ∗ − wz ∗

wl+px≤wL+π

2. market clearing

l ∗ + z ∗ = L and x ∗ = q ∗

In this example, equilibrium is unique.

Illustration of the 2 Welfare Theorems

I Th 1 : The (unique) equilibrium allocation is PO

I Th 2 : The (unique) PO allocation is the equilibrium
allocation (no transfer is needed in this example)

Without the convexity assumptions (preferences and production

set):
I An equilibrium is still PO (”Th 1 still holds”)
I A PO allocation may not be an equilibrium allocation, even
with transfers (”Th 2 does not hold”)
Remark: production function and production set

Definition of the production set Y :

I y ∈ Y if and only if y = (y1 , ..., yL ) is a technologically
feasible vector
I convention sign: yl < 0 whenever l is an input, yl > 0
whenever l is an output

For a technology defined by a production function f (the output is

good L, inputs are goods 1, ..., L − 1):
I the associated production set Y is
n o
y ∈ IR L /yL ≤ f (−y1 , ..., −yL−1 )

I Y convex ⇔ f concave
Example: f (z) = Az α
I α < 1 : DRTS (f concave), ”everything is OK”
I α = 1 : CRTS (f linear), technology determines the relative
prices, π = 0, the production level is determined by demand
(the supply is infinitely elastic)
I α > 1 : IRTS (f convex), no equilibrium
Remark: Returns to Scale

For a technology defined by a production set Y :

I decreasing (DRTS) ∀y ∈ Y , ∀a ∈ [0, 1] , ay ∈ Y
I increasing (IRTS) ∀y ∈ Y , ∀a ≥ 1, ay ∈ Y
I constant (CRTS) ∀y ∈ Y , ∀a ≥ 0, ay ∈ Y

For a technology defined by a production function f :

L−1
I DRTS: ∀z ∈ IR+ , ∀a ≥ 1, f (az) ≤ af (z)
L−1
I IRTS: ∀z ∈ IR+ , ∀a ≥ 1, f (az) ≥ af (z)
L−1
I CRTS: ∀z ∈ IR+ , ∀a ≥ 0, f (az) = af (z) (f homogenous of
degree 1)
Third example: J producers

J firms use L inputs to produce one different output each

global inputs endowment z̄ = (z̄1 , ..., z̄L )  0
∂f
technologies fj (C 2 , ∂zjlj > 0 and D 2 fj negative definite)
exogenous output prices p = (p1 , ..., pJ )
input prices w = (w1 , ..., wL )
JL+L
Definition : An equilibrium is (z ∗ , w ) ∈ IR+
I ∀j, zj∗ maximizes pj fj (zj ) − w .zj
P ∗
j zj = z̄
I
1st Order Conditions (for an interior equilibrium only, ∀j, zj  0)
= a system of equations with unknown (z, w ) characterizes the
equilibrium

∂fj
∀l, ∀j, pj (zj ) = wl ,
∂zjl
X
∀l, zjl = z̄l .
j

Illustration of Th 1: an equilibrium allocation z ∗ maximizes the

production value: X
Pmax pj fj (zj )
j zj =z̄
j
Proof:
P P
I the joint profit j (pj fj (zj ) − w .zj ) is j pj fj (zj ) − w .z̄.
Hence, the max of joint profit and the max of the prod value
have the same solution.
P
I the FOC of max joint profit (under the constraint j zj = z̄)
are the same as the FOC of equilibrium
∂fj
∀l, ∀j, pj (zj ) = wl ,
∂zjl
X
∀l, zjl = z̄l .
j

I hence z ∗ maximizes the joint profit.

Producers (but not consumers) can be aggregated: a unique firm

with J technologies make the same decisions (and gets the same
profit) as J independent firms with one technology each.
GE versus partial equilibrium: a taxation example

N towns, 1 firm/town (production function f )

Labor supply (inelastic) : M workers,
Wage w , good = numeraire

At equilibrium, w = f 0 M


N
(from max profit : w = f 0 (ln ) and market clearing: n ln = M -
P
equilibrium is symmetric)

Introduction of a tax t in town 1 : w + t = f 0 (l1 )

Partial equilibrium analysis in town 1:
I workers freely move between towns + w in towns 2,...,N ⇒ w
remains constant in town 1
I hence l1 determined by w + t = f 0 (l1 )
I the profit decreases, not the wage
I the firm bears the whole burden of the tax t
GE Analysis:
I w and l1 , ..., lN determined by:

w + t = f 0 (l1 ) and ∀n ≥ 2, w = f 0 (ln )

l1 + ... + lN = M
M−l1
(hence l2 = ... = lN = N−1 )
I Introduction of a small tax dt

dw + dt = f 00 (l1 ) dl1 and dw = f 00 (l) dl

dl1 + (N − 1) dl = 0

(denote l = l2 = ... = lN )
I Variation of the profit of a firm π1 = f (l1 ) − (w + t) l1 and
π = f (l) − wl

dπ1 = f 0 (l1 ) dl1 − (w + t) dl1 − l1 (dw + dt)

dπ = f 0 (l) dl − wdl − ldw

And
 
M 0 M
dπ1 = f dl1 − wdl1 − (dw + dt)
N N
 
0 M M
dπ = f dl − wdl − dw
N N
M
with l1 = l = N at the no tax equilibrium (t = 0)
I Variation of the aggregate profit dπ1 + (N − 1) dπ
   
0 M
= f − w (dl1 + (N − 1) dl)
N
M M
− (dw + dt) − (N − 1) dw
N N
= 0

since
   
00 M 00 M
dw + dt = f dl1 and dw = f dl
N N
dl1 + (N − 1) dl = 0

I the workers bear the whole burden of the tax (w decreases,

not the profit)
The end of the chapter