General Equilibrium, Welfare and the Edgeworth Box

Econ 212: Intermediate Microeconomics

John S. Schuler
November 16, 2019

Assume the economy contains only coffee, tea, and sugar. Thus, we can price coffee and tea in terms of
sugar. For simplicity, assume you have an endowment of sugar and you can trade it. We can then derive
demand curves for coffee and tea. Notice firstly, we have two prices both quoted in terms of sugar. Thus,
in a three good economy, there will be two prices. In an n-good economy, there will be n − 1 prices. This
1

PCoffee
is known as the Price Vector. Our initial price vector is: 1 . Anything not spent on tea and coffee
PTea
is leftover sugar which is consumed as sugar. Thus, our commodity
 1 vector
 is three goods. In general, in an
QSugar
n-good economy, the quantity vector is n-long. Here is it:  Q1Coffee .
Q1Tea

Coffee Tea

2 1 2
DCoff SCoff DTea DTea

2
PTea
1
1
SCoff PTea
2
PCoff
1
PCoff

STea

Q1Coff Q2Coff Q1Tea Q2Tea

Now suppose a hurricane damages the coffee plantations in Latin America. The world supply curve for
coffee shifts left sending the price up. Since tea is a substitute, the demand curve for tea then shifts to the
right. Thus, the price of tea also goes up but so does the quantity. Notice that people have substituted
from coffee into tea due to a price change but there has also been an income change.
 2 Both  prices are higher
PCoffee
because there is less overall wealth in the economy. Now, our price vector is 2 and our quantity
PTea

1
 Q2Sugar
 

vector is  Q2Coffee . This is an example of general equilibrium thinking. Whenever we consider more than
Q2Tea
one market, we are, implicitly at least using the general equilibrium model where markets clear together.

The Welfare Theorems

We assume a fixed number of goods in the economy, allowing us to represent both endowments with one
point. If our endowment point is (x1 , y1 ) and there are (xE , yE ) goods in the economy, the second agent
has (xE − x1 , yE − y1 ) = (x2 , y2 ). Thus, both indifference curves pass through this point. For any set of
endowments, there is a price line they will trade along representing the best bargain each can manage. Thus,
agent one sacrifices ∆Y to gain ∆x along the price line P. Both agents are better off and neither could have
gotten a better deal. It turns out that given a set of tradable goods, and assuming agents value only these
goods, the general equilibrium allocation is Pareto Efficient; that is, no agent can be made better off without
making at least one agent worse off. Further, for every Pareto efficient allocation, there is at least one initial
endowment for which that allocation is the general equilibrium! If we consider all possible endowments, we
will find many equilibria. Considered together, these are the contract curve C.

P C

E I2
I1

−∆y

∆x G