Trade in Competitive Markets

• Consider trade in perfectly competitive markets.

• Each consumer is a price taker trying to maximize her own utility

given p1, p2 and her own endowment.

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
Trade in Competitive Markets

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Trade in Competitive Markets

• So given p1 and p2, consumer A’s net demands for commodities 1

and 2 are 𝑥1∗𝐴 − 𝜔1𝐴 and 𝑥2∗𝐴 − 𝜔2𝐴 .

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
Trade in Competitive Markets

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Trade in Competitive Markets

• So given p1 and p2, consumer B’s net demands for commodities 1

and 2 are 𝑥1∗𝐵 − 𝜔1𝐵 and 𝑥2∗𝐵 −𝜔2𝐵 .

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Gross vs. Net Demand

• The gross demand of agent A for good 1, say, is the total amount of good 1 that
he wants at the going prices.
• The net demand of agent A for good 1 is the difference between this total
demand and the initial endowment of good 1 that agent A holds.

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Trade in Competitive Markets
• A general equilibrium occurs when prices p1 and p2 cause both the
markets for commodities 1 and 2 to clear. In other words,

and

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
Trade in Competitive Markets

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
Copyright © 2019 Hal R. Varian
 Trade in Competitive Markets
• For arbitrary prices (p1, p2) there is no guarantee that supply will equal
demand—in either sense of demand.
• In terms of net demand, this means that the amount that A wants to buy (or
sell) will not necessarily equal the amount that B wants to sell (or buy)
• In terms of gross demand, this means that the total amount that the two agents
want hold of the goods is not equal to the total amount of that goods available

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Trade in Competitive Markets

• This case the market is in disequilibrium

• In such a situation, it is natural to suppose that the to change the prices of the
goods
• If there is excess demand for one of the goods, the price of that good will rise
• If there is excess supply for one of the goods, its price will fall

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
Trade in Competitive Markets

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
Copyright © 2019 Hal R. Varian
 Trade in Competitive Markets
• At the new prices p1 and p2 both markets clear.
• It is called a market equilibrium, a competitive equilibrium, or a
Walrasian equilibrium
• Trading in competitive markets achieves a particular Pareto optimal
allocation of the endowments.

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Trade in Competitive Markets

• If each agent is choosing the best bundle that he can afford, then his marginal
rate of substitution between the two goods must be equal to the ratio of the
prices
• But if all consumers are facing the same prices, then all consumers will have to
have the same marginal rate of substitution between each of the two goods
• An equilibrium has the property that each agent’s indifference curve is tangent to
his budget line
• But since each agent’s budget line has the slope −p1/p2, this means that the two
agents’ indifference curves must be tangent to each other.

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
Trade in Competitive Markets

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
Copyright © 2019 Hal R. Varian
 First Fundamental Theorem of Welfare
Economics
• Given that consumers’ preferences are well behaved, trading in
perfectly competitive markets implements a Pareto optimal
allocation of the economy’s endowment.

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Second Fundamental Theorem of Welfare
Economics
• Pareto optimal allocation (i.e., any point on the contract curve) can
be achieved by trading in competitive markets provided that
endowments are first appropriately rearranged among the
consumers.

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Second Fundamental Theorem of Welfare
Economics
• Given that consumers’ preferences are well behaved,
for any Pareto optimal allocation there are prices and an allocation of
the total endowment that makes the Pareto optimal allocation
implementable by trading in competitive markets.

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
Second Fundamental Theorem of Welfare
Economics

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
Second Fundamental Theorem of Welfare
Economics

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
Second Fundamental Theorem of Welfare
Economics

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Walras’s Law
• Walras’s law is an identity, i.e., a statement that is true for any positive prices
(p1, p2), whether these are equilibrium prices or not.

• Every consumer’s preferences are well behaved so, for any positive prices (p1,
p2), each consumer spends all of his budget.
For consumer
For consumer

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Walras’s Law

Summing
which can be rearranged to

This says that the summed market value of excess demands is zero for any positive
prices p1 and p2.This is Walras’s law.

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Implications of Walras’s Law
Two key implications of Walras’s law for a two-commodity exchange economy:

• If one market is in equilibrium then the other market must also be in

equilibrium.

• An excess supply in one market implies an excess demand in the other market.

© Dr. Abhishek Naresh

Assistant Professor
(CQEDS)
BIT Mesra
 Exchange Economies
• Pure exchange economies involve no production, only endowments,
so there is no description of how resources are converted to
consumables.
• General equilibrium: all markets clear simultaneously.
• Both the first and second fundamental theorems of welfare
economics hold true.

• Now we add input markets and output markets and describe firms’
technologies.
© Dr. Abhishek Naresh
Assistant Professor
(CQEDS)
BIT Mesra