ECON5210 Lecture 3: Equilibrium and Welfare

Rui Tang, HKUST

Email: ruitang@ust.hk
Office hour: Tuesday 4-5 p.m.
Roadmap

Exchange economy.

The concept of Walrasian equilibrium.

Excess demand function with well-behaved agents’ utilities.

The existence of a Walrasian equilibrium.

Welfare theorems.

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Exchange Economy

A nonempty and finite set of agents: A.

Each agent is denoted by a ∈ A.
Let u a : R+n → R be the utility function of agent a.
Let ω a = (ω1a , ..., ωna ) ∈ R+n be the endowment of agent a. We do not require
ω a ∈ R++
n
, and ω a = 0 is allowed.

Aggregate endowment: X
ω̄ = ω a  0.
a∈A

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Walrasian Equilibrium

n
Suppose in the exchange economy, the price vector is given by p ∈ R++ .
a
Then the income of agent a is p · ω .
The budget set of agent a is B(p, p · ω a ), and demand correspondence is
x̄ a (p, p · ω a ) if it is not empty.

Definition
n
p ∈ R++ is a Walrasian equilibrium price vector if for each agent a ∈ A, there
exists x̂ a ∈ B(p, p · ω a ) for each agent a such that

u a (x̂ a ) ≥ u a (x), ∀x ∈ B(p, p · ω a ), ∀a ∈ A,

X X
x̂ a = ωa .
a∈A a∈A
a
{x̂ }a∈A is called an Walrasian allocation.

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Strongly monotone preference leads to strongly monotone utility function

x > y ⇒ u(x) > u(y ).

If agent’s utility function is (1) continuous, (2) strongly monotone and (3)
strictly quasiconcave, then the agent’s demand x̄(p, w ) is a (i) continuous
function and satisfies (ii) the budget identify and (iii) the boundary property.

The demand function x̄(p, w ) also satisfies (iv) zero-homogeneous:

∀t > 0, x̄(tp, tw ) = x̄(p, w ).

This is because
∀t > 0, B(tp, tw ) = B(p, w ).

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Exchange Economy

We will assume that u a satisfies (1)-(3) for each agent a ∈ A till the end of
the proof of the existence theorem.
The agent a’s demand x̄ a (p, p · ω a ) is a function of p when ω a is fixed. We
write it as x a (p).
The agent’s excess demand is defined as

z a (p) = x a (p) − ω a .

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Exchange Economy

Observation 1: The excess demand function z a (p) = x a (p) − ω a is

zero-homogeneous: z a (tp) = z a (p) for all t > 0.

Proof. For any t > 0, x̄ a (tp, tp · ω a ) = x̄ a (p, p · ω a ).

Observation 2: z a obeys Walras’ law:

p · z a (p) = 0, ∀p ∈ R++
n
.

Proof. The agent’s utility function is (strongly) monotone, and thus budget
identify holds:

p · x a (p, p · ω a ) = p · ω a ⇒ p · z a (p) = p · x a (p, p · ω a ) − p · ω a = 0.

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Aggregate Excess Demand
Define aggregate demand at price p as:
X
X (p) = x a (p).
a∈A

Define aggregate excess demand at price p:

X X
Z (p) = X (p) − ωa = z a (p).
a∈A a∈A

n
Z is zero-homogeneous and obeys Walras’ Law: for all p ∈ R++ and all t > 0,
X X
Z (tp) = z a (tp) = z a (p) = Z (p),
a∈A a∈A
X
p · Z (p) = p · z a (p) = 0.
a∈A

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Aggregate Excess Demand

Since Z is zero-homogeneous, Z (p) = 0 ⇔ Z (tp) = 0, for any t > 0. Thus,

you can always assume that p1 = 1. We have n − 1 unknowns parameters.

Each agent’s demand x a is a function of p. Hence, the equilibrium condition

Z (p) gives you n more conditions. One redundant condition?

If we know Zi (p) = 0 for i = 1, ..., n − 1, then by p · Z (p) = 0 and p  0, we

know Zn (p) = 0. Hence, we essentially have n − 1 conditions.

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Solving Walrasian Equilibrium

Assume p1 = 1.

Solve for x̄ a (p, p · ω a ) as a function of p.

Let a∈A x̄ia (p, p · ω a ) = a∈A ωia for i = 1, ..., n − 1.

P P

In what follows, we show that such p exists.

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Existence of Equilibrium

The existence of an equilibrium price p reduces to the problem of finding

n
p ∈ R++ such that Z (p) = 0.

We first identify some properties of Z . These properties can be used to show

the existence of equilibrium price when n = 2. For larger n, we will define a
new function Z r and obtain the properties of Z r in a similar way.

Since Z (p) = a∈A x a (p) − a∈A ω a and each x a is continuous, we know

P P
that Z (p) is a continuous function of p.

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Boundary Property

Recall that boundary property of x a : If (p n , w n ) → (p̄, w̄ ) such that w̄ > 0

and I = {i : p̄i = 0} is nonempty, then
!
X
lim x̄ia (p n , w n ) → +∞.
n→+∞
i∈I

The boundary property is also infectious through aggregation.

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Proposition
Suppose p n tends to p̄ 6= 0 such that I = {i : p̄i = 0} is nonempty. Then
!
X
n
lim Zi (p ) → +∞.
n→+∞
i∈I

Proof.
Suppose that for good k, p̄k > 0.
Since a∈A ω b  0, there is an agent b such that ωkb > 0.
P

Agent b’s income w b = p n · ω b converges to w̄ b = p̄ · ω b > 0.

Agent b’s demand on I goes to infinity, and hence aggregate demand on I
goes to infinity, and hence the aggregate excess demand on I .

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Proposition
Aggregate excess demand function Z : Rn++ → Rn has the following properties:

It is zero-homogeneous;
It obeys Walras’ law;
It is continuous;
It satisfies the boundary property;
It is bounded below.

Proof. Z is bounded below since

X X
Z (p) = X (p) − ωa ≥ − ωa .
a∈A a∈A

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Theorem (Arrow and Debreu; McKenzie)
If for each a ∈ A, u a satisfies (1)-(3), then there exists p  0 such that Z (p) = 0.

Warm-up: n = 2.
WLOG, consider the price vector (1, p2 ).
By the boundary property,

lim Z2 (1, p2 ) → +∞.

p2 →0

Consider p2 → ∞. By zero-homogeneity, We have

1
lim Z1 (1, p2 ) = lim Z1 ( , 1) → +∞.
p2 →+∞ p2 →+∞ p2

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Proof.
For p2 large enough such that Z1 (1, p2 ) > 0, by Walras’ law, we have

−Z1 (1, p2 ) · 1
Z2 (1, p2 ) = < 0.
p2

By the previous arguments, there are p2 > 0 and p20 > 0 such that
Z2 (1, p2 ) > 0 and Z2 (1, p20 ) < 0.

Since Z is continuous, by the intermediate value theorem, there is p2∗ > 0

such that Z2 (1, p2∗ ) = 0.

By Walras’ law, Z2 (1, p2∗ ) = 0 ⇒ Z1 (1, p2∗ ) = 0. Hence, Z (1, p2∗ ) = 0.

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Brouwer’s Fixed Point Theorem.
Let K be a compact and convex set in R n . Suppose φ : K → K is continuous.
There exists x ∗ ∈ K such that φ(x ∗ ) = x ∗ .

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Existence for n ≥ 3.
We impose additional constraint for each agent by restricting her budget:

B r (p, p · ωa ) := B(p, p · ωa ) ∩ {x ≤ 2ω̄}.

Agent a’s restricted demand becomes

x r ,a (p) = arg max u a (x).

x∈B r (p,p·ωa )

Pn
Observation. x r ,a (p) is a function for all p ∈ ∆ = {p > 0 : i=1 pi = 1},
and is continuous.

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Existence for n ≥ 3.

x a,r (p) satisfies budget identity

p · x a,r (p) = p · ω a .

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Existence for n ≥ 3.

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Existence for n ≥ 3.
Define Z r : ∆ → Rn as
X
Z r (p) = [x a,r (p) − ω a ] .
a∈A

Z r is continuous and obeys Walras’ Law.

To proceed, we claim that there is p ∗  0 such that Z r (p ∗ ) = 0.

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Existence for n ≥ 3.
Define ψ : ∆ → ∆ such that

pj + max Zjr (p), 0
ψj (p) = Pn for all j ∈ {1, ..., n}.
1 + i=1 max {Zir (p), 0}

∆ is compact and convex, and this map is continuous.

Brouwer fixed point theorem: there is p ∗ such that ψ(p ∗ ) = p ∗ .
If pi∗ = 0 for some i, then max {Zir (p ∗ ), 0} = 2|A|ω̄i − ω̄i > 0. This implies
that ψi (p ∗ ) 6= pi∗ = 0, contradiction. Hence, p ∗  0.

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Existence for n ≥ 3.
Walras’s Law: there is i such that max {Zir (p ∗ ), 0} = 0.
pi∗ + 0
pi∗ = ψi (p ∗ ) = Pn n o.
1 + j=1 max Zjr (p ∗ ), 0
n
X
max Zjr (p ∗ ), 0 = 0

⇒
j=1

⇒ Zjr (p ∗ ) ≤ 0, ∀j ∈ {1, ..., n}.

By Walras’ Law, we have Zjr (p ∗ ) = 0, ∀j ∈ {1, ..., n}.

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Existence for n ≥ 3.
The final step is to show that Z (p ∗ ) = Z r (p ∗ ) = 0.
We only need to show that x a (p ∗ ) = x a,r (p ∗ ) for each agent a ∈ A.

x a,r (p ∗ ) 6= x a (p ∗ ) ⇒ u a (x a (p ∗ )) ≥ u a (x a,r (p ∗ )) ⇒ u a (x ∗ ) > u a (x a,r (p ∗ )).

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Formal Proof.
Suppose for some agent a, x a (p ∗ ) 6= x a,r (p ∗ ).
Then u a (x a (p ∗ )) ≥ u a (x a,r (p ∗ )).
Since Z r (p ∗ ) = 0, we have x a,r (p ∗ ) ≤ ω̄  2ω̄.
Choose t ∈ (0, 1) close to 1 such that

x ∗ = tx a,r (p ∗ ) + (1 − t)x a (p ∗ ) and x ∗  2ω̄.

Since p ∗ · x a,r (p ∗ ) = p · x a (p ∗ ) = p ∗ · ω a , we have p ∗ · x ∗ = p ∗ · ω a . That is,

x ∗ ∈ B r (p ∗ , p ∗ · ω a ).
However, by strict quasiconcavity of u a , u a (x ∗ ) > u a (x a,r (p ∗ )), contradiction.

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Feasible Allocation

Consider the exchange economy {{ω a }a∈A , {u a }a∈A }.

An allocation is {y a }a∈A such that

y a ∈ R+n , ∀a ∈ A.

A feasible allocation is an allocation {y a }a∈A such that

X
y a = ω̄.
a∈A

A Walrasian allocation {x̂ a }a∈A , by its definition, is a feasible allocation.

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Definition
An allocation {z a }a∈A is a Pareto improvement of another allocation {y a }a∈A if

u a (z a ) ≥ u a (y a )

for every agent a ∈ A, and there exists some agent b ∈ A such that

u b (z b ) > u b (y b ).

Definition
A feasible allocation {y a }a∈A is Pareto optimal if it has no feasible Pareto
improvement.

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Theorem (First Welfare Theorem)
If u a is monotone for each agent a ∈ A, then every Walrasian allocation is Pareto
optimal.

Proof.
Consider a Walrasian allocation {y a }a∈A under price p  0.
By definition, for each a ∈ A, u a (y a ) ≥ u a (x) for all x ∈ B(p, p · ω a ).
Suppose to the contrary that {y a }a∈A has a Pareto improvement {z a }a∈A .
We show that there is a contradiction.
By definition of Pareto improvement, we know

u a (z a ) ≥ u a (y a ), ∀a ∈ A,

u b (z b ) > u b (y b ), for some b ∈ A.

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Proof.
We show that u a (z a ) ≥ u a (y a ) ⇒ p · z a ≥ p · y a .
Suppose to the contrary that p · z a < p · y a , we can find  > 0 very small
such that p · (z a + (, ..., )) < p · y a .
Since u a is monotone, we have

u a (z a + (, ..., )) > u(z a ) ≥ u(y a ), contradiction.

Similarly, we can show that u b (z b ) > u b (y b ) ⇒ p · z b > p · y b .

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Proof.
Hence, for the feasible allocation {z a }a∈A , we have

p · z a ≥ p · y a , ∀a ∈ A,

p · z b > p · y b , for some b ∈ A.

X X
⇒p· za > p · y a , contradiction.
a∈A a∈A

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Definition
An allocation {y a }a∈A is a Walrasian allocation with transfers if it is feasible and
there is p ∗  0 and {t a }a∈A ⊆ R with a∈A t a = 0 such that
P

y a ∈ x̄ a (p ∗ , p ∗ · ω a + t a ), ∀a ∈ A.

Remark. Here, it cannot happen that p ∗ · ω a + t a < 0.

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Theorem (Second Welfare Theorem)
If for every agent a ∈ A, u a satisfies conditions (1)-(3), then every Pareto optimal
allocation is a Walrasian allocation with transfers.

Proof.
Consider a Pareto optimal allocation {y a }a∈A .
Consider the economy where agent a’s endowment is y a . By the existence
theorem, there is a Walrasian equilibrium price vector p  0 with the
associated Walrasian allocation {x a }a∈A where x a = x̄ a (p, p · y a ).
We claim that y a = x a for each a ∈ A.
Optimization means that u a (x a ) ≥ u a (y a ) for all a ∈ A.
Strict quasiconcavity means that if x a 6= y a , u a (x a ) > u a (y a ).
It has to be y a = x a for all a ∈ A: otherwise {x a }a∈A Pareto improves
{y a }a∈A .

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Proof.
Now, y a = x̄ a (p, p · y a ) for each a ∈ A.
Recall that the endowment of agent a is ω a but not y a .
We just need to give each agent the right amount of money t a such that
p · ω a + t a = p · y a , as if their endowment is y a .
It is trivial that a∈A t a = 0 since {y a }a∈A is feasible.
P

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