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Ch29 General Equilibrium
Ch29 General Equilibrium
Exchange
Exchange
Two consumers, A and B.
Their endowments of goods 1 and 2
are A A A and B
( 1 , 2 ) B B
( 1 , 2 ).
A
E.g. ( 6,4 ) and ( 2, 2).
B
A B
Width = 1 1 6 2 8
Starting an Edgeworth Box
Height =
A B
2 2
4 2
6
A B
Width = 1 1 6 2 8
Starting an Edgeworth Box
Height =
A B The dimensions of
2 2 the box are the
4 2 quantities available
6 of the goods.
A B
Width = 1 1 6 2 8
Feasible Allocations
What allocations of the 8 units of
good 1 and the 6 units of good 2 are
feasible?
How can all of the feasible
allocations be depicted by the
Edgeworth box diagram?
Feasible Allocations
What allocations of the 8 units of
good 1 and the 6 units of good 2 are
feasible?
How can all of the feasible
allocations be depicted by the
Edgeworth box diagram?
One feasible allocation is the before-
trade allocation; i.e. the endowment
allocation.
The Endowment Allocation
A B
Width = 1 1 6 2 8
The Endowment Allocation
Height =
A B
2 2
4 2
6
A ( 6,4 )
B
A
B ( 2, 2)
Width = 1 1 6 2 8
The Endowment Allocation
OB
OA
A ( 6,4 )
B
( 2, 2)
8
The Endowment Allocation
OB
6
4
OA
A ( 6,4 )
6
8
The Endowment Allocation
2
OB
2
6
4
OA
6 B
( 2, 2)
8
The Endowment Allocation
2
OB
2
6 The
4 endowment
allocation
OA
A ( 6,4 )
6 B
( 2, 2)
8
The Endowment Allocation
More generally, …
The Endowment Allocation
1B
OB
B
A 2
2
A The
B
2 2 endowment
allocation
OA
A
1
1 1
A B
Other Feasible Allocations
A A
( x1 , x 2 ) denotes an allocation to
consumer A.
B B
( x1 , x 2 ) denotes an allocation to
consumer B.
An allocation is feasible if and only if
x1A xB1 1
A
B
1
A B A B
and x 2 x 2 2 2 .
Feasible Reallocations
xB
1
OB
A
2 xB
2
B
2
A
x2
OA
x1A
1 1
A B
Feasible Reallocations
xB
1
OB
A B
2 x2
B
2 A
x2
OA
x1A
1 1
A B
Feasible Reallocations
A
2
OA
1A x1A
Adding Preferences to the Box
xA For consumer A.
2
A
2
OA
1A x1A
Adding Preferences to the Box
xB For consumer B.
2
B
2
OB
1B xB
1
Adding Preferences to the Box
xB For consumer B.
2
B
2
OB
1B xB
1
Adding Preferences to the Box
B
xB For consumer B. 1 OB
1
B
2
xB
2
Adding Preferences to the Box
xA For consumer A.
2
A
2
OA
1A x1A
Adding Preferences to the Box
xA
2
B
x1 1B OB
B
2
A
2
OA
1A x1A
B
x2
A
Edgeworth’s Box
x2
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
Pareto-Improvement
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
A
Pareto-Improvements
x2
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
The set of Pareto-
improving allocations xB
2
Pareto-Improvements
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
The set of Pareto-
improving reallocations xB
2
Pareto-Improvements
Pareto-Improvements
Pareto-Improvements
Trade
improves both
A’s and B’s welfares.
This is a Pareto-improvement
over the endowment allocation.
Pareto-Improvements
New mutual gains-to-trade region
is the set of all further Pareto-
improving
reallocations.
Trade
improves both
A’s and B’s welfares.
This is a Pareto-improvement
over the endowment allocation.
Pareto-Improvements
Further trade cannot improve
both A and B’s
welfares.
Pareto-Optimality
Better for
consumer A
Better for
consumer B
Pareto-Optimality
A is strictly better off
but B is strictly worse
off
Pareto-Optimality
A is strictly better off
but B is strictly worse
off
B is strictly better
off but A is strictly
worse off
Pareto-Optimality
Both A and
B are worse A is strictly better off
off but B is strictly worse
off
B is strictly better
off but A is strictly
worse off
Pareto-Optimality
Both A and
B are worse A is strictly better off
off but B is strictly worse
off
The allocation is
Pareto-optimal since the
only way one consumer’s
welfare can be increased is to
decrease the welfare of the other
consumer.
Pareto-Optimality
An allocation where convex
indifference curves are “only
just back-to-back” is
Pareto-optimal.
The allocation is
Pareto-optimal since the
only way one consumer’s
welfare can be increased is to
decrease the welfare of the other
consumer.
Pareto-Optimality
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
A
Pareto-Optimality
x2 All the allocations marked by
a are Pareto-optimal.
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
Pareto-Optimality
2A 2B
OA A
1 A
x1
The contract curve
xB
2
Pareto-Optimality
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
The set of Pareto-
improving reallocations xB
2
A
The Core
x2
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
A
The Core
x 2 Pareto-optimal trades blocked
by B
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
Pareto-optimal trades blocked
by A xB
2
A
The Core
x2 Pareto-optimal trades not blocked
by A or B
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
A
The Core
x2 Pareto-optimal trades not blocked
by A or B are the core.
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
The Core
The core is the set of all Pareto-
optimal allocations that are welfare-
improving for both consumers
relative to their own endowments.
Rational trade should achieve a core
allocation.
The Core
*A
x2
A
2
OA
x*1A 1A x1A
Trade in Competitive Markets
B
2
x*2B
OB
1B x*1B xB
1
Trade in Competitive Markets
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
Trade
A
in Competitive Markets
x2 Can this PO allocation be
achieved?
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
Trade
A
in Competitive Markets
x 2 Budget constraint for consumer A
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
Trade
A
in Competitive Markets
x 2 Budget constraint for consumer A
B
B
x1 1 OB
*A
x2
2A 2B
OA A
1 A
x1
x*1A
xB
2
Trade
A
in Competitive Markets
x2
B
B
x1 1 OB
*A
x2
2A 2B
OA A
1 A
x1
x*1A
B
x
Budget constraint for consumer B 2
Trade
A
in Competitive Markets
x2
x*1B
B
B
x1 1 OB
*B
x2
*A
x2
2A 2B
OA A
1 A
x1
x*1A
B
x
Budget constraint for consumer B 2
Trade
A
in Competitive Markets
x2
x*1B
B
B
x1 1 OB
*B
x2
*A
x2
2A 2B
OA A
1 A
x1
x*1A
But
x*1A x*1B 1A 1B xB
2
Trade
A
in Competitive Markets
x2
x*1B
B
B
x1 1 OB
*B
x2
*A
x2
2A 2B
OA A
1 A
x1
x*1A
and
x*2A x*2B 2A 2B xB
2
Trade in Competitive Markets
2A 2B
OA A
1 A
x1
xB
2
Trade
A
in Competitive Markets
x2 Which PO allocations can be
achieved by competitive trading?
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
Trade in Competitive Markets
2A 2B
OA A
1 A
x1
xB
2
Trade
A
in Competitive Markets
x2 Which PO allocations can be
achieved by competitive trading?
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
Trade
A
in Competitive Markets
x2 Which PO allocations can be
achieved by competitive trading?
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
Trade
A
in Competitive Markets
x 2 Budget constraint for consumer A
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
Trade
A
in Competitive Markets
x 2 Budget constraint for consumer A
B
B
x1 1 OB
x*2A 2A 2B
OA A
1 A
x1
x*1A
xB
2
Trade
A
in Competitive Markets
x2
B
B
x1 1 OB
x*2A 2A 2B
OA A
1 A
x1
x*1A
Budget constraint for consumer B xB
2
Trade
A
in Competitive Markets
x2 *B
x1
B
B
x1 1 OB
x*2B
x*2A 2A 2B
OA A
1 A
x1
x*1A
Budget constraint for consumer B xB
2
Trade
A
in Competitive Markets
x2 *B
x1
B
B
x1 1 OB
x*2B
x*2A 2A 2B
OA A
1 A
x1
x*1A
So
x1 x1 1 1
*A *B A B
xB
2
Trade
A
in Competitive Markets
x2 *B
x1
B
B
x1 1 OB
x*2B
x*2A 2A 2B
OA A
1 A
x1
x*1A
and
x2 x2 2 2
*A *B A B
xB
2
Trade in Competitive Markets
At the new prices p1 and p2 both
markets clear; there is a general
equilibrium.
Trading in competitive markets
achieves a particular Pareto-optimal
allocation of the endowments.
This is an example of the First
Fundamental Theorem of Welfare
Economics.
First Fundamental Theorem of
Welfare Economics
Giventhat consumers’ preferences
are well-behaved, trading in perfectly
competitive markets implements a
Pareto-optimal allocation of the
economy’s endowment.
Second Fundamental Theorem of
Welfare Economics
The First Theorem is followed by a
second that states that any 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 amongst
the consumers.
Second Fundamental Theorem of
Welfare Economics
Giventhat 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.
Second Fundamental Theorem
A
x2
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
The contract curve
xB
2
Second Fundamental Theorem
A
x2
*B B
B
x1 x1 1 OB
*A *B
x2 x2
2A 2B
OA *A A
x1 1 A
x1
xB
2
Second Fundamental Theorem
A Implemented by competitive
x2
trading from the endowment .
*B B
B
x1 x1 1 OB
*A *B
x2 x2
2A 2B
OA *A A
x1 1 A
x1
xB
2
Second Fundamental Theorem
A Can this allocation be implemented
x2
by competitive trading from ?
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
Second Fundamental Theorem
A Can this allocation be implemented
x2
by competitive trading from ? No.
B
B
x1 1 OB
2A 2B
OA A
1 A
x1
xB
2
Second Fundamental Theorem
A But this allocation is implemented
x2
by competitive trading from q.
B
x1 q1
B
OB
q2
A
q2
B
OA
q1
A A
x1
xB
2
Walras’ Law
Walras’ Law is an identity; i.e. a
statement that is true for any
positive prices (p1,p2), whether these
are equilibrium prices or not.
Walras’ Law
Every consumer’s preferences are
well-behaved so, for any positive
prices (p1,p2), each consumer spends
all of his budget.
For consumer A:
p1x*1A p2x*2A p1 1A p2 2A
For consumer B:
p1x*1B p2x*2B p1 1B p2 2B
Walras’ Law
p1x*1A p2x*2A p1 1A p2 2A
p1x*1B p2x*2B p1 1B p2 2B
Summing gives
p1 ( x*1A x*1B ) p2 ( x*2A x*2B )
p1 ( 1A 1B ) p 2 ( 2B 2B ).
Walras’ Law
p1 ( x*1A x*1B ) p2 ( x*2A x*2B )
p1 ( 1A 1B ) p 2 ( 2B 2B ).
Rearranged,
p1 ( x1 x1 1 1 )
*A *B A B
p 2 ( x*2A x*2B 2A 2B ) 0.
That is, ...
Walras’ Law
p1 ( x1 x1 1 1 )
*A *B A B
p 2 ( x 2 x 2 2 2 )
*A *B A B
0.
This says that the summed market
value of excess demands is zero for
any positive prices p1 and p2 --
this is Walras’ Law.
Implications of Walras’ Law
Suppose the market for commodity A
is in equilibrium; that is,
*A
x1 x1
*B
1
A
1
B
0.
Then
p1 ( x1 x1 1 1 )
*A *B A B
p 2 ( x 2 x 2 2 2 )
*A *B A B
0
implies
*A
x2 x2
*B
2
A
2
B
0.
Implications of Walras’ Law
p 2 ( x 2 x 2 2 2 )
*A *B A B
0
implies
*A
x2 x2
*B
2
A
2
B
0.
Implications of Walras’ Law