SESSION 4

…IN WHICH WE EXAMINE HOW – AND WHETHER - MARKET EXCHANGE

DELIVERS EQUITY, EFFICIENCY AND EQUILIBRIUM
READINGS

• Chapter 32 of Hal Varian’s Intermediate Microeconomics

EXCHANGE IN A MARKET ECONOMY

• Free markets: people free to transact and exchange according to the

amount of endowments they have, and their own desires and needs.
• In such an anarchic system, is an equilibrium possible? Will it be efficient?
• More importantly, will it be equitable?
WHAT ARE THE NECESSARY ASSUMPTIONS
ABOUT INDIVIDUAL BEHAVIOUR?
• The individual is rational. She works to maximise her well being. Given certain
constraints. Her behaviour is consistent.
• Preferences are well behaved (complete, reflexive and transitive).
• We are able to construct well-behaved indifference curves for each individual.
• The set of preferences are monotonic (more of each good is always preferred).
• The set of preferences are convex (averages preferred to extremes).
THE EDGEWORTH BOX

• A simple device to help us analyse exchange between two individuals A and B. Two
goods, 1 and 2.
• Consumption of A = (, ) Consumption of B = (, ).
• Initial endowments of A and B = (, ) and (, ). What they come to market with.
• Feasible allocations: total consumption equals total available supply.
• Condition for feasible allocation: + = + and + = +
Consumers come to the market with
initial endowment (given by point
W), end with final allocation (point
M).

Shaded region is where possibility of

exchange happens, where both A and
B made better off.
 PARETO EFFICIENT
ALLOCATION
M is the Pareto efficient point: on highest indifference
curve of A (given that of B), and highest indifference
curve of B (given that of A).

1. No way to make either one better off without

making anyone worse off.

2. No more mutually advantageous trade can be made.

3. All gains from trade exhausted.

Contract curve: set of all Pareto efficient points.

WILL PRICE SYSTEM BRING
ABOUT PARETO EFFICIENT
EQUILIBRIUM?
Given the endowment, and given prices of goods,
can draw a budget line through W (slope of
budget line = relative prices).

At this set of relative prices, sum of gross

demands (total amount each individual wants to
consume) is more than available supplies.

Net demands (or excess demands) are not equal.

 IF PRICES CAN
ADJUST
If relative prices allowed to adjust, the budget line
can change slope till it reaches the Pareto efficient
point.

Excess demands equalized. Total demand = total

supply. A and B cannot be made better off. Thus,
free exchange can bring about efficient equilibrium.

Important point: The actual equilibrium will will

depend on the initial endowment.
FIRST THEOREM OF WELFARE ECONOMICS

• A market equilibrium is where individual is buying the best bundle they can afford. Is this
always Pareto efficient?
• Imagine there is some feasible allocation Y that is preferred to the market equilibrium X
(thus X is not Pareto efficient). If X is market equilibrium, individuals can afford it. If Y
is better, individuals cannot afford Y. Thus Y cannot be a market equilibrium.
• Thus there is no market equilibrium preferred to X, and hence X is Pareto efficient.
• First Rule of Welfare Economics: All market equilibria are Pareto efficient.
• Important point: Pareto efficiency does not mean a just outcome. One individual can own
everything. Also, this result only true for perfect competition.
 SECOND THEOREM
OF WELFARE
ECONOMICS
Pick a Pareto efficient point X. Since it is Pareto
efficient, we know it is at tangency of indifference
curves. We can draw some budget line with some set of
relative prices through it.

Thus, 2nd theorem: when preferences convex, there

exists some set of prices such that every Pareto efficient
allocation is a market equilibrium.
IMPORTANCE OF
CONVEX
PREFERENCES
Where preferences are not convex, a
Pareto efficient allocation may not be
achieved through market exchange.

Here, consumer A will prefer Y to X

and can afford Y to X.
IMPLICATIONS OF FIRST AND SECOND WELFARE
THEOREM
• First welfare theorem: important and powerful result. Any system of market exchange will
guarantee a Pareto equilibrium. But qualifications:
• I. Competitive markets.
• 2. Rational agents.
• 3. No externalities. Agents should only worry about their own consumption, not others’
consumption.
• Implication: competitive markets of rational individuals with no externalities can bring
about an efficient equilibrium.
• Second welfare theorem implication: distribution and efficiency are two separate outcomes.
Any Pareto equilibrium can be brought about by a market mechanism. The question of how
to allocate resources is separate from whether the allocation is “fair” or not.
• Neoclassical theory: Pricing decisions and mechanism of market is separate from questions
of how much is fair. Any Pareto equilibrium can be achieved through market. If you want a
specific equilibrium, undertake a suitable distribution of initial endowments, let the market
ensure an efficient allocation.
• Taxes are fine on endowments, not on choices. Taxing and redistribution of income fine, not
subsidizing prices.
FAIRNESS OF EQUILIBRIUM (REFER SECTION
34.5 AND 34.6, CH 34 OF VARIAN)
• A perfectly competitive market mechanism leads to:
• 1. An equilibrium where demand = supply.
• 2. An equilibrium where all possible gains of trade exhausted.
• 3. An equilibrium where no one can be made better off without making someone worse
off.
• But is this equilibrium “fair”? Will everyone be happy with this equilibrium?
• Assume goods in an economy divided equally. This is a symmetric distribution. Will this
always be an efficient equilibrium? Using language of mainstream theory, when would an
equal division of goods not be an efficient equilibrium?
• Assume a new distribution that is Pareto efficient. Will this be “fair”? Will everyone be
happy with this equilibrium?
• How can we ensure Pareto efficiency and equity? How does mainstream theory define
equitable distributions?
• Neoclassical definition of equitable distribution: No agent should prefer anybody else’s
bundle of goods to theirs.
• Fair allocation: An allocation that is both Pareto efficient and equitable.
• Assume two agents A and B, in a symmetric equilibrium. They trade, and reach a Pareto
efficient equilibrium. But A prefers B’s bundle, i.e. A is envious of B. Explicitly:
• (, ) < (, )
• Let prices of good 1 and 2 be (, )
• If A prefers B’s bundle, but A’s bundle is the best she can afford at ruling prices, then it
must mean B’s bundle costs more than A can afford.
• i.e. + < +
• But this is a contradiction, since initial assumption is that both started from a symmetric,
equal distribution. If A can’t afford B’s bundle, B can’t afford it either.
• A Pareto efficient equitable distribution can thus be achieved by redistributing initial
endowments equally, and then letting market mechanism determine allocations.
• If the initial distribution is equal, then the resultant Pareto efficient allocation is equitable
too.
PROBLEMS

• Free market implies that each individual, acting on private desires and market-determined
incentives, brings about a Pareto efficient equilibrium. But which Pareto efficient
equilibrium would be preferred by society? No way for that information to be revealed.
• Even if this information were to be revealed, there may be no political process by which
redistribution can be done. Thus, implication is that by there’s nothing wrong with market
mechanism, the only thing stopping equitable outcomes is political process for
redistribution (is this a legitimate analysis or a dodge of important questions?)
• Problem in focusing only on utility from consumption. Does symmetric distribution of
goods in initial state help disabled individuals, for instance?