Chapter 32

Exchange
Learning Outcomes

 Budget Constraint with an Endowment

 Edgeworth Box

 Pareto Efficient Allocations

 Relative Prices

 Equilibrium and Efficiency

 Welfare Theorems
The Edgeworth Box

 Edgeworth box : can be used to analyze the exchange of two goods between
two people.
 Two people A and B
 two goods 1 and 2
 A’s consumption bundle by XA = (x1A, x2A)
 B’s consumption bundle by XB = (x1B, x2B)
 x1A represents A’s consumption of good 1 and x2A represents A’s consumption of
good 2
 x1B represents B’s consumption of good 1 and x2B represents B’s consumption of
good 2
The Edgeworth Box

 A pair of consumption bundles, XA and XB, is called an allocation.

 An allocation is a feasible allocation if the total amount of each good
consumed is equal to the total amount available.
 x1A + x1B = ω1A + ω1B
 x2A + x2B = ω2A + ω2B
 initial endowment allocation= (ω1A , ω2A ) and (ω1B , ω2B )
 If there are 10 units of good 1 and 20 units of good 2,then if A holds (7,12), B
must be holding (3,8)
 The points in the Edgeworth box can represent all feasible allocations in this
simple economy.
The Edgeworth Box

Hal R. Varian
Trade

 how does this trade takes place?

 Where is the region of the box where A and B are both made better off?
 Clearly it is in the intersection of these two regions. This is the lens shaped
region
 suppose they reach to a point like M at this point person A giving up |x1A−ω1A|
units of good 1 and acquiring in exchange |x2A−ω2A| units of good 2 and person
B acquires |x1B−ω1B| units of good 1 and gives up|x2B−ω2B| units of good 2
Pareto Efficient Allocations
 A Pareto efficient allocation can be described as an allocation where:
 There is no way to make all the people involved better off or
 there is no way to make some individual better off without making someone
else worse off; or
 all of the gains from trade have been exhausted; or
 there are no mutually advantageous trades to be made
 The indifference curves of the two agents must be tangent at any Pareto
efficient allocation
 From the tangency condition it is easy to see that there are a lot of Pareto
efficient allocations in the Edgeworth box.
 The set of all Pareto efficient points in the Edgeworth box is known as the
Pareto set, or the contract curve.
Pareto Efficient Allocations

Hal R. Varian
Market Trade

Hal R. Varian
Market Trade

Hal R. Varian
The Algebra of Equilibrium

 let x1A(p1, p2) be agent A’s demand function for good 1

 Let x1B(p1, p2) be agent B’s demand function for good 1
 let x2A(p1, p2) be agent A’s demand function for good 2
 Let x2B(p1, p2) be agent B’s demand function for good 2
 we can describe this equilibrium as a set of prices (p∗1, p∗2) such that:
 x1A (p∗1, p∗2 )+ x1B (p∗1, p∗2 )= ω1A + ω1B
 x2A (p∗1, p∗2 )+ x2B (p∗1, p∗2 ) = ω2A + ω2B
 These equations say that in equilibrium the total demand for each good
should be equal to the total supply
The Algebra of Equilibrium

 Another way to describe the equilibrium

 (x1A - ω1A )+ (x1B - ω1B ) =0
 ( x2A - ω2A )+ (x2B - ω2B ) = 0
 These equations say that the sum of net demands of each agent for each good
should be zero. Or, in other words, the net amount that A chooses to demand
(or supply) must be equal to the net amount that B chooses to supply (or
demand).
The Algebra of Equilibrium

 another formulation of these equilibrium equations comes from the concept of the aggregate
excess demand function
 Denote net demand function for good 1 by agent A by
 e1A(p1, p2) = x1A(p1, p2) − ω1A
 Denote net demand function for good 1 by agent B by
 e1B(p1, p2) = x1B(p1, p2) − ω1B
 Similar for good 2.

 e1A(p1, p2) measures agent A’s net demand or his excess demand
 z1(p1, p2) = e1A(p1, p2) + e1B(p1, p2) aggregate excess demand for good 1.
 z2(p1, p2) = e2A(p1, p2) + e2B(p1, p2) aggregate excess demand for good 2.
 an equilibrium (p∗1, p∗2 ) is where
 z1 (p∗1, p∗2 ) =0
 Z2 (p∗1, p∗2 ) =0
 It turns out that if the aggregate excess demand for good 1 is zero, then the aggregate excess
demand for good 2 must necessarily be zero.
Walras’ Law

 Walras’ law states that

 p1z1(p1, p2) + p2z2(p1, p2) ≡ 0.
 the value of aggregate excess demand is identically zero.
 it is zero for all possible choices of prices, not just equilibrium prices.
 Proof:
 Consider first agent A. Since her demand for each good satisfies her budget constraint,
we have :
 p1x1A(p1, p2) + p2x2A(p1, p2) ≡ p1ω1A+ p2ω2A
 p1x1A(p1, p2)- p1ω1A + p2x2A(p1, p2) - p2ω2A ≡0
 P1 [x1A(p1, p2)- ω1A ] + p2 [x2A(p1, p2) - ω2A ] ≡0
 P1 e1A(p1, p2) + p2 e2A(p1, p2) ≡0 equation(1)
 the value of agent A’s net demand is zero
Walras’ Law

 The same thing for agent B

 p1x1B(p1, p2) + p2x2B(p1, p2) ≡ p1ω1B+ p2ω2B
 p1x1B(p1, p2)- p1ω1B + p2x2B(p1, p2) - p2ω2B ≡0
 P1 [x1B(p1, p2)- ω1B ] + p2 [x2B(p1, p2) - ω2B ] ≡0
 P1 e1B(p1, p2) + p2 e2B(p1, p2) ≡0 equation(2)
 the value of agent B’s net demand is zero
 Equation(1)+equation(2) ≡0
 P1 e1A(p1, p2) + p2 e2A(p1, p2) + P1 e1B(p1, p2) + p2 e2B(p1, p2) ≡0
 P1 [e1A(p1, p2) + e1B(p1, p2) ]+ p2 [e2A(p1, p2) + e2B(p1, p2)] ≡0
 p1z1(p1, p2) + p2z2(p1, p2) ≡ 0 done
Walras’ Law

 We can now demonstrate that if demand equals supply in one market, demand
must also equal supply in the other market. Note that Walras’law must hold for all
prices, since each agent must satisfy his or her budget constraint for all prices.
Since Walras’ law holds for all prices, in particular, it holds for a set of prices
where the excess demand for good 1 is zero
 z1(p∗1, p∗2) = 0. he excess demand for good 1 is zero
 According to Walras’ law it must also be true that
 p∗1z1(p∗1, p∗2) + p∗2 z2(p∗1, p∗2) = 0
 If p∗2 >0 so it implies z2(p∗1, p∗2) = 0
 In general, if there are markets for k goods, then we only need to find a set of
prices where k − 1 of the markets are in equilibrium. Walras’ law then implies that
the market for good k will automatically have demand equal to supply
Relative Prices

 How can you solve for k prices with only k − 1 equations?

 The answer is that there are really only k − 1 independent prices.
 Because equilibrium price is a relative price.
Equilibrium and Efficiency

 Is the market equilibrium Pareto efficient ?

 Yes. Because IC’s for both persons are tangent with one another in another
words the set of bundles that A prefers doesn’t intersect the set of bundles
that B prefers
The Algebra of Efficiency

 Suppose that we have a market equilibrium that is not Pareto efficient. We will
show that this assumption leads to a logical contradiction.
 the market equilibrium is not Pareto efficient means that there is some other
feasible allocation (y1A, y2A, y1B y2B) such that
 y1A + y1B = ω1A+ ω1B eq1
 y2A + y2B = ω2A+ ω2B eq2
 And (y1A, y2A ) >A (x1A, x2A) eq3
 (y1B, y2B ) >B (x1B, x2B) eq4
 by hypothesis, we have a market equilibrium where each agent is purchasing the
best bundle he or she can afford. If (y1A, y2A) is better than the bundle that A is
choosing, then it must cost more than A can afford,and similarly for B:
The Algebra of Efficiency

 p1 y1A + p2 y2A > p1ω1A+ p2ω2A

 p1 y1B + p2 y2B > p1ω1B+ p2ω2B
 Now add these two equations together to get
 p1 (y1A + y1B )+ p2 (y2A + y2B ) > p1 (ω1A+ ω1B )+ p2( ω2A+ ω2B )
 Substitute from equations (1) and (2) to get
 p1 (ω1A+ ω1B )+ p2( ω2A+ ω2B ) > p1 (ω1A+ ω1B )+ p2( ω2A+ ω2B )
 which is clearly a contradiction, since the left-hand side and the right-hand
side are the same. Therefore, this assumption must be wrong. It follows that
all market equilibria are Pareto efficient: a result known as the First
Theorem of Welfare Economics.
First Theorem of Welfare Economics.

 The First Welfare Theorem guarantees that a competitive market will exhaust
all of the gains from trade.
 an equilibrium allocation achieved by a set of competitive markets will
necessarily be Pareto efficient
 First Welfare Theorem says nothing about the distribution of economic
benefits.
Efficiency and Equilibrium

 The Second Theorem of Welfare Economics. When preferences are convex,

a Pareto efficient allocation is an equilibrium for some set of prices.

Hal R. Varian
Efficiency and Equilibrium

Hal R. Varian