General Equilibrium I

Pure Exchange (no production)

Analyzing exchange b/w 2 people; Background material from consumer theory, optimization, trading
from endowment

Exchange
Consumers A & B
Their endowments of goods 1 & 2:
o wA = (w1A,w2A)
&
ex.

wB = (w1B,w2B)

wA = (6,4) & wB = (2,2)

total quantities available :
o w1A + w1B = 6 + 2 = 8 units of good 1
o w2A + w2B = 4 + 2 = 6 units of good 2

Edgeworth box: Edgeworth and Bowleys diagram

8
o to show all possible allocations of available quantities of goods 1 & 2 between 2
consumers
o dimensions of the box = quantities available of the goods
height = units of good 2; width = units of good 1
o Assumptions:
1. Indiff curves convex and appropriate to origin
2. Indiff curves are smooth
3. Both goods essential to consumer
4. Quantity of the 2 goods consumed are the only variables that affect economic wellbeing

Feasible Allocations
allocations of 8 units of good 1 and 6 units of good 2 are feasible?
How are all feasible allocations depicted in the Edgeworth box diagram?
Endowment allocation: before-trade allocation (1 feasible allocation)
Endowment Allocation
Height=
w2A +
w2B = 4
+2
=6

Endowment
allocation is
wA = (6,4) &
wB = (2,2)

Width = w1A + w1B = 6 +

Generally:

Other

Feasible Allocations
(x1A,x2A) = allocation to
(x1B,x2B) = allocation to
feasible only if
o x1A + x1B < w1A + w1B
o x2A + x2B < w2A + w2B

consumer A
consumer B

Feasible Reallocations
all pnts in box (with boundary) = feasible allocations of combined endowments
which allocations make consumer better off?
Which allocations will be blocked by 1/both consumers?

Adding

Preference to the Box

rotated As add B

Size of box NOT =

to Sum of Endowments

edgeworths box (done

right)

Welfare Improvements Pareto

utilitarian prescription is to find an allocation that achieves the greatest good for the greatest
number
any change in allocation is a good thing if the gain in utility to someone exceeds the sacrifice by
someone else
operational comparing utility across individuals
o not possible utility = ordinal (cant be measured)
if a change makes everyone better of then it should be made
Pareto: isnt necessary to make everyone better off, as long as someone is made better off and
nobody made worse off
*when indifference curves are tangent at a point in Edgeworth box that point = Pareto-optimal
Pareto-Improvement
Pareto-improving allocation: Allocation endowment that improves welfare of a consumer w/o
reducing welfare of another
Where are the Pareto-improving allocations?
A better off, B no worse off

B better off, A no worse off

Both Better Off

Pareto Improvements

Consumer can refuse to trade only possible outcomes from exchange are Pareto-improving
allocations
Which particular Pareto-improving allocation will be the outcome of trade?

Pareto Optimal Allocations

A change in a Pareto Improvement if the change makes nobody worse off, and at least one person
better off
Pareto Efficient/optimal if it is not possible to make any change that results in a Pareto
Improvement
Pareto-Optimality
-

welfare

black dot: optimality: allocation where convex

indifference curves are back-to-back is Pareto- optimal
- allocation is pareto-optimal since only way one consumers
can be increased is to decrease welfare of ther other consumer

contract curve: set of all Pareto-optimal allocations (pass through pts of tangency

Pareto-Optimality
which of the allocations on the contract curve will consumers trade?
o Depends on how trade is conducted
In perfectly competitive markets? (prices are given)
One-on-one bargaining?
o Allocation depends on relative bargaining ability, final allocation is determined by a bargaining
game
Set of Final Allocations The Core
Trade is voluntary no trader will agree to participate in trade that results in allocation the reduces
their utility relative to that of initial endowment
o These trade blocked by one consumer (the ones whose utility would be reduced)
The Core: Trades not Blocked by either A or B
A will agree to trade that make A better off
o might agree to trade that makes A no worse off
o will not agree to trade that makes A worse ogg
A will block many possible trade
B will block trade that makes B worse off

core: 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
which core allocation?
o Depends on manner in which trade is conducted

Trade in Competitive Markets

Perfectly competitive markets
Each consumer = price-taker trying to maximize her own utility given p1,p2 and her own endowments
Competitive Trading Assumption
b/w only 2 people competitive behavior more like bargaining
convectional exchange model: simplifying assumption of price-taking behavior by both parties yet
Box is only for 2
Reconciling Competitive Trading with Two Consumers
assume thousands identical consumers of type A and B
each A has same preferences and endowment
each B has same preferences and endowment
o assume each consumer takes price as given (each consumer s trading in a competitive market)
Competitive Trading
consumer maximizes their own utility subject to constraint that the value of the final allocation
(combination of goods) is no greater that value of original endowment. When evaluated at some
specified set of prices
trading from endowment, to maximize utility
- given p1 & p2, consumer As net demands for commodities 1 and 2 : x1A* - w1A
&
x2A* - w2A
B
B
- given p1 & p2, consumer Bs net demands for commodities 1 and 2 : x1 * - w1
&
x2B* - w2B
x

- general equilibrium: when (at p1 & p2) both markets for commodities 1 & 2 clear
o
x1A* + x1B* = w1A + w1B
o x2A* + x2B* = w2A + w2B

at given prices p1 & p2 :

o excess supply of commodity 1
o excess demand for commodity 2
neither markets clear at prices p1 &
p1 = no general equilibrium

How can Equilibrium be Attained?

Excess demand for commodity 2 p2 will rise
Excess supply of commodity 1 p1 will fall
Slope of budget constraint = - p1/p2 will pivot about the endowment point and become less
steep
As utility Maximization at New Prices

Bs utility Maximization at New Prices

Solving for Pareto-Optimal Allocation Associated with a Specified Endowment

Only relative prices matter:
o Endowment of goods (some X, some Y) and prices are Px and Py
o Set of consumption opportunities (budget set) is the same as if prices were
100Px and 100Py;
20Px and 20Py
ZPx and ZPy , for any +ve number Z
multiplying prices by same +ve constant leaves the budget set unchanged
increase in price of what is bought is compensated by an = increase in the value of what is sold
Py = 1
Px = Px/Py = p
price variable is the relative price of good X
Solving: The Steps
First: find expressions for QD by each person as a function of endowment amounts and p
Second: impose condition of exactly 0 excess demand in market X or Y (if 1 market clears 0 excess
demand so will the other)
o Solve that 0 excess demand equation for p

Third: substitute solution value of p into demand functions & compute quantities of each good that
each consumer demands

Example:
- Mick endowed with 30 units X, 5 units Y
- Keith endowed with 20 units X, 20 units Y
- Utility Functions:
-

Find market-clearing relative price of X, and amounts consumed in equilibrium by Mick and
Keith
o if utility is form of:
o

satisfies budget constraint:

optimal quantities consumers are:

Cobb-Douglas Demands:
o Value of endowments:
o

Demands (optimal quantities):

Impose 0 Excess Demands for X:

o Total QD by Mick and Keith = total endowment (30+20 = 50) is market X clears
Impose condition and solve for p
o Qd(Mick) + Qd(Keith) = 50

Common denominator = 12; multiple by 12p; solve for p

Substituting p into optimal quantities (demand functions)

Net Demands (who buys which good?)

o Mick started with 30 X, wants to consumer 10; so he sells 20 units at p = 0.5
o Mick started with 5 Y, wants to consume 15; so he buys 10 at p = 1
o Keith started with 20 X, wants to consume 40; so he buys 20 units at p = 0.5
o Keith started with 20 Y, wants to consume 10; so sells 10 at p = 1

Example: same utility function, different endowments

- Mick endowed with 30 X, 12 Y
- Keith endowed with 20 X, 13 Y
o Relative price of X = p = 0.4
- Mick sells 15 units X to Keith
- Keith sells 6 Y to Mick
Identical CD utilities General Result
When both have same Cobb-Douglas utilities, the contact curve is a straight line
Denoting original endowments as variables with bars optimal quantities consumed for each person:

Set total QD = Quantity available (sum of QD of B = sum of endowments of B);

equilibrium price

solve for

Special Case- Identical CD utilities

Equilibrium price = common MRS function of the relative sums of
endowments of 2 goods
Optimal ratio of goods consumers are functions of price optimal
ratios of goods consumed are functions of relative sums of
endowments of 2 goods
Trade

in Competitive Markets
At new prices p1 & p2 both markets clear general equilibrium
Trading in competitive market achieves Pareto-optimal allocation of endowments
Ex of First Fundamental Theorem of Welfare Economics

First Fundamental Theorem of Welfare Economics

Trading in perfectly competitive markets achieves a Pareto-Optimal allocation of economys
endowment
Second Fundamental Theorem of Welfare Economics
Any Pareto-optimal allocation
o Any point on the contract curve
Can be achieved by trading in competitive markets provided that endowments are 1 st appropriately
rearranges amongst the consumers
Given consumers preference are well-behaved
o For any pareto-optimal allocation
There are prices and an allocation of total endowment, that makes Pareto-optimal
allocation implementable by trading in competitive markets

2 Fundamental Theorems (of Welfare Economics)

First: a competitive equilibrium is Pareto-optimal
Second: ANY Pareto-Optimal allocation can be attained as the result of competitive trading
following approp redistributive transfers
Walras Law and GENERAL Equilibrium
Value of what a consumer wants to sell must = value of what consumer wants to buy evaluated at
any set of prices
o True for any prices
Nobody sells something w/o spending al of the proceeds, and the value of what is purchased cannot
exceed the revenue received from selling something
Walras Law
Is an identity (statement that is true for any +ve prices (p1,p2), whether these are equilibrium prices
or not)
Consumers preferences are well-behaved for any +ve prices each consumer spends all of his
budget
Consumer A:
o p1x1A* + p2x2B* = p1w1A + p2w2B
consumer B:

o p1x1A* + p2x2B* = p1w1A + p2w2B

summing

summed market value of excess demands is 0 for any +ve prices p1 & p2 Walras Law

Implications of Walras Law

suppose market for commodity A is in equilibrium

(1) implication for a two-commodity exchange economy

market must also be in equilibrium
if there is excess QS of commodity 1

if 1 market is in equilibrium, then other

(2) implication for a two-commodity exchange economy excess supply in 1 market implies an excess
demand in the other market