Chapter 18W: General Equilibrium and Market E ciency

So far each time we have analyzed the behavior of a market or an agent, we have done that in isolation from the rest of the economy. This type of analysis is called partial equilibrium analysis. For example, when we studied how much of a good a consumer wants to buy, we assumed that the price of that good was xed. Yet, we know that when agents have enough market power, the interaction between demand and supply impacts that price...

Once we take these cross eects into account, we are in the realm of general equilibrium analysis. General equilibrium analysis is typically concerned with nding equilibrium prices. All the results of this chapter will thus be in terms of existence and characteristics of equilibrium prices. Prices are set by an auctioneer.

3 parts for this chapter: part 1: exchange economy (no production; today) part 2: production with 1 input: comparative advantage (Tuesday) part 3: production with two inputs (full monty; Tuesday)

GENERAL EQUILIBRIUM: PRICES AS ALLOCATION DEVICES

Part I Simple Exchange Closed Economy

Closed economy:

The agents in the economy own all the resources in that economy

What is produced can only be consumed within the same economy

Autarky: no exchanges with the rest of the world

GEA of a Simple Exchange Economy

In such an economy there are only consumers. Production is absent. Consumers are endowed initially with a share of the economy resources: s manna from Heaven. For simplicity, we analyze an economy with 2 consumers, labelled A and B; and 2 consumption goods, clothing, C and food , F :
CB = C CA ; F B = F FA

In this economy, the only two resources are the two consumption goods.

1.1

Edgeworth Box

A clever way to represent this economy is the Edgeworth box, named after the British economist Francis Edgeworth. The height of the box corresponds to the total available quantity of one of the two goods, and the width of the box corresponds to the total available quantity of the other good. The two consumers are placed respectively in the bottom left corner and the top right corner of the box.

Focus on the consumer in the bottom left corner, A say. Her endowment can then be represented as the point R = (CA; FA) in the box. Because of the way the box is constructed, this point also corresponds to the initial endowment of consumer B : C CA and F FA: Suppose for example that
C = 200; F = 100 CA = 70; FA = 75

Then the Edgeworth box is as the one above.

1.2

Exchange and the Contract Curve

Both consumerspreferences can be represented by indierence curves.

A indierence curves are, as usual, convex and A utility is increasing in the s s distance between the curve and the origin, that is, the bottom left corner of the box.

How do we represent B indierence curves? s As usual, with the only caveat that, the origin being in this case the top right corner, B indierence curves are concave (face downward). For B too, the s further away from the top right corner a curve is, the higher is his utility.

Focus on the two indierence curves that go through the initial endowment point. These dene the two consumerslevel of utility if they consume their endowment. Can the two consumers trade and be better o?

Yes! Why? Look at the two indierence curves that go through the endowment point, R: Suppose A oers B 10 extra units of food in exchange for 15 extra units of clothing from B: This is point T in the box. Is this a good idea for A? Yes: this allows her to reach a higher indierence curve. Will B accept? Yes: this allows him to reach a higher indierence curve. The two consumers will continue to carry out such exchanges until neither of them can increase his or her utility without decreasing that of the other agent.

This nal point is dened as the tangency point between the two agentshighest possible indierence curves, point M in the box

This point is Pareto superior to R: both players are better o with respect to the initial situation. Because neither player can improve on M without hurting the other player, M is Pareto optimal. If we look for all the Pareto optimal point as a function of all possible initial endowment point, the locus of all such optimal points is called the Contract Curve.

Given the consumers endowments, only a portion of the contract curve is attainable:

This is a general equilibrium analysis because we consider how the decisions of one side of the market, A; interact with those of the other side of the market, B. But to make it even more general we should add prices. , Question: given an initial endowment, can we nd prices that push the two consumers to choose a point on the contract curve? That is, can we have e ciency in consumption?

1.3

Adding Relative Prices

So far we abstracted from prices. Imagine now that there is an auctioneer that xes the price of food to PF and that of clothing to PC such that:
PC =PF = 1

Assume the initial endowments are now:

CA = 50 = CB FA = 100 = FB

We can draw a line with slope point E:

1 that goes through the initial endowment

This straight line tells us which consumption points can be reached starting from E given the market prices. We can nd the preferred consumption bundle of A and B on this line: it is just an application of the rational choice model. Solving these two problems yields points A0 and B0 .

Problem: these two point are impossible. Both players cannot have more clothes, given that the sum of their initial endowments is equal to the total amount of clothing available in the economy as a whole. For PC =PF = 1 there is therefore excess demand of clothing and excess supply of food. How can we restore the equilibrium?

By changing the relative price of clothing and food! How?

Make clothing more expensive with respect to food. The auctioneer will continue to increase the relative price of clothing until the optimal points for A and B coincide. At that point, A optimal demand of clothing is equal to the dierence between s the total amount of clothing available in the economy and B optimal demand s of clothing. The same holds for food.

Thus, in equilibrium, there exist PC and PF such that:

CA = C FA = F M RSA = CB FB ; and
PC PF

= M RSB

Then, we are on the contract curve and we have e ciency in consumption.

It should be obvious that for general utility functions, changing the two consumers endowment leads (most of the time) to a dierent optimal relative price. This implies that the following graph in your text is not general but holds only 1) for utility functions such as the Cobb-Douglas and 2) if both consumers have the same utility function:

Indeed, imagine 2 consumers i = 1; 2 have utility:

x11x1 21

and x12x22

Their endowments are (1; 2) and (2; 1) : 1 wealth is p1 + 2p2 and 2 wealth is 2p1 + p2: s s

1 demand for the two good is the solution to: s 8 p x21 < = 1 1 x11 p2 : p1x11 + p2x21 = p1 + 2p2 yielding:
p1 + 2p2 ; p1 p1 + 2p2 x21 = (1 ) p2 x11 =

(this is immediate if you remember that with Cobb-Douglas utilities the share of the budget you dedicate to good 1, p1x11, is times your income, which here is p1 + 2p2)

Similar calculations can be done for 2 (do them!), yielding: 2p1 + p2 x12 = ; p1 2p + p2 x22 = (1 ) 1 p2

This implies that equilibrium relative prices must be such that: (x11 + x12 = )
p1 + 2p2 2p1 + p2 + =3 p1 p1 , p1 ( + 2 ) + p2 (2 + ) = 3p1 p1 2 + = p2 3 2

yielding:

If

= , we indeed have that:

p1 2 + = p2 3 2

3 3 3

which is independent of the endowment point (here 3).

What happens if we change the endowments? Suppose these are now (2; 3) and (3; 2) : Going through the above steps yields: 2p1 + 3p2 ; x11 = p1 2p + 3p2 x21 = (1 ) 1 p2 and 3p1 + 2p2 ; p1 3p + 2p2 x22 = (1 ) 1 p2
x12 =

This implies that equilibrium relative prices must be such that:

x11 + x12 =

2p1 + 3p2 3p1 + 2p2 + =5 p1 p1

p1 = p2 1

yielding again:

1.4

Smith Invisible Hand Theorem s

An equilibrium produced by competitive markets (through the appropriate pricing of the goods considered) will exhaust all possible gains from exchange

This is the rst fundamental theorem of welfare economics.

An alternative way of stating the theorem is to say that in competitive markets there exist a relative price such that the equilibrium consumption allocation is Pareto optimal. All the equilibria (each equilibrium is associated with an initial endowment and a relative price) are on the contract curve.

This leads us to the second fundamental theorem of welfare economics:

Any allocation on the contract curve can be sustained as a competitive equilibrium.

This theorem implies that the issue of equity in distribution is logically distinct and separable from that of e ciency in allocation!!

Example: Let Society redistribute individual incomes as it prefers (let Society choose the endowment point), but then let market forces drive how individuals spend the incomes they are endowed with after the redistribution (Let individuals choose their preferred point on the contract curve), through the setting of appropriate prices. Of course, this works IF the costs associated to redistribution are not too high.