Exchange (Chapter 17) (General Equilibrium) Pure Exchange Economy n consumers and k goods. Allocation to consumer i, x i  x i1 , ...

, x ik Each consumer has -utility function u i x i -initial endowments w i  w i1 , ..., w ik Let x  x 1 , ..., x n denote a specific allocation of all goods to all consumers. n n x is feasible iff i1 x i i1 w i . If we have 2 goods and 2 consumers, the whole economy can be represented in an Edgeworth box. We want to analyze link between market equilibrium and efficiency.

Walrasian Equilibrium Definition: Market equilibrium refers to a situation where each consumer receives a bundle maximizing his utility and where the price is such that the final allocation is feasible: For all i, x i p arg max x i u i x i n n and i1 x i p i1 w i . Note that m i  p.w i thus only variables are prices. Graphical Analysis.

Existence of Walrasian Equilibria Will there always exist p such that the makets clear? Define z p  xi p wi
i1 n

the aggregate excess demand. Walras Law: For any p we have p.z p 0. The value of excess demand is equal to zero. p.z p  p.x i p p.w i  0
i1 n

since Walrasian demand satisfy the budget constraint for any p.

Walras law  definition of equilibrium  1) Market clearing: If demand equals supply in k 1 markets and if p k  0, then demand equals supply in the k th market. Proof: If not Walras Law would be violated. 2) If p is an equilibrium price and z j p  0 then p j  0. If some good is in excess supply in equilibrium then it must be free. Proof: In equilibrium z p 0. Thus for all p k 0, p .z p is a sum of non positive  0 terms. If z j p  0 and p j  0  p .z p which contracdicts Walras Law.

3) If all goods are desirable and p is an equilibrium price then z p  0 . Definition: A good j is desirable if at p j  0 we have z j 0  0. Proof: Assume all goods are desirable and assume that there exist a good for which z j p  0. Then we would have p j  0 according to 2). But then since j is desirable, we should have z j 0  0 which contradicts our assumption. Existence of an equilibrium If z . : S k1 R k is a continuous function which satisfies Walras Law, then there always exists p in S k1 such that z p 0. In an economy with 2 goods, there always p forming an equilibrium. All we get exist p 2 1 are relative prices.

The 1st Theorem of Welfare Definition: Pareto Efficiency: An allocation x is Pareto Efficient if there is no other feasible allocation x such that

x i x i for all i
i

and x i x i for at least 1 i.

i

In a setting with 2 consumers and 2 goods, where utilities are differentiable the set of Pareto Efficient allocations solve MRS A  MRS B
B A B xA 1  x1  w1  w1 B A B xA 2  x2  w2  w2

The set of all Pareto Efficient allocations is called the contract curve.

First theorem of Welfare: If x p , p forms a Walrasian Equilibrium, then x p is a Pareto efficient allocation. Proof. Definition 2 of W.E.: x p , p is a WE if n n (1) x p is feasible: i1 x i p  i1 w i (2) Each agent is making an optimal choice from his budget set: If there exists x i x i such that x i i x i then px i  px i .

Assume x p is not Pareto efficient. Then x x such that x is feasible and such that x i i x i for all i. Since x i i x i for all i, we have px i  px i  pw i for all i. Summung over all individuals we get

p wi  p xi  p wi

i1

i1

i1

which is a contradiction.

Second theorem of Welfare Suppose x is a PE allocation in which each agent holds a positive amount of each good. Suppose that are convex, continuous and monotonic. Then there exists p such that x is a WE for the initial endowments w i  x i . We prove that x is a WE considering definition 2 of WE but where we will show that if there exists x i x i such that x i i x i then px i  px i . Define V i  x i R k : x i i x i the set of bundles strictly preferred to x i by i. Define

V

z : z  xi, xi Vi
i1