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Pareto Efficiency
Pareto Efficiency
Pareto Efficiency
M. Utku Unver
Micro Theory
Boston College
M. Utku Unver
Micro Theory (BC)
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General Equilibrium
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Micro Theory (BC)
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An Exchange Economy
Consumers: A and B
Goods: 1 and 2
Endowments: = ( A , B ) = ((1A , 2A ), (1B , 2B ))
Total endowment of goods in the economy:
Good 1: 1A + 1B
Good 2: 2A + 2B
Demands: X = (x A , x B ) = ((x1A , x2A ), (x1B , x2B ))
Demands should be feasible:
Good 1: x1A + x1B = 1A + 1B
Good 2: x2A + x2B = 2A + 2B
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Micro Theory (BC)
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Edgeworth Box
For equilibrium analysis we use a useful tool called Edgeworth Box
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Micro Theory (BC)
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Pareto efficiency
If we can make some agents better off without making any agent worse
off, then an allocation is not Pareto efficient.
Formally, an allocation is Pareto efficient if it is not possible that we can
make some agents better off without making any agent worse off.
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Micro Theory (BC)
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Micro Theory (BC)
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M. Utku Unver
Micro Theory (BC)
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MRS A = MRS B
U A /x1A
U B /x1B
A
= B
A
B
U /x2
U /x2
x2B
x2A
A = B
x1
2x1
Use the feasibility condition we found above
to isolate one persons choice, for example As
x2A
2 x2A
A =
A
x1
2(3 x1 )
6x2A 2x1A x2A = 2x1A x1A x2A
x2A
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Micro Theory (BC)
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2x1A
6x1A
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Micro Theory (BC)
2
5
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Note that if both of the agents have the same MRS in this case, all the
points in the Edgeworth box are Pareto efficient. Why?
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Micro Theory (BC)
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The plot of above equation (the contract curve:) Observe that there are
parts of contract curve where MRSs are not equal, corner solutions.
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Micro Theory (BC)
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Competitive Equilibrium
each person is choosing the most preferred bundle in his budget set
and
there is neither excess demand nor excess supply for any good. (i.e.,
markets clear)
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Micro Theory (BC)
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In the above figure, the price ratio p1 /p2 specified by slope of the budget
line(s) and the allocation specified by (x A , x B ) is not a competitive
equilibrium. While each agent is maximizing their utilities, the markets do
not clear. There is excess demand for good 2 and excess supply for good 1.
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Micro Theory (BC)
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The tangency point in the above Edgeworth box figure is the competitive
equilibrium for that economy. The price ratio p1 /p2 together with the
allocation x = (x A , x B ) is a competitive equilibrium for this economy.
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Micro Theory (BC)
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Micro Theory (BC)
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Solution:
Step 1 : First we find the demand functions of the agents for both goods.
Let p1 = 1 (numeraire good,) and p2 = p (unknown, we can only
determine one of the prices)
The demand functions of agent A are as follows (Cobb-Douglas
preferences):
1 mA
A
x1 = 2 p1 = 12 p1p+1p2 = 12 (1 + p ) where mA =the value of the endowment
of agent A.
1 mA
A
x2 = 2 p2 = 12 1+p p .
The demand functions of agent B are as follows (Cobb-Douglas
preferences):
1
2 mB
1 mB
B
B
x1 = 3 p1 = 3 (2 + p ) and x2 = 3 p2 = 32 2+p p where mB = the value of
the endowment of agent B.
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Micro Theory (BC)
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Micro Theory (BC)
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Micro Theory (BC)
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Walras Law
(Walras Law)
Suppose there are k goods in the exchange economy. If (k-1) markets
clear, then the kth market clears as well.
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Micro Theory (BC)
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Welfare Economics
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