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Final Topic Comp. Equilibrium
Final Topic Comp. Equilibrium
Competitive Equilibrium
in an Exchange Economy
Exchange
Two consumers, A and B.
Their endowments of goods 1 and 2
are A A A
ω = (ω 1 , ω 2 ) and ω = (ω 1 , ω 2 ).
B B B
A
E.g. ω = ( 6,4 ) and ω = ( 2, 2 ).
B
A B
ω
Width = 1 + ω 1 = 6+2= 8
Starting an Edgeworth Box
Height =
A B
ω2 + ω2
= 4+2
=6
A B
ω
Width = 1 + ω 1 = 6+2= 8
Starting an Edgeworth Box
Height =
A B The dimensions of
ω2 + ω2 the box are the
= 4+2 quantities available
=6 of the goods.
A B
ω
Width = 1 + ω 1 = 6+2= 8
Feasible Allocations
What allocations of the 8 units of
good 1 and the 6 units of good 2 are
feasible?
How can all of the feasible
allocations be depicted by the
Edgeworth box diagram?
Feasible Allocations
What allocations of the 8 units of
good 1 and the 6 units of good 2 are
feasible?
How can all of the feasible
allocations be depicted by the
Edgeworth box diagram?
One feasible allocation: the
endowment allocation.
The Endowment Allocation
OB
6
4
OA A
ω = ( 6,4 )
6
8
The Endowment Allocation
2
OB
2
6
4
OA
6 B
ω = ( 2, 2 )
8
The Endowment Allocation
2
OB
2
6 The
4 endowment
allocation
OA A
ω = ( 6,4 )
6 B
ω = ( 2, 2 )
8
The Endowment Allocation
More generally, …
Other Feasible Allocations
A A
( x1 , x 2 ) denotes an allocation to
consumer A.
B B
( x1 , x 2 ) denotes an allocation to
consumer B.
An allocation is feasible if and only if
x1A + xB1 ≤ ω 1
A
+ ω B
1
A B A B
and x 2 + x 2 ≤ ω 2 + ω 2 .
Feasible Reallocations
B
x1
OB
A
ω2 xB
2
+
B
ω2
A
x2
OA
x1A
A B
ω1 + ω1
Feasible Reallocations
B
x1
OB
A B
ω2 x2
+
B
ω2 A
x2
OA
x1A
A B
ω1 + ω1
Feasible Reallocations
A
ω2
OA
ω 1A x1A
Adding Preferences to the Box
xA For consumer A.
2 M
or
e
pr
ef
er
re
d
A
ω2
OA
ω 1A x1A
Adding Preferences to the Box
xB For consumer B.
2
B
ω2
OB
ω 1B xB
1
Adding Preferences to the Box
xB For consumer B.
2 M
or
e
pr
ef
er
B re
ω2 d
OB
ω 1B xB
1
Adding Preferences to the Box
B
xB For consumer B. ω 1 OB
1
M B
ω2
or
e
pr
ef
er
r ed
xB
2
Adding Preferences to the Box
xA For consumer A.
2
A
ω2
OA
ω 1A x1A
A
Edgeworth’s Box
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Pareto-Improvement
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
A
Pareto-Improvements
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
The set of Pareto-
improving allocations xB
2
Pareto-Improvements
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
The set of Pareto-
improving reallocations xB
2
Pareto-Improvements
Pareto-Improvements
Pareto-Improvements
Trade
improves both
A’s and B’s welfares.
This is a Pareto-improvement
over the endowment allocation.
Pareto-Improvements
Trade
improves both
A’s and B’s welfares.
This is a Pareto-improvement
over the endowment allocation.
Pareto-Improvements
Further trade cannot improve
both A and B’s
welfares.
Pareto-Optimality
A is strictly better off
but B is strictly worse
off
Pareto-Optimality
A is strictly better off
but B is strictly worse
off
B is strictly better
off but A is strictly
worse off
Pareto-Optimality
Both A and
B are worse A is strictly better off
off but B is strictly worse
off
B is strictly better
off but A is strictly
worse off
Pareto-Optimality
Both A and
B are worse A is strictly better off
off but B is strictly worse
off
The allocation is
Pareto-optimal since the
only way one consumer’s
welfare can be increased is to
decrease the welfare of the other
consumer.
Pareto-Optimality
An allocation where convex
indifference curves are “only
just back-to-back” is
Pareto-optimal.
The allocation is
Pareto-optimal since the
only way one consumer’s
welfare can be increased is to
decrease the welfare of the other
consumer.
Pareto-Optimality
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
A
Pareto-Optimality
x2 All the allocations marked by
a are Pareto-optimal.
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Pareto-Optimality
B
ω 2A ω2
OA A
ω1 A
x1
The contract curve
xB
2
Pareto-Optimality
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
The set of Pareto-
improving reallocations xB
2
A
The Core
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
A
The Core
x 2 Pareto-optimal trades blocked
by B
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
Pareto-optimal trades blocked
by A xB
2
A
The Core
x2 Pareto-optimal trades not blocked
by A or B
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
A
The Core
x2 Pareto-optimal trades not blocked
by A or B are the core.
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
The Core
DEFINITION: The core is the set of all
Pareto-optimal allocations that are
welfare-improving for both consumers
relative to their own endowments.
Considertrade in perfectly
competitive markets.
A’s income
*A
x2
A
ω2
OA
x*1A ω 1A x1A
Trade in Competitive Markets
B
ω2
x*2B
OB
ω 1B x*1B xB
1
Trade in Competitive Markets
1) X is an optimal bundle
2) X is affordable
3) Markets clear
Trade
A
in Competitive Markets
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
in Competitive Markets
x2 Can this PO allocation be
achieved?
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
in Competitive Markets
x 2 Budget constraint for consumer A
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
in Competitive Markets
x 2 Budget constraint for consumer A
B
xB ω1 OB
1
*A
x2
B
ω 2A ω2
OA A
*A ω1 A
x1
x1
xB
2
Trade
A
in Competitive Markets
x2
B
xB ω1 OB
1
*A
x2
B
ω 2A ω2
OA A
*A ω1 A
x1
x1
B
x
Budget constraint for consumer B 2
Trade
A
in Competitive Markets
x2
x*1B
B
xB ω1 OB
1
x*2B
*A
x2
B
ω 2A ω2
OA A
*A ω1 A
x1
x1
B
x
Budget constraint for consumer B 2
Trade
A
in Competitive Markets
x2
x*1B
B
xB ω1 OB
1
x*2B
*A
x2
B
ω 2A ω2
OA A
*A ω1 A
x1
x1
But *A *B A B
x1 + x1 < ω1 + ω1 xB
2
Trade
A
in Competitive Markets
x2
x*1B
B
xB ω1 OB
1
x*2B
*A
x2
B
ω 2A ω2
OA A
*A ω1 A
x1
x1
and *A *B A B
x2 + x2 > ω2 + ω2 xB
2
Trade in Competitive Markets
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
in Competitive Markets
x2 Which PO allocations can be
achieved by competitive trading?
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade in Competitive Markets
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
in Competitive Markets
x2 Which PO allocations can be
achieved by competitive trading?
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
in Competitive Markets
x2 Which PO allocations can be
achieved by competitive trading?
B
xB ω1 O
1 B
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
in Competitive Markets
x 2 Budget constraint for consumer A
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Trade
A
in Competitive Markets
x 2 Budget constraint for consumer A
B
xB ω1 OB
1
B
* A ω 2A
x2 ω2
OA A
*A ω1 A
x1
x1
xB
2
Trade
A
in Competitive Markets
x2
B
xB ω1 OB
1
B
* A ω 2A
x2 ω2
OA A
*A ω1 A
x1
x1
Budget constraint for consumer B xB
2
Trade
A
in Competitive Markets
x2 *B
x1
B
xB ω1 OB
1
x*2B
B
* A ω 2A
x2 ω2
OA A
*A ω1 A
x1
x1
Budget constraint for consumer B xB
2
Trade
A
in Competitive Markets
x2 *B
x1
B
xB ω1 OB
1
x*2B
B
* A ω 2A
x2 ω2
OA A
*A ω1 A
x1
x1
So *A *B A B
x1 + x1 = ω1 + ω1 xB
2
Trade
A
in Competitive Markets
x2 *B
x1
B
xB ω1 OB
1
x*2B
B
* A ω 2A
x2 ω2
OA A
*A ω1 A
x1
x1
and *A *B A B
x2 + x2 = ω2 + ω2 xB
2
First Fundamental Theorem of
Welfare Economics
Giventhat consumers’ preferences
are well-behaved, trading in perfectly
competitive markets implements a
Pareto-optimal allocation of the
economy’s endowment.
Second Fundamental Theorem of
Welfare Economics
Giventhat consumers’ preferences
are well-behaved, for any Pareto-
optimal allocation there are prices
and an allocation of the total
endowment that makes the Pareto-
optimal allocation implementable by
trading in competitive markets.
Second Fundamental Theorem
A
x2
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
The contract curve
xB
2
Second Fundamental Theorem
A
x2
*B B
xB x1 ω1 OB
1
*A *B
x2 x2
B
ω 2A ω2
OA *A A
x1 ω1 A
x1
xB
2
Second Fundamental Theorem
A Implemented by competitive
x2
trading from the endowment ω.
*B B
xB x1 ω1 OB
1
*A *B
x2 x2
B
ω 2A ω2
OA *A A
x1 ω1 A
x1
xB
2
Second Fundamental Theorem
A Can this allocation be implemented
x2
by competitive trading from ω?
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Second Fundamental Theorem
A Can this allocation be implemented
x2
by competitive trading from ω? No.
B
xB ω1 OB
1
B
ω 2A ω2
OA A
ω1 A
x1
xB
2
Second Fundamental Theorem
A But this allocation is implemented
x2
by competitive trading from θ.
xB θ1
B
OB
1
θ2
A
θ2
B
OA
θ1
A A
x1
xB
2
Walras’ Law
Walras’Law is an identity; i.e. a
statement that is true for any
positive prices (p1,p2), whether these
are equilibrium prices or not.
Walras’ Law
Every consumer’s preferences are
well-behaved so, for any positive
prices (p1,p2), each consumer spends
all of his budget.
For consumer A:
*A *A A A
p1x1 + p 2x 2 = p1ω 1 + p 2ω 2
For consumer B:
p1x*1B + p 2x*2B = p1ω 1B + p 2ω 2B
Walras’ Law
p1x*1A + p 2x*2A = p1ω 1A + p 2ω 2A
p1x*1B + p 2x*2B = p1ω 1B + p 2ω 2B
Summing gives
p1 ( x*1A + x*1B ) + p 2 ( x*2A + x*2B )
= p1 ( ω 1A + ω 1B ) + p 2 ( ω 2B + ω 2B ).
Walras’ Law
p1 ( x*1A + x*1B ) + p 2 ( x*2A + x*2B )
A B B B
= p1 ( ω 1 + ω 1 ) + p 2 ( ω 2 + ω 2 ).
Rearranged,
*A *B A B
p1 ( x 1 + x 1 − ω 1 − ω 1 ) +
p 2 ( x*2A + x*2B − ω 2A − ω 2B ) = 0 .
That is, ...
Walras’ Law
*A
p 1 ( x1 + x1
*B
− ω1
A
− ω1 ) +
B
p 2 ( x *2A + x *2B − ω 2A − ω B2 )
= 0.
This says that the sum of the excess
demands across market is zero for
any positive prices p1 and p2 --
this is Walras’ Law.
Implications of Walras’ Law