Intermediate Microeconomics

INTMMIE

Week 3
Theory of Competitive Markets

Dr. Harold Houba

Department of Economics
School of Business and Economics
Vrije Universiteit Amsterdam

September 2022

1
“Every individual ... intends only his own gain, and he is in this as in many
other cases led by an invisible hand to promote an end which was no part
of his intention. By pursuing his own interest he frequently promotes that
of society more effectually than when he really intends to promote it.”

Adam Smith, Wealth of Nations (1776).

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Overview

1 Partial Equilibrium in competitive markets

2 General Equilibrium

3 The pure exchange economy

The Edgeworth box
Competitive markets (Leon Walras)
Bargaining markets (Edgeworth)
Efficiency

4 Production

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 Section 1

Partial Equilibrium in competitive markets

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Partial equilibrium in competitive markets

So far, we have studied consumers and producers in isolation.

Now it’s time to bring them together on a market and let them interact.

The outcome of that interaction is referred to as a market equilibrium.

Because we look at one market in isolation, we call it partial equilibrium

After that we shall study multi-market settings, we call it general equilibrium.

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The model of partial equilibrium in competitive markets is the single most
used model of price determination.

We will mostly be interested in how changes in underlying market conditions

affect the equilibrium outcomes (price and output).

Moreover, we will be interested in how consumers and producers are affected

by these shocks (consumer surplus, profits and welfare effects).

Market shocks can be anything:

▸ Demand side: A fall in consumers’ income level, change in consumers’
preferences, etc.
▸ Supply side: A rise in the rental rate of capital, the introduction of a new
production technology, etc.

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The competitive paradigm

We assume that firms and consumers are active on a perfectly competitive

market. This means that:
▸ Firms (consumers) come in large numbers, and they behave so as to
maximize their profits (utility)
▸ Firms produce and sell standardised (homogeneous) products
▸ Each firm (consumer) is a price-taker in the input and output markets
▸ There are no market frictions (no transaction costs due to search,
contractual, etc. frictions)
▸ In long-run partial equilibrium, we also assume there is free entry into and
exit from the market.

Price-taking firms do not act strategically as in Monopoly or Oligopoly.

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When considering the effects of an exogenous shock, economists often make
use of the (partial) competitive model, even if the market in question is not
exactly perfectly competitive.

For example, if you ask economists about the effects of lower oil prices on
the price of airline tickets, most of them will answer this question having the
competitive framework in mind.

However, probably none of them believes the airline industry is perfectly

competitive! It’s just that on a first approximation the strategic issues (to
be studied during Advanced Microeconomics) that arise in imperfectly
competitive markets can be regarded of secondary importance.

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From a single consumer’s demand to market demand
In Week 1, we derived the utility maximizing (uncompensated) demand
function for a single consumer:

x ∗ = x(px , py , I )

Therefore, if there are n consumers market demand is given by:

n
QD = ∑ xi (px , py , Ii )
i=1

(Note: In this sum all consumers face the same market prices but they
typically vary in their incomes and utility functions.)

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 Date 27.02.2013

The market demand curve is the (horizontal) sum of the individual demand
> The market demand curve is the (horizontal) sum of the
curves.
individual demand curves.

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Own-price elasticity of the market demand

∂QD p
ϵQ,p =
∂p QD
Demand is said to be inelastic if −1 < ϵQ,p < 0, and elastic if ϵQ,p < −1.

Income elasticity of the market demand

∂QD I
ϵQ,p =
∂I QD
Cross-price elasticity of the market demand

∂QD p ′
ϵQ,p′ =
∂p ′ QD

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What about the market supply of firms?

We have to distinguish between the

Very short run:
▸ Production is fixed

Short run:
▸ Number of active firms is fixed, but they can adjust to changing market
conditions.
▸ Fixed costs are sunk

Long run:
▸ All inputs are flexible
▸ Number of active firms varies (entry/exit)

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 Very short run supply
Supply and equilibrium in the very short run

p QS

No supply response; products are E1

p1
already in the marketplace and will
be sold at any price E0
p0
Q’D
Supply curve is fully inelastic QD

Examples: perishable goods, houses

Q* Q

In 2022, Russia cut off 40% of the EU’s contracted annual gas
supply for geopolitical reasons concerning Russia’s war in Ukraine.
Then global markets suffered a severe reduction of Q ∗ and a surge
in the energy price as global supply needs time to adjust.

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The short-run market supply of a single firm
We have already seen that an individual competitive firm chooses an output level
such that p = MC (as long as p ≥ AVC ).
Because each firm is “small” relative to the market, each firm will sell all the units
it desires to sell at the market price.
The short-run market supply curve is thus the sum of the short-run supply curves
Date 27.02.2013
of all firms that are already active in the market.
Therefore, if there are m firms active, market supply is given by:
> The short-run market supply curve is the sum of the
short-run
m supply curves of all firms that are already active in
QS = ∑ qj (p, w , v )
the market.
j=1

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Price elasticity of the market supply

∂QS p
ϵQS ,p =
∂p QS

Remark: The market supply curve of Figure 12.3 of the textbook is also
interesting, because it features horizontal gaps. This may cause problems
of existence of a short run market equilibrium if the demand curve slides
through such a gap.
0 if p < 1 0 if p < 2
F.e. SA (p) = { , SB (p) = { , QD (p) = 4.5 − p.
p if p ≥ 1 p if p ≥ 2
Solution: impose additional assumptions such that an intersection point
exists.

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Market equilibrium > Bringing
in the together the short-run demand and sho
short-run
supply curve yields the short-run market equilib
Bringing together the>demand
(p ; Qand) represents
short-run supply curve yields since
an equilibrium, the for thi
short-run market (or Walrasian) equilibrium,
price-quantity which is denoted
combination quantity (p ∗ ; Q ∗ ).
by demanded
quantity supplied.
At the market equilibrium,
each firm maximizes profits
(p ∗ = MC )
each consumer maximizes utility
(given the budget constraint)
the market clears,
QD (p ∗ ) = QS (p ∗ ) (= Q ∗ )
But why is this called an equilibrium? At price p ∗ neither consumers nor
suppliers have an incentive to change their behavior!

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 Date 27.02.2013

Supply
Supply decision
decision of a of a single
single firm,firm andmarket
of the the market
and the market
equilibrium
equilibrium in the short-run
> At p , the aggregate supply of firms is such that supply
At equals
p ∗ , the market
aggregate supply equals
demand at p .aggregate demand.

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The individual supply of firm i is qi∗ . The firm obtains positive profits.

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Analysis of supply and demand shocks
Let the demand be written as

QD (p, α),

where α is a parameter that captures shifters of the demand curve (e.g.

income level, preferences, etc.).
∂QD /∂p < 0, but ∂QD /∂α depends on the type of demand shock and can
thus have any sign.

Likewise, let the supply function be written as

QS (p, β),

where β is a parameter that shifts the supply curve (e.g. input prices,
technological progress, etc.)
∂QS /∂p > 0 but ∂QS /∂β can have any sign.

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In equilibrium, QD (p, α) = QS (p, β).
We can now introduce a demand or supply shock by changing α or β.
Let’s consider a shift in demand (α), holding supply (β) constant.
Differentiate the eq. condition wrt. α yields:
∂QD ∂p ∂QD ∂QS ∂p
+ =
∂p α ∂α ∂p α

Solving for the impact on the equilibrium price gives:

∂Q
D ∂QD
∂p
= − ∂QD ∂α ∂QS = ∂QS
∂α
∂α ∂p
− ∂p ∂p
− ∂Q
∂p
D

The denominator of this expression is clearly positive. Therefore the sign of

the impact of the demand shock depends on the sign of ∂QD /∂α.

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Using “back of the envelope calculations” to be able to tell more
than “the journalist”
We can write the previous expression on the impact of a demand shock in
elasticity terms as follows:

∂p α ϵQD ,α
ϵp,α = =
∂α p ϵQS ,p − ϵQD ,p

These elasticities are often known from empirical studies.

Example: Suppose that the income elasticity of demand for smartphones
equals 4, the price elasticity of demand for smartphones is −1.5 and the
price elasticity of supply for this market is given by 0.5. Then
4
ϵp,α = = 2,
0.5 − (−1.5)

which means that a 1 percent increase in consumers’ incomes shall lead to a

2 percent increase in the equilibrium price of smartphones.
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The (free-entry) long-run equilibrium

Aggregate supply in the free-entry long-run

In the long run, there are three main forces that determine the market
supply:

▸ Firms still maximize profits, so p = MC .

▸ Firms can adjust all their inputs, so we need to use long-run cost curves.
▸ Entry/exit depending on the profit opportunities in the market, that is, we
need to allow the number of firms n to vary with market conditions.

In this discussion, we will have to distinguish between the symmetric firms

case and the asymmetric firms case.

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Free-entry long-run competitive equilibrium
As long as firms make profits or losses, entry or exit will occur (as it is
assumed that entry and exit are costless).

Only when profits are zero, i.e. when p = AC of the last entrant, no
additional firm will have an incentive to enter or leave the market.

A competitive market is in free-entry long-run equilibrium if

▸ All the conditions for the short-run competitive equilibrium are fulfilled,
▸ and p = AC for the firm at the margin (zero-profits (free entry) condition).

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Since in the free-entry long-run market equilibrium p = AC = MC for the
marginal firm, this firm (or actually all of them in the symmetric firms case)
Date 27.02.2013

operates at the minimum of the long-run average cost curve: minimum

> Since in the long-run equilibrium p = AC = MC, each firm
efficient scale
operates at the minimum of the long-run average cost
curve: minimum efficient scale

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Free-entry adjustment in long-run market equilibrium with
symmetric firms
Suppose initially we are in long-run equilibrium at (p1 , Q1 )
Suppose price rises to p2 (e.g. due to a preference shock, i.e. a shift in
Date 27.02.2013

demand from D to D ) ′
Short-run equilibrium: positive demand shock
the production of each individual firm will increase from q1 to q2 ; for this
> Inlevel
output the short run,
p2 > AC price
, so rises
firms willtomake
p2 and the output
a profit level of
(temporarily).
each firm to q2 ; p2 > AC, firms make a profit.

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 Date 27.02.2013
The observation that firms make money is an invitation to other (similar,
symmetric) firms to enter the market.
Long-run equilibrium: positive demand shock
The entry of new firms will shift the industry supply outwards
> This induces entry of new firms in the long run (the
Firms short-run supply
will continue curveuntil
to enter shifts outward)
again p = MC = AC .
> Firms will enter until p = MC = AC.

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 As a result, the free-entry long-run market supply curve in the symmetric
firms case is fully elastic! Date 27.02.2013

This case is also called the constant cost industry because as firms enter the
> The long-run supply curve for a constant cost industry is
average industry cost remains the same.
fully elastic!

The free-entry long-run market equilibrium number of firms (assuming

symmetric firms) is given by 37

n1 = Q1 /q1 before the demand shock.

n2 = Q3 /q1 after the demand shock.
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Constant cost industry vs. increasing cost industries
In the previous slides we have assumed that firms are symmetric. As a
result, entry of new firms does not affect the average unit cost.
This assumption is also referred to as constant cost industry assumption.
For such an industry, the free-entry long-run market supply curve is flat.
Suppose now that firms are asymmetric. In such a case, entry of new firms
increases the average cost of the industry because the pool of firms active in
the industry contains a higher proportion of high cost firms.
This case is called the increasing cost industry case. In this case, the
free-entry long-run market supply function is upward sloping.
These two situations can also be explained in terms of input price pressure. Even if we
have symmetric firms, if the entry of new firms does not affect input prices, the average
cost of a typical firm, and that of the industry, will remain constant. This would be the
constant cost industry case.

The increasing cost industry case obtains when entry of new firms shifts up the average
cost of all firms due to increasing input prices.

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Free-entry adjustment in an increasing cost industry
Date 27.02.2013
As before, assume the initial free-entry long-run market equilibrium is
(p1 , Q1 ), with a number of firms n1 = Q1 /q1 .
Increasing cost industry
If there is a positive demand shock, the short-term effect is to raise the
> If there is
equilibrium a positive
price from p1demand shock,
to p ′ and firmsthe short-run
start making a positive profit.
equilibrium price becomes p0 and firms make a profit...

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New, less efficient, firms are attracted to the market.
As a result, as firms enter, the cost curve of the marginalDateproducer
27.02.2013
is higher
and higher.
Increasing
A cost industry
new equilibrium is established where the price is (p2 , Q2 ).
> Thus,
Thus, the the long-run
free-entry marketmarket
long-run supplysupply
curve S LR is S
curve upward
LR is upward sloping.
sloping

42

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What about decreasing cost industries?

Perhaps economists argue that decreasing cost industries are impossible,

because more cost-efficient firms enter last instead of first.

However Big Tech and disruptive firms are said to have economies of scale
(or IRS). How does that work out?
Well, the marginal cost curve will be decreasing.
Marginal cost pricing results in a loss for the industry. Why?
Possible resolution two-part tariffs: Fixed fee plus unit price.
F.e. network costs of energy supply is a lump-sum fee to recover costs.

Thesis topic?

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Welfare in a competitive equilibrium
Can we say something about the level of well-being of ALL consumers and
ALL producers together when the market is at equilibrium?

Yes! We can use the notions of consumer’s surplus (CS) and producer’s
surplus (PS).

The sum of the two is usually called social welfare:

SW = CS + PS

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 Date 27.02.2013

We know that aggregate consumer surplus can be well approximated by the

> below
area We know that consumer’s
the market surplus
(Marshallian) can be
demand measured
curve by the
and above the price:
area below the demand curve and above the price:
p̄
CS = ∫ Q (p)dp Z p̄
D
pm CS = QD (p)dp
pm

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The producer surplus will be equal to 0 in free-entry long-run equilibrium
with symmetric firms.
But in the more general case of asymmetric firms, producer surplus will be
given by the area below the market price and above the long-run market
supply curve. This producer surplus captures the collective profits obtained
Date 27.02.2013

by all the inframarginal firms.

The producer’s surplus is the area below the market price and
abovepmthe supply curve:
Z pm
PS = ∫ Qs (p)dp
p0 PS = Qs (p)dp
p0

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Welfare analysis
Date 27.02.2013
In the LR comp. equilibrium, social welfare is maximized. In the SR, it is
also maximized
Welfare but conditional on the existing number of firms.
analysis
At p c , the value of the item to the last consumer who buys it equals the MC
> In the LR comp. equilibrium, social welfare is maximized.
the last firm who produces incurs to make it: all beneficial trades are
> At pc , marginal value of last consumer who buys equals MC
exhausted.
of last unit produced: all beneficial trades are exhausted.

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Tax incidence analysis

Given that the long-run competitive equilibrium maximizes welfare, we can

study the welfare effects of government intervention.

One of the most important applications of the partial equilibrium model of

competitive markets is the tax incidence analysis: To what extent does a tax
on a good fall on consumers and firms?

As we will see, this largely depends on the price elasticities of supply and
demand

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 Consider a per unit tax t on a particular good; this tax drives a wedge
between what consumers pay, which is the equilibrium price p ∗ and what
producers receive, which is p ∗ − t.
Still, in market equilibrium we must have:

QD (p ∗ ) = QS (p ∗ − t)

Differentiation this equality wrt. t yields:

∂QD dp ∗ ∂QS dp ∗ ∂QS

= − ,
∂p ∗ dt ∂p ∗ dt ∂p ∗

Recall dP/dα analysis of D(P, α) = S(P, β). Here you may take β = t and
we are analyzing dP/dβ. The book and slides do not contain the dP/dβ
analysis, but there is enough guidance for you how to proceed.

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Isolating ∂p ∗ /∂t gives:

∂p ∗ ∂QS /∂p ∗
=
∂t ∂QS /∂p ∗ − ∂QD /∂p ∗

This equality can be rewritten using elasticities as follows (do it!):

dp ∗ ϵQS ,p
= ,
dt ϵQS ,p − ϵQD ,p

where ϵQS ,p and ϵQD ,p denote the price elasticities of supply and demand,
respectively.

This formula tells us what the (marginal) change in the consumer price is
due to a (marginal) change in the tax rate.

If the price elasticity of demand is low (relative to the price elasticity of

supply), ∂p ∗ /∂t is close to 1: burden of the tax falls to a large extent on
consumers.

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 Date 08.03.2013

Graphical analysis
Graphical of taxofincidence
analysis when when
tax incidence demand is relatively
demand is
inelastic
inelastic

7
Burden of the tax falls to a larger extent on consumers.

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 Date 08.03.2013

Tax generates revenues for the government

> Tax generates revenues for the government

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 Date 08.03.2013

Efficiency (“deadweight”) loss since output is lower than the competitive

> Efficiency (“deadweight”) loss since output is lower than the
output
competitive output

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 Date 08.03.2013

Graphical analysis of tax incidence when demand is

Graphical
elastic
analysis of tax incidence when demand is relatively elastic

10

Burden of the tax falls to a larger extent on producers.

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 Date 08.03.2013

Tax revenues are reduced due to larger restriction in output

> Tax revenues are reduced due to larger restriction in output

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 Date 08.03.2013

> Due to the larger drop in output, deadweight loss is also

Due to the larger drop in output, deadweight loss is also higher
higher

12

43
 Section 2

General Equilibrium

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General equilibrium

During the last class we presented the notion of market equilibrium for one
market in isolation (Ch. 12).
This was called partial equilibrium analysis.
A very important result from partial equilibrium analysis is that in
competitive settings the market equilibrium is efficient, i.e. it maximizes the
sum of consumer and producer surplus.
Economies however consist of many markets, all of them open to conduct
transactions at the same time.
Except in very special cases, what happens in one market does have
repercussions on what happens in other markets.
General equilibrium (Ch. 13) is an approach for understanding equilibrium in
multi-market settings.

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Main question: can we get some sort of harmony in an economy full of
self-interested individuals that can participate in various markets?

How is this harmony achieved?

Is this harmony efficient? Under which conditions?

Is it equitable? Is there a trade-off between equity and efficiency?

How can we move across consumer and producer allocations in order to

maximize welfare in the economic system? What is the cost of doing that?

General equilibrium and welfare analysis enable us to address these sorts of

important questions.

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 Section 3

The pure exchange economy

47
 Subsection 1

The Edgeworth box

48
The pure exchange economy

Economists Francis Edgeworth and Arthur Bowley devised a diagram,

called the Edgeworth box, to study general equilibrium in a simple
economy in which buyers are endowed with different bundles of goods and
can exchange them

There isn’t production. Ignoring production is obviously unrealistic but

The pure exchange economy is the simplest possible setting in which we
can show the insights and the methods from general equilibrium theory.

We shall extend the framework by allowing for production later on.

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Consider the following 2x2 pure exchange economy :

▸ Two consumers: A and B and two markets: the market for good x and the
market for good y .
▸ Each consumer has an initial endowment of goods; let ω i denote the initial
endowment for consumer i:

ω i = (ωxi , ωyi ) , i = A, B
▸ There is no production, but these endowments can be traded.
▸ Strictly speaking, consumers do not have income but have goods and these
goods can be traded to get “income”.
▸ Consumer’s “income” thus obtains from “selling” the initial endowment at
the market prices, or from exchanging it at some bargained deals.

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 No production, so total amounts of goods x and y in the economy equal the
sum of endowments:

ωx = ωxA + ωxB and ωy = ωyA + ωyB

Example
If the initial endowments of A and B are

(ωxA , ωyA ) = (4, 1) and (ωxB , ωyB ) = (2, 3),

the total amounts of goods x and y in the economy are

ωx = 6 and ωy = 4

If px = 1 and py = 2, the de facto levels of wealth are

IA ≡ px ωxA + py ωyA = 6
IB ≡ px ωxB + py ωyB = 8

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As mentioned, we are interested in:

▸ What are all the feasible ways to allocate these goods?

▸ What is the equilibrium allocation of these goods, given the initial

endowments?

▸ Is the equilibrium allocation “efficient”?

▸ Does efficiency say anything about whether the equilibrium distribution of

wealth in an economy is equitable?

▸ If we like a particular allocation, can we get the economy to move there?

How? And at what cost?

52
Let us construct an Edgeworth box for our simple economy and study the
above questions.

The length of this box is ωx : the economy’s total endowment of good x.

The height of this box is ωy : the economy’s total endowment of good y .
Amounts of goods allocated to A can be measured using the southwest
corner of the box as the origin (OA ).
Amounts allocated to B can be measured using the northeast corner of the
box (OB ).

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The Edgeworth box

The Edgeworth box depicts all feasible allocations in the economy.

54
Any allocation of goods between the two consumers can be represented by a
point in the box (e.g. see allocation z = {{zxA , zyA }, {zxB , zyB }}).

55
Initial endowment

One particular allocation is the starting point: the initial endowment ω.

56
For example:

(ωxA , ωyA ) = (4, 1) and (ωxB , ωyB ) = (2, 3),

57
Reallocations

A trade from one feasible allocation to another is called a reallocation (e.g.

a move from allocation ω to allocation z).

Starting form the endowment point, are reallocations desirable? This will
depend on how individuals like the current allocation and on whether there
are gains from trade.

To see this, let us add preferences and prices to the Edgeworth box.

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Adding preferences to the box

Every allocation provides some utility to each consumer. We can show this
by drawing maps of indifference curves in the Edgeworth box.

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Given initial endowments and the preferences of the individuals, will
any trade occur?

Trade will occur if there are mutual benefits. Which trades will realize will depend
on the trading institution.
competitive markets (Walrasian equilibrium, agents adapt choices to given
prices)
bargaining (Edgeworth equilibrium, agents negotiate, no prices)
60
 Subsection 2

Competitive markets (Leon Walras)

61
Adding prices to the box

Suppose the price for good x is px and the price for y is py .

Agents are price takers: this means that they do not choose prices
themselves
Market prices create trading opportunities: individuals can sell their
endowments to make money which they can in turn use to buy products.
This idea defines individuals’ budget sets, or affordable sets:
combinations of amounts of goods x and y that are affordable for the
individuals at the given prices px and py :

Bi (px , py ; ωxi , ωyi ) ≡ {(xi , yi ) ≤ (ωx , ωy ) ∣ px xi + py yi ≤ px ωxi + py ωyi }

62
We can depict the budget sets in the box.
The blue area is the budget set of A (denoted BA (⋅)); the green area is the
one of B (denoted BB (⋅)).

The border of each set is the budget line that goes through the initial
endowment point.
The budget line has slope −px /py , the ratio of market prices.
63
Trading in competitive markets

Facing prices px and py , the problem of individual i = A, B is:

max U i (xi , yi )
xi ,yi

subject to px xi + py yi = px ωxi + py ωyi ≡ I i Saves time!∗

´¹¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¸¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¶
value of endowment

The Lagrangian is:

L(xi , yi , λ) = U i (xi , yi ) + λ(I i − px xi − py yi )

and the FOCs:

∂U i
− λpx = 0
∂xi
∂U i
− λpy = 0
∂yi
px xi + py yi = I i (= px ωxi + py ωyi )
∗
The market value of the endowments plays the role of income I .
64
Manipulating the first two equations, we get the usual condition

MUxi px
MRS i = = .
MUyi py

Agent i’s utility maximization yields her Marshallian demands

xi (px , py , ωxi , ωyi ) and yi (px , py , ωxi , ωyi ),

which in this case they are functions of her endowment (ωxi , ωyi ).

Example: CD utility function U i (xi , yi ) = (xi )α (yi )β has demand function

α px ωxi + py ωyi
xi (px , py , ωxi , ωyi ) = ⋅ etc.
α+β px

65
Trading in competitive markets (graph)

Given the price ratio, A’s demand for goods x and y should be such that

MUxA px
MRS A = =
MUyA py

Agent A’s utility maximization indicates that A wishes to move to allocation A.

This means that A would like to sell some units of good x: ωxA − xA . And buy
some units of good y : yA − ωyA . Often called ”net demands”

66
Demand functions and offer curves
The demand of an individual depend on the relative prices. By changing
relative prices, we can obtain the loci of utility-maximizing bundles of goods.

When good y is more expensive than before, agent A wishes to buy fewer
units of good y and to sell less units of good x (move from ω to A′ ).

67
 The curve connecting different utility-maximizing consumption bundles ω, A′
and A for different prices is called the offer curve.

OFFER%CURVE%

(The offer curve is obtained in a similar way as a demand curve but notice
they are not quite the same thing.)

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General Equilibrium

In the model of the exchange economy presented above, a general (or

Walrasian) equilibrium is a vector of prices p ≡ (px , py ) for which:
1 individuals maximize utility given market prices and value of their
endowments
⇒ individual demand is Marshallian demand
2 all markets clear, that is Marshallian demand equals supply:

xA (px , py , ωxA , ωyA ) + xB (px , py , ωxB , ωyB ) = ωxA + ωxB

´¹¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹¸ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¶ ´¹¹ ¹ ¹ ¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹ ¹ ¹ ¶
Marshallian demand for good x fixed supply for good x

yA (px , py , ωxA , ωyA ) + yB (px , py , ωxB , ωyB ) = ωyA + ωyB

´¹¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹¸ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¹ ¶ ´¹¹ ¹ ¹ ¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹ ¹ ¹ ¶
Marshallian demand for good y fixed supply for good y

Example on next slide

69
Example of General Equilibrium
α (px ωx +py ωy )
i i
U i (xi , yi ) = (xi )α (yi )β ⇒ xi (px , py , ωxi , ωyi ) = α+β px , etc.

Suppose α = β = 12 , ωxA = 7, ωyA = 3 and ωxB = 3, ωyB = 7.

1 Utility maximization implies Marshallian demand functions:

7px +3py 3px +7py
xA (px , py , 7, 3) = 2px
, xB (px , py , 3, 7) = 2px
,
7px +3py 3px +7py
yA (px , py , 7, 3) = 2py
, yB (px , py , 3, 7) = 2py
.

2 All markets clear:

7px +3py 3px +7py
xA (px , py , 7, 3) + xB (px , py , 3, 7) = 2px
+ 2px
= 10 = ωxA + ωxB ,

7px +3py 3px +7py

yA (px , py , 7, 3) + yB (px , py , 3, 7) = 2py
+ 2py
= 10 = ωyA + ωyB .

We postpone solving for equilibrium prices and allocations

70
 In a general equilibrium framework, only relative prices do matter.
▸ This follows from Walras’ law (see later)
px w
▸ Relative prices are signals of relative scarcity. recall MRS = py
, RTS = v

Because demand functions are homogeneous of degree zero, we can always

rescale prices without changing the general equilibrium.
▸ the price of one of the goods is often set equal to 1. This good is called the
numéraire good.
▸ For the two-good case only, we may define the relative prices p ≡ px /py .

Example: Division by the prices in the denominators yields:

7px +3py 3px +7py 7 3 py 3 7 py py
2px + 2px = 2 + 2 px + 2 + 2 px = 10 ⇒ px = 1,
7px +3py 3px +7py 7 px 3 3 px 7 px
2py + 2py = 2 py + 2 + 2 py + 2 = 10 ⇒ py = 1.

Alternatively, numéraire py = 1 ⇒ px = 1 follows in both equations.

It may be surprising that two equations with two unknowns, px and py ,
do not yield a pair of prices, but only a relative price p.

71
 The general equilibrium allocation is denoted ((xA∗ , yA∗ ), (xB∗ , yB∗ )) and is
given by the demands evaluated at the equilibrium price ratio:

xA∗ = xA (p ∗ , ω A ), yA∗ = xA (p ∗ , ω A ),
xB∗ = xB (p ∗ , ω B ), yB∗ = xB (p ∗ , ω B ).

Example (continued): Recall p ∗ = 1 is the general equilibrium price ratio.

Then,

xA∗ = xA (p ∗ , ω A ) = 7 3 1
2 + 2 p∗ = 5, yA∗ = xA (p ∗ , ω A ) = 5,
xB∗ = xB (p ∗ , ω B ) = 7 ∗
2p + 2
3
= 5, yB∗ = xB (p ∗ , ω B ) = 5.

A consumes bundle (xA∗ , yA∗ ) = (5, 5) and B consumes (xB∗ , yB∗ ) = (5, 5).
GE allocation ((xA∗ , yA∗ ), (xB∗ , yB∗ )) = ((5, 5), (5, 5)) is a pair of bundles.
Both markets clear.

72
The previous example with ppyx = 1 was atypical in that the choice of the
numéraire good did not matter. Consider a price ratio of 2.

px
For py = 2, if good x is the numéraire, then we set px = 1 and obtain
py = 12 ; if good y is the numéraire, then we set py = 1 and obtain px = 2.

73
General Equilibrium: Demand equals supply on both markets

Theorem: A Walrasian equilibrium exists when consumers have com-

plete, transitive, continuous, monotone and strictly convex prefer-
ences.

74
Walras’ Law

For calculating general equilibrium prices and its allocations the previous
slides provide sufficient guidance.
But for understanding why we cannot escape general equilibrium price ratios
instead of a pair of prices we need to discuss Walras’ Law,
named after Leon Walras (1834-1910)
†
https://en.wikipedia.org/wiki/Leon_Walras
Leon Walras brought the right-hand side to the left-hand side and obtained:

xA (px , py , 7, 3) + xB (px , py , 3, 7) − ωxA − ωxB = 0,

yA (px , py , 7, 3) + yB (px , py , 3, 7) − ωyA − ωyB = 0.

The obtained left-hand sides are called excess demand functions.

What can we learn from excess demand functions?

†
According to Joseph Schumpeter: ”the greatest of all economists”.
75
Denote ω A = (ωxA , ωyA ), ω B = (ωxB , ωyB ) and allocation ω = (ω A , ω B ).
Recall the relative price p ≡ px /py .
Let us define the excess demand functions for x and y as a function of the
relative price p and the initial endowments ω:

EDx (p, ω) = xA (p, ω A ) + xB (p, ω B ) − ωxA − ωxB

EDy (p, ω) = yA (p, ω A ) + yB (p, ω B ) − ωyA − ωyB

Economic interpretation:
If EDx > 0, then the demand for good x is larger than its supply; if EDx < 0
the supply for good x is larger than its demand; and if = both are equal.
Similar for good y .
Obviously, price ratio p ∗ is a general equilibrium price ratio if

EDx (p ∗ , ω) = 0 and EDy (p ∗ , ω) = 0.

As before, demand equals supply on both markets / both markets clear.

76
Why are excess demand functions of interest?
▸ It expresses economic intuition:
if the relative price for good x is too low, demand will be larger than supply
(EDx > 0) and the (unmodeled) market forces of supply and demand will
lower the relative price.
Similar if the relative price is too large (EDx < 0).
▸ It enabled Computable General Equilibirum (not this course):
It allowed to program software
https://en.wikipedia.org/wiki/Computable_general_equilibrium
You may develop a simple tool in excel, R, Python, etc. As long as EDx > 0,
slightly lower p, as long as EDx < 0 slightly raise p. Stop if EDx = 0.

The general equilibrium allocation is denoted ((xA∗ , yA∗ ), (xB∗ , yB∗ )) and is
given by the demands evaluated at the equilibrium price ratio:

xA∗ = xA (p ∗ , ω A ), yA∗ = xA (p ∗ , ω A ), xB∗ = xB (p ∗ , ω B ), yB∗ = xB (p ∗ , ω B ).

77
Quizz 1: Observe the figure below. Individual A maximizes her utility, and
B too. Is the ratio of prices shown a competitive equilibrium?

78
Answer Quizz 1:
NO! Clearly, this is not an equilibrium.

A’s demand is given by (xA , yA ) and B’s demand is (xB , yB ).

Given these choices, there is excess demand for good x and excess supply of
good y :

xA + xB > ωx and yA + yB < ωy .

or

EDx (p, ω) > 0 and EDy (p, ω) < 0.

The last result is a general result (as we will see later)

79
Another Example:

Consider an exchange economy with two goods, x and y , and two

consumers, A and B.
Initial endowments of the agents are

ωA = (1, 1) and ωB = (1, 1).

The indirect utility functions of the consumers are given by:

vA (px , py , I A ) = log [I A ] − a log[px ] − (1 − a) log[py ] a ∈ (0, 1)

B B
vB (px , py , I ) = log [I ] − b log[px ] − (1 − b) log[py ] b ∈ (0, 1)

where I A and I B denote ”market income” (originating from ”selling” the

individuals’ endowments).

Quizz 2: Calculate the market clearing prices and the general equilibrium
allocation.

80
Answer Quizz 2:

First use Roy’s theorem to calculate Marshallian demands.

(Or expenditure function, Shephard and Marshallian demand functions.)
Notice that I A = I B = px + py , i.e, income obtained from selling the
endowments at market prices.
For individual A, we get:

∂V /∂px −a/px aI A a(px + py )

x A (p, ω) = − = − = = ,
∂V /∂I A 1/I A px px

∂V /∂py −(1 − a)/py (1 − a)I A (1 − a)(px + py )

y A (p, ω) = − = − = =
∂V /∂I A 1/I A py py
For individual B, similarly,

bI B b(px + py ) B (1 − b)I B (1 − b)(px + py )

x B (p, ω) = = , y (p, ω) = = .
px px py py

81
Next, set demand equal to supply (or excess demands equal to zero)
and solve for p = px /py , the general-equilibrium relative price.

As before, take good x. There are two units of this good, or:
py bpy
a+a +b + =2
px px
´¹¹ ¹ ¹ ¹ ¸¹ ¹ ¹ ¹ ¹ ¶ ´¹¹ ¹ ¹ ¹ ¹¸¹ ¹ ¹ ¹ ¹ ¹¶
x A (p,ω) x B (p,ω)

Solving for the inverse price ratio py /px = p −1 yields

py 2 − a − b
> 0 ⇒ p∗ =
a+b ‡
= .
px a+b 2−a−b
The competitive allocation follows from plugging the inverse price ratio
into the demand functions:
2a 2(1−a) 2b 2(1−b)
(x A , y A ) = ( a+b , 2−a−b ) (x B , y B ) = (2 − x A , 2 − y A ) = ( a+b , 2−a−b ) .

‡
Both 0 < a < 1 and 0 < b < 1 imply 2 − a − b > 0
82
Walras’ Law At last!!!

For any vector of prices, the value of the aggregate excess demand
equals zero.

Premultiplying the vector of excess demand functions by the price vector:

px EDx + py EDy (= value excess demand)

= px (xA + xB − ωxA − ωxB ) + py (yA + yB − ωyA − ωyA )

= px xA + px xB − px ωxA − px ωxB + py yA + py yB − py ωyA − py ωyA
= (px xA + py yA − px ωxA − py ωyA ) + (px xB + py yB − px ωxB − py ωyB )

= (px xA + py yA − I A ) + (px xB + py yB − I B )
= 0 + 0,

because, for each consumer, demand satisfies the budget constraint.

83
First implications of Walras’ Law

In the two-goods case: if in one market demand equals supply then it must
be true that in the other market demand equals supply as well!

If EDx = 0 (demand for x equals supply) ⇒ EDy = 0.

Proof. Since

px EDx + py EDy = 0 (Walras’ law)

and px , py > 0, it must be the case that EDy = 0 holds, so demand equals
supply on market y as well. QED

If demand equals supply in n − 1 markets, then demand equals

supply in the nth market as well.

84
Second implications of Walras’ Law

Recall answer Quizz 1:

Disequilibrium with opposite signs EDx > 0 and EDy < 0.
A second implication of Walras’ Law in the two good case is that an excess
supply in one market implies an excess demand in the other market.

If EDy > 0 (demand for x equals supply) ⇒ EDx < 0.

Proof. Since

px EDx + py EDy = 0 (Walras’ law)

EDy > 0 and px , py > 0, it must be the case that EDx < 0 holds. QED

If demand is larger than supply in one of n markets, then supply

is larger than demand in at least one of the other n markets.

85
 Subsection 3

Bargaining markets (Edgeworth)

Only first two slides of this subsection will be part of the exam!!

86
Walrasian equilibrium does not really explain price formation: individuals are
price takers and adjust consumption to the prevailing prices.
Where do the prices come from? Walrasian model only tells us that
equilibrium prices exist.
Economists often refer to a fictitious Walrasian auctioneer as a
“mechanism” to have prices adjusted towards equilibrium.
An alternative is to think that individuals bargain in an economy without
prices. In the so-called Edgeworth equilibrium individuals engage in
negotiations.
Edgeworth’s approach to equilibrium predicts that there are many outcomes,
but as we increase the number of individuals the set of outcomes shrinks and
approaches the Walrasian equilibrium.

87
 Definition: The core (or Edgeworth equilibria) of our 2x2 economy is the set
of allocations that could be the outcome of a “reasonable” negotiation
process between the 2 agents.

An allocation A belongs to the core if there does not exist another allocation
B for which no agent is worse off and at least one of the two individuals is
better off in B than in A.

Graphical representation of the core:

OB
▸ w initial endowment

u2B
▸ z would be agreed upon by B and A
u2A
▸ but A would not stop there and propose
allocation q
q
core
▸ allocations in the core have indifference curves
z
back-on-back
w

OA

Note that the competitive equilibrium is included in the core.

88
Reconciling the Walrasian approach and the Edgeworth view.
Not pat of the exam
As the number of agents increases, the set of allocations in the core
shrinks till we are left, in the limit, with the competitive equilibrium.

Replica economy: Consider there are two types of consumers and an equal
number N of consumers of each type. Consumers in each group have the
same endowment and the same preferences.

An allocation is in the core of the replica economy if there does not exist a
(sub-)group of agents that can improve upon the given allocation without
affecting the rest of the agents.

It is possible to prove the following. Fix N and take a point in the core
that is not a Walrasian equilibrium. Then this allocation drops out of the
core when we make N sufficiently large.

89
Illustrating the shrinking core
Not pat of16.the
Chapter exam
General Equilibrium

Start with the core for a 2-agents (individuals 1 and 2) economy.

Graph 16.11: EndisPoints

Initial endownment pointof Core
E =no{(1.5,
Longer in
9),the(11.5,
Core as1)}.
the Economy Expands

The core is the green segment connecting points A and B.

90
Consider now the replica
Chapter economy with 2 individuals type-1 and 2 individuals
16. General Equilibrium 565

type-2.

Let us show thatGraph 16.11: End Points of Core no Longer in the Core as the Economy Expands
allocation A is not anymore in the core.

In fact, the coalition of 3 individuals {1, 1, 2} will “block” the allocation A:

good for every one x2 good they each receive. This implies that individual 2 would agree to accept 2 x1
goods in exchange for two x2 goods because there are two of “type 1” and one of “type 2”. Any trade that is
Starting from
madeE , each
under type-1
these terms person
then implies that the can give
new “type 4 units
2” allocation (afterof
the good x2 astofarthe
trade) is twice from Etype-2 individual,
who will in on the budget
turn giveline2.5
(that incorporates
units ofthexproposed terms of trade) as the new “type 1” allocation.
1 to each of the type-1’s.
Suppose, then, that the subgroup composed of two “type 1” and one “type 2” individuals agrees to trade in
such a way that “type 1” individuals end up at C and the “type 2” individual ends up at D (which is twice as far
This reallocation
from E as C results in greater
) in Graph 16.11. utility
Again, this is logically for the
possible 3 three-person
for this parties coalition;
involved they are insimply
the coalition (type-1
reallocating what they had at point E. But this means that the “type 1” individuals will end up moving to the blue
agents moveindifference
from E
curve to
whilepoint C
the one “type and
2” type-2
individual agent
moves to the magentamoves form
indifference curve; E to
i.e., all D).
three indi- The other type-2
viduals in the coalition are better off after trading with each other than than they would be at point A. Thus, the
individual isallocation
not at point A is not in the core for the four-person economy even though it is in the core for the two-per-
affected.
son economy. Economists would say that “the coalition of two ‘type 1’ individuals and one ‘type 2’ individual
blocks the proposed allocation A,” and they would refer to this coalition as a blocking coalition. 91
 The previous slide shows that allocation A cannot be in the core of the
4-persons economy.

By the same token, point B cannot be either, it would be blocked by the

3-persons coalition {1, 2, 2}. Do it!

The core of the 4-persons economy is then a subset of the core of the
2-persons economy.

When we have more agents of each type, there are more coalitions that can
be formed, and this increases the likelihood that an allocation is blocked.

Theorem: when the number N of agents of each type goes to infinity,

the only allocation left is the same as the one corresponding to the
Walrasian equilibrium.

92
Subsection 4

Efficiency

93
Efficiency of an allocation

To study the welfare properties of allocations (and of the equilibrium

allocations in particular), we need to introduce a couple of concepts:

Pareto improvement: it occurs after a re-allocation that makes no one worse

off and at least one individual strictly better off.

Pareto efficiency : An allocation is Pareto efficient when no one can be made

better off without making someone else worse off (i.e., a Pareto
improvement is not possible any more).

94
Let’s go back to our initial endowment point in the Edgeworth box.
Is the initial endowment Pareto efficient?

95
Clearly not! All allocations in the grey area lead to a Pareto improvement
compared to the initial endowment.

96
Take now one of the allocations in the grey area. Is it Pareto efficient?
▸ Not necessarily! As long as MRS A ≠ MRS B , a Pareto improving reallocation
is again possible.

Only when MRS A = MRS B , the allocation is such that no one can be made
better off without making someone else worse off.

For an allocation to be Pareto efficient, it must be the case that

MRS A = MRS B .

Definition: The contract curve (or Pareto set) consists of all the Pareto
efficient allocations.

97
The contract curve

The black solid line represents the contract curve.

98
Finding (mathematically) the Pareto efficient allocations

For Pareto efficiency we need to solve the problem It returns later!!

max U A (xA , yA ) (1)

xA ,yA ,xB ,yB

subject to
U B (xB , yB ) = U
xA + xB = ωx
yA + yB = ωy

This is equivalent to maximizing the Lagrangian

L(xA , yA , xB , yB , λ1 , λ2 , λ3 ) = U A (xA , yA ) + λ1 (U − U B (xB , yB ))+

λ2 (ωx − xA − xB ) + λ3 (ωy − yA − yB )

(Let op! Attention! Pass auf! Attenzione!: No prices here!)

99
The FOCs:
∂U A
− λ2 = 0
∂xA
∂U A
− λ3 = 0
∂yA
∂U B
−λ1 − λ2 = 0
∂xB
∂U B
−λ1 − λ3 = 0
∂yB

plus the constraints.

Combining the first two and the second two gives
λ2 ∂U A /∂xA ∂U B /∂xB λ2
= = λ3 reads as a price ratio
λ3 ∂U A /∂yA ∂U B /∂yB
which demonstrates that an allocation is in the Pareto set if and only if

MRS A = MRS B .
100
Competitive equilibrium, the core and efficiency
What do we know about the efficiency of an equilibrium allocation?

Since each consumer faces the same relative prices, we get:

px
MRS A = = MRS B Ô⇒ MRS A = MRS B
py

For allocations in the core we also concluded that the indifference curves had
to be back-on-back.

A B
So MRSx,y = MRSx,y holds for every Pareto efficient allocation, for every
allocation in the core and for every Walrasian equilibrium.

101
First Fundamental Theorem of Welfare Economics:

Every General Equilibrium is Pareto efficient.

This theorem also holds true when production takes place in the economy
(we will see this later).
For the result we need that there exist markets for all goods, that all goods
are private, and that consumers have quasi-concave utility functions (or
convex indifference curves) and firms concave(!) production functions (DRS
⇒ convex isoquants).
From Chapter 12 we know that the partial competitive equilibrium is Pareto
efficient.
But this result is much stronger because it says that the competitive
equilibrium will produce an efficient outcome in all the markets at a time,
and when production is possible the economy will also produce the “right”
goods in the “right” amounts.

102
Equity
As we have seen from the graphs, the initial endowment is critical in
determining the competitive equilibrium allocation, or the core.
If the initial endowment is very unequal, it is likely that the equilibrium will
also look like quite “unequal/unfair.”
Even if unfair, we know it will be efficient.
Can we improve fairness without compromising Pareto efficiency?

In theory yes, via lump-sum taxation! ,

▸ but in practice there will be a trade-off between efficiency and equity because

lump-sum taxation is idealistic. /

103
The Second Fundamental Theorem of Welfare Economics

Every Pareto efficient allocation can be obtained as the outcome

of a General Equilibrium if society can redistribute wealth in a non-
distortionary fashion.

This implies that the planner can always choose the most “desirable” Pareto
efficient allocation by adjusting the initial endowments accordingly.
But what does “desirable” mean? Social welfare functions p.433-434.

104
Suppose that z is regarded as the most desirable Pareto efficient allocation (under
some criterion).
Given the initial endowments, it is impossible to get there at equilibrium.
However, there exists a price vector (in dashed) that decentralizes the desired
allocation z. The ratio of shadow prices λλ23 for U = U(xB , yB ) in z!!!
Then if we physically redistribute the endowments from ω to ω ′ on the dashed
line, the desirable Pareto efficient allocation z will arise as the market outcome of
a general equilibrium.

105
Monetary Lump-Sum redistribution

Recall maximization problem (1) to calculate Pareto efficient allocations.

Take U equal to B’s utility in allocation z.
Then we obtain λ2 and λ3 and we set prices px = λ2 and py = λ3 .
The dashed line can be seen as budget lines for A and B.
Let us write z = ((zxA , zyA ), (zxB , zyB )).
Agent A’s expenditure in z is worth px zxA + py zyA = λ2 zxA + λ3 zyA .
Agent A’s endowments in ω are worth I A = px ωxA + py ωyA = λ2 ωxA + λ3 ωyA .
The budget line through ω and parallel to the dashed budget line through z
lies further away from the origin.
Since income I A is larger than A’s expenditure at z, we may interpret the
difference as a lump-sum tax paid by agent A.
Agent B is the beneficiary, who receives a lump-sum subsidy of equal size.

106
Monetary Lump-Sum redistribution reformulated

Suppose agent A is allowed budget deficit BD A and B is allowed BD B

If positive, it is a subsidy; if negative it is a tax
Budget balance imposes BD A + BD B = 0, or BD A = −BD B
Agent A’s ”allowed” expenditure is I A + BD A .
Agent B’s ”allowed” expenditure is I B + BD B .

There exists a general equilibrium price ratio and allocation for

economies that allow ”small” budget deficits.

107
Example of General Equilibrium with budget deficits
α (px ωx +py ωy )
i i
U i (xi , yi ) = (xi )α (yi )β ⇒ xi (px , py , ωxi , ωyi ) = α+β px , etc.

Suppose α = β = 12 , ωxA = 7, ωyA = 3 and ωxB = 3, ωyB = 7.

Additionally suppose BD A = −BD B = −2
1 Utility maximization implies Marshallian demand functions:
7px +3py −2 3px +7py +2
xA (px , py , 7, 3, BD A ) = 2px
, xB (px , py , 3, 7, BD B ) = 2px
,
7px +3py −2 3px +7py +2
yA (px , py , 7, 3, BD A ) = 2py
, yB (px , py , 3, 7, BD B ) = 2py
.

2 All markets clear:

7px +3py −2 3px +7py +2
2px
+ 2px
= 10 = ωxA + ωxB ,

7px +3py −2 3px +7py +2

2py
+ 2py
= 10 = ωyA + ωyB .

The −2 and +2 cancel in each equality ⇒ px /py = 1 as before.

108
Example (continued):

Recall p ∗ = 1 is the general equilibrium price ratio.

For our purposes, we need a price vector. A convenient choice is
px∗ = py∗ = 1. Then,

7px∗ +3py∗ −2
xA∗ = xA (p ∗ , ω A , BD A ) = 2px∗ = 4, yA∗ = xA (p ∗ , ω A , BD A ) = 4,
3px +7py +2
xB∗ = xB (p ∗ , ω B , BD B ) = 2px = 6, yB∗ = xB (p ∗ , ω B , BD B ) = 6.

A consumes bundle (xA∗ , yA∗ ) = (4, 4) and B consumes (xB∗ , yB∗ ) = (6, 6).
GE allocation with budget deficits ((xA∗ , yA∗ ), (xB∗ , yB∗ )) = ((4, 4), (6, 6)) is
a pair of bundles.
Both markets clear.

109
Policy Implications and Applications

Society should aim to achieve a Pareto efficient allocations only.

The Second Fundamental Theorem of Welfare Economics implies that
societies that include competitive markets can (in principle) achieve every
Pareto efficient allocation that such society desire to achieve and that it is
to politics to decide what the desired Pareto efficient allocation is.
German re-unification of 1990: The member states of pre-1990 Federal
Republic of Germany (BRD) allowed the former Deutsche Demokratische
Republik (DDR) a deficit of 100 billion euros a year for 20 years to
restructure former DDR.
Social welfare can be seen as allowing some agents to receive subsidies paid
by taxes borne by wealthier agents.
The Euro crisis of 2009 can also be viewed as negotiating an ”allowed
deficit” run by Southern countries paid by Northern countries.

110
Section 4

Production

111
So far we have discussed the existence of general equilibrium and its
efficiency properties in a setting without production. Individuals were
endowed with some amounts of the goods and could exchange some goods
for other goods.

Now we shall go beyond and add production to the setting.

With production, the goods are available in amounts that are not fixed
anymore, they react to the market prices.
We ask:
Does the notion of general equilibrium ensures that all goods are produced
efficiently?
And are those goods brought to the market in the right amounts?

112
A more general economy

2 individuals (A and B) produce and consume 2 goods, housing (h) and

food (f).

Production uses 2 inputs (capital and labor) also supplied by the very
same consumers.

Production functions are h(Kh , Lh ) and f (Kf , Lf ), where Ki and Li are the
amounts of capital and labor allocated to the production of good i = h, f .

Consumer utility functions u A (h, f , L) and u B (h, f , K ) so consumers

supply labor and capital.

Let us look at the efficient allocations first, and then see if the market
“delivers”.

113
Pareto optimum
Edgeworth box in production
Production possibilities represented by the box. Firms endowed with some
capital and labor (point A).
L""
in"housing" Lh"
K"" Oh"
in"food"
isoquants"
Kh"

A"

Kf"
K""
isoquants" in"housing"
Of" L""
Lf" in"food"

(This can be generalized to several inputs and several outputs.)

114
Efficient input allocation to production occurs when
f h §
MRTSL,K = MRTSL,K .

L"in""
housing" Oh"
K"in""
food"

A"

K"in"
housing"
Of" L"in"
food"

§ MPL
Recall that MRTSL,K = MPK
where MPL (MPK ) denotes the marginal product of
labor (capital).
115
The feasible production set and the production possibilities frontier
(PPF ).
Corresponding to the contract curve in the input exchange economy, we
can derive the production possibility set.

Housing(
Oh( (h)(
Produc2on(
possibility((
fron2er(
(PPF)(

A"
A(

Of( Food((f)(

Points in the contract curve map into points in the PPF. Points outside the
contract curve map into points inside the production possibility set.

116
 The slope of the PPF is called the marginal rate of product transformation
of food and housing (MRTf ,h ).
It tells us how much of good f the economy has to give up in order to
produce another unit of good h (the opportunity cost of one good in terms
of the other).

Housing
(h) PPF

Feasible
outputs
h* MRT= - dh/df

f* Food (f)

By giving up one unit of f , factors of production are freed and moved into
the production of good h.
117
Explanation: Suppose it takes two units of f to produce one unit more of h,
the MRTf ,h = −dh/df = 1/2.

Giving up one unit of food frees a total of MCf in resources. An additional

unit of housing needs MCh in resources. The MRTf ,h is then

MCf
MRTf ,h =
MCh

where MCf (MCh ) denotes the marginal cost of producing one unit of f (h).
When production functions have decreasing returns to scale, the PPF is
concave. This is easy to see because as we “walk” along the PPF and
produce more food and less housing the MCf increases and the MCh
decreases so the MRTf ,h goes up.
But even with constant returns to scale the PPF will be concave if the
goods use inputs in different proportions.

118
Efficient production and consumption
The PPF contains many technically efficient output bundles.
But which ones are Pareto efficient for consumers?
Suppose the output bundle produced is (f ∗ , h∗ ), which is then available for
allocation across consumers A and B.

Housing(
(h)( PPF(
OB(
h*(

OA( f*( Food((f)(

119
 A Pareto efficient economy must operate simultaneously
f h
on the PPF (so MRTSL,K = MRTSL,K ) and
on the consumers’ contract curve (so MRSfA,h = MRSfB,h )
but in addition it must produce an efficient output mix (so MRTf ,h =
MRSfA,h = MRSfB,h ).

Suppose that with the production (f ∗ , h∗ ) consumers MRSfi ,h are not

equal to the MRTf ,h .

Housing(
(h)( PPF( MRT$≠$MRS$
OB(
h*(
MRT((

MRS((
120
When an economy is producing and consuming such that the MRSf ,h of
consumers ≠ to the MRTf ,h there is a possibility to make consumers better
off by rearranging the pattern of production.

Suppose for example that MRSf ,h = 1 < MRTf ,h = 2.

MRSf ,h = 1 signifies that consumers would need one unit of housing to be

compensated for losing one unit of food.

MRTf ,h = MCf /MCh = 2 means that giving up one unit of food allows for
the production of 2 units of housing.

Clearly, consumer can improve if we reallocate consumption and

production as follows: lower the production (and consumption) of 1 unit of
food and produce in exchange 2 units of housing, which they get allocated
to consumers.

So Pareto efficiency implies MRSfi ,h = MRTf ,h for all i.

121
The idea is represented in this graph.
In this graph, we start with the opposite situation where where initially
MRSf ,h > MRTf ,h .
We can increase production of f and lower production of h (a new
consumption Edgeworth box arises, see the arrows).

Housing(
(h)( PPF( MRT((
OB(
h*( hB(=(h’B(
(
fB(=(f’
h’*( O’B( B(
(
MRS((
MRT’((

OA( f*( f’*( Food((f)(

But how do we see that this reallocation entails a Pareto improvement?

122
Now let us give individual B the same allocation as before (so B has the
same utility!).

Housing
(h) PPF
OB
h*
fB
h’* v O’B
MRS fB
MRT
hB

hB

OA
B has the samef Food (f)
*
f’*
level of utility

(Notice that B’s utility is measured now in a different origin, while A’s
utility in the same origin.)
123
So we have found a reallocation of production factors and consumption so
that there is more production of f and less of h, individual A consumes
more of f and less of h, thereby increasing her utility, while individual B’s
utility stays constant.

Housing
(h) PPF
OB
h* hB = h’B
fB = f’B
h’* v O’B
MRS fB
MRT

hB

OA
B has the samef Food (f)
*
f’*
level of utility but A has higher

Such a reallocation is a Pareto improvement; therefore the initial situation

where MRSf ,h > MRTf ,h is not Pareto efficient.
124
Summarizing, the Pareto efficient allocation has the following properties.

Housing(
(h)( PPF( MRT(=(MRS((
L"in""
housing" Oh"
K"in"" h’*( O’B(
food"

MRT((
MRS((
A"

MRS((

K"in" OA(
B(has(the(same(( f’*( Food((f)(
housing"
Of" L"in" level(of(u?lity(but(A(has(higher(((
food"

Efficient input mix: Efficient consumption:

MRTSL,K f h
= MRTSL,K MRSfA,h = MRSfB,h .
Efficient output mix:
MRTf ,h = MRSfi ,h , i = A, B.

125
The market: decentralized coordination of production and
consumption

Suppose individual A and individual B jointly produce housing (h) and food
(f ).
Production functions are h(Kh , Lh ) and f (Kf , Lf ).
A has labor and B has capital.
Consumer utility functions u A (h, f , L) and u B (h, f , K ).
Price of h is ph
Price of f is pf
Wage rate for labor is w ; and the price of capital is r .

126
Cost-minimization implies that labor and capital be demanded so as to
equalize
h f w
MRTSL,K = MRTSL,K =
r
Firm’s profit-maximization problem is

max π = ph h + pf f − wL − rK

Isoprofit line is
π̄ + wL + rK pf
h= − f
ph ph

The profit-maximizing production plan is where pf = MCf and ph = MCh ,

which implies MRTf ,h = pphf .

127
Utility-maximizing consumer choices imply that
pf
MRSfA,h = MRSfB,h =
ph
Individual A utility-maximizing labor supply implies
A w
MRSL,f =−
pf
while Individual B utility-maximizing capital supply implies
r
MRSKB,f = − .
pf
Conclusion: in a competitive equilibrium with production all the conditions
for Pareto efficiency are satisfied.

128
THANKS A LOT FOR YOUR ATTENTION!

Questions? Problems?

<harold.houba@vu.nl>

129