Exchange: ECO201 - Intermediate Microeconomics

Exchange
ECO201 - Intermediate Microeconomics
Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 1 / 41

Introduction
Outline
1 Introduction
2 Exchange Economy
3 Pareto-optimal Allocations
4 Walrasian Equilibrium
5 Welfare theorems

Introduction
General Equilibrium Theory
Analyzing the allocation of (scarce) resources in a decentralized

economy (each agent takes his actions without taking into considera-
tion the other agents’ behavior), competitive (perfect markets, agents
are price-takers) economy, accounting for interactions between mar-
kets.
Theory of Value
Determines relative prices and the allocation of resources.
Explains how prices can optimally coordinate individual decisions (the
“invisible hand”).
First Welfare Theorem: An equilibrium is “efficient”.

Introduction History
The origins of general equilibrium theory
Adam Smith (1723 - 1790, UK) and the invisible hand (An inquiry
into the Nature and Causes of the Wealth of Nations, 1776)
A decentralized economy does not lead to chaos but to a socially desir-
able outcome.
Competition induces agents (firms, individuals) to produce what society
needs and resources are allocated where they can be more efficiently
used.
Competition allows to efficiently adjust prices and quantities.
Antoine-Augustin Cournot (1801 - 1877, France), Recherches sur les

principes mathématiques de la théorie des richesses (1838)
Different parts of an economic system are interdependent and abstracting
from such interactions (e.g., partial equilibrium) may lead to significant
mistakes.

Introduction History
Other “actors” of general equilibrium theory
Léon Walras (1834 - 1910, France)

Eléments d’économie politique pure (1874)
Vilfredo Pareto (1848 - 1923, Italy)

Cours d’économie politique (1896) and Manuale d’economia politica con
une introduzione alla scienze sociale (1906)
Gérard Debreu (1921 - 2004, France/USA) - Nobel Prize 1983

The Theory of Value (1959)
Main results (existence and optimality) derived in the 1950’s (e.g.,

Gérard Debreu and Kenneth Arrow (Nobel Prize 1972 jointly with John
Hicks)).
In the 1970’s: uniqueness, stability.

Introduction Fundamental assumptions
Competition and perfect markets
General equilibrium theory relates to perfectly competitive markets.
Agents (firms and consumers) are price-takers:

Each agent takes prices as given and assumes that s/he can buy or
sell any quantity at the given prices.
It is thus reasonable to think of markets as including many“small”agents
without “market power”.
A single price for each good: all units of a given product are ex-
changed on the market at the same price.
No transaction cost, perfect information, no externalities, no public

goods.

Exchange Economy
Outline
1 Introduction
2 Exchange Economy
5 Welfare theorems

Exchange Economy The exchange economy model
Exchange economy
I consumers, i = 1, 2, . . . , I .
L goods, j = 1, 2, . . . , L.
Initial endowment in good j for consumer i: ωji .
Pi=I
Global endowment in j: ω= i=1 ωji .
Consumer i’s demand for good j: xji

Beware: xji is the quantity consumed/used, non the quantity exchanged
on the market which is xji − ωji .
Price vector: p = (p1 , . . . , pL ) ∈ RL++ .
Useful special case: 2 goods, 2 consumers.

Exchange Economy The exchange economy model
Preferences / Utility functions
Consumer i’s utility function is u i : RL+ → R.
Function u i is assumed to be continuous and at least monotonic.

We often assume that u i is strictly quasi-concave (⇔ preferences are
strictly convex) which implies that

The demand function x i p, p.ω i is the unique solution of the following
constrained maximization problem:
max u i x i , s.t. p.x i ≤ p.ω i .

x i ∈RL+
For L = 2, indifference curves are strictly decreasing and strictly convex.

At the optimum: p.x i p, p.ω i = p.ω i .
Moreover, we often assume that u i is C 2 (twice-continuously differen-

tiable).

Exchange Economy Edgeworth Box
Edgeworth Box
Francis Ysidro Edgeworth (1845-1926), Irish economist and lawyer.
In the special case with two consumers (i = A, B) and two goods

(j = 1, 2), this exchange economy can be represented by:
A rectangular “box” of size ω1 × ω2 .

Two-axis system: x1A , x2A (starting from the bottom-left corner) and
x1B , x2B (from top-right corner).
An allocation of the initial endowment between the two consumers is
given by a single point within the box. The same
point defines consumer
A’s allocation (measured along the x1A , x2A axis) and consumer B’s
allocation (measured along the x1B , x2B axis).
The rectangular box represents the set of feasible allocations, i.e.,
allocations that satisfy xlA + xlB = ωl for any l = 1, 2.

Edgeworth box
x2A
1B
x1B
2B
2A
x1A
1A
x2B

Edgeworth box and preferences
x2A
1B
x1B
2B
2A
x1A
1A
x2B

Pareto-optimal Allocations
Outline
1 Introduction
2 Exchange Economy
5 Welfare theorems

Pareto-optimal Allocations Definition
Pareto-optimal allocations
Vilfredo Pareto (1848-1923, Italy)
A feasible allocation x is Pareto-optimal (or is a Pareto-optimum)
when there does not exist any feasible allocation y such that:
∀i u i y i ≥ u i x i for some i0 , u i0 y i0 > u i0 x i0

and
Pareto-optimal allocations are feasible allocations for which it is

impossible to reallocate resources in a way that would (strictly)
improve one agent’s situation without negatively affecting any
other agent.

Pareto-improvement and Pareto-optimality
i y i ≥ u i x i for any i and

If two allocations x and y are such that u
there exists i0 for which u i0 y i0 > u i0 x i0 , then y Pareto-dominates

x (or x is Pareto-dominated by y ).
A feasible allocation x is Pareto-optimal if and only if it is not

Pareto-dominated by any other feasible allocation.
The Pareto-domination order is not complete.
The Pareto-optimality concept is purely based on consumers’ prefer-

ences and global endowment. There is no reference to prices or indi-
vidual initial endowments.

Pareto-dominated allocation
x2A
1B
x1B
2B
Allocations that
Pareto-dominate X
2A
x1A
1A
x2B

Pareto-optimal allocation
x2A
1B
x1B
2B
Pareto-optimum
2A
x1A
1A
x2B

Pareto-optimal Allocations Characterization
Characterizing (interior) Pareto-optimal allocations
One way to characterize Pareto-optimal allocations is to fix I − 1 con-

sumers’ utility levels and look for the feasible allocation that maximizes
the remaining consumer’s utility (and then to vary the I −1 utility levels
to identify all the Pareto-optima). This problem writes as:
j=I
xlj = ωl , ∀l.
X
i i k k k

max u x , s.t.: u x ≥ u , ∀k 6= i and
x
j=1
With two goods and two consumers, this program simplifies to:
max u A x1A , x2A , s.t.: u B ω1 − x1A , ω2 − x2A ≥ u B .

(x1A ,x2A )

Characterizing (interior) Pareto-optimal allocations

Interior Pareto-optimal allocations
When preferences are strictly convex, a feasible interior (i.e., all quan-
tities are strictly positive) allocation is Pareto-optimal if and only if:
∀l 6= l 0 and ∀i 6= k : i i k k

MRSl,l 0 x = MRSl,l 0 x .
It is possible to have a Pareto-optimal allocation for which MRS are

not equal (even with strictly convex preferences), but it then involves
a corner solution (i.e., at least one quantity is equal to 0).
Pareto-optimality is a way to define the notion of “efficient allocation
of resources.”
However, Pareto-optimality does not mean fairness. When prefer-
ences are strictly monotonic, an allocation that gives all the resources
to one agent and nothing to the others is a Pareto-optimal allocation.
Interior Pareto-optimal allocation
x2A
1B
x1B
2B
PARETO-OPTIMUM
MRSA1/2=MRSB1/2
2A
x1A
1A
x2B

x2A
1B
x1B
2B
2A
Set of Pareto-optimal
allocations
x1A
1A
x2B

Walrasian Equilibrium
Outline
1 Introduction
2 Exchange Economy
5 Welfare theorems

Walrasian Equilibrium Budget constraint
The budget constraint

Consumer i’s budget constraint is:
p. x i − ω i ≤ 0 p.x i ≤ p.ω i .

⇐⇒
Everything happens as if consumer i could first sell his initial endow-

ment on the market before deciding what to buy under the constraint
not to exceed his newly acquired “revenue”.
Special case 2 consumers - 2 products:
Consumer A’s budget line is given by:
p1 x1A + p2 x2A = p1 ω1A + p2 ω2A
Consumer B’s budget line is given by:
p1 x1B + p2 x2B = p1 ω1B + p2 ω2B
Using the fact that, for any feasible allocation we have (for any l = 1, 2)
xlA + xlB = ωl , one can notice that consumer B’s budget line coincides
with consumer A’s.
Budget constraints (lines) in the Edgeworth Box
Budget constraints (lines) for consumers A and B are represented

– in the Edgeworth box – by the same line: this one includes the
initial allocation and has a slope equal to the relative price pp12 .
Points located on or below the budget line are the bundles that A can
afford.
Points located on or above that line are the bundles that B can afford.
The allocations that both can afford are thus the points of the
budget line that are within the Edgeworth Box.

Budget constraints (lines) in the Edgeworth Box
x2A
1B
x1B
2B
Set of affordable
bundles for consumer B
2A Set of affordable

bundles for consumer A
x1A
1A
Budget constraint
x2B

Walrasian Equilibrium Demand
Consumer A’s demand
x2A
2A
x2A(p, A)
1A x1A(p, A) x1

Walrasian Equilibrium Excess demand
Equilibrium and excess demand
It is often said that prices and quantities are determined in markets

through demand and supply (partial equilibrium).
In particular, demand equals supply in equilibrium.
In our exchange setting, this happens too, even though prices and
quantities are given. The next slides depict (i) a situation where there is
excess demand for good 1 and (ii) a situation where demand equals supply.
The first situation is not an equilibrium whereas the second one is an
equilbrium.

Non-zero (aggregate) excess demands

x2A
x1B
A (B) wants to buy more good 1

(2) than B (A) is willing to sell.
x1A
x B
2
The price vector is not an equilibrium one: since there is excess demand,
this means that prices can be corrected to solve for this inefficiency.
Walrasian equilibrium for an exchange economy

x2A
x1B
No excess demand =>

Equilibrium
x1A
x B
2
The price vector is such that that every consumer is maximizing his utility
while demand equals supply: equilibrium
Consumer demand
For each consumer i, we denote by x i (p, R) the consumer’s optimal

bundle at prices p = (p1 , . . . , pL ) ∈ RL++ when her income is R.
In this exchange economy, the consumer’s optimal choice – given his

initial allocation ω i and the vector of prices p – is therefore x i p, p.ω i .

When the optimal solution is interior (all J quantities are strictly pos-
itive) and consumer i’s preferences are strictly convex, the solution
satisfies:
pl
p.x i p, p.ω i = p.ω i and ∀l, l 0 : MRSl,l
i i
p, p.ω i =

0 x .
pl 0

Aggregate excess demand
We call consumer i’s excess demand for good j at prices p, the differ-
ence between the quantity that consumer i would like to consume (i.e.,
his demand) and his initial endowment in good j, that is:
zji (p) = xji p, p.ω i − ωji .

We call aggregate excess demand for good j, the sum of all individual
excess demands, that is:
i=I
X i=I
X
zji (p) xji p, p.ω i − ωji .

∀j : zj (p) = =
i=1 i=1
In general, for a given vector of prices, aggregate excess demands do

not equal 0 for all products. This means that consumer A’s preferred
allocation does not coincide with consumer B’s preferred allocation. In
this case, individual demands do not define a feasible allocation.
Walrasian Equilibrium Equilibrium
Walrasian equilibrium for an exchange economy

Walrasian Equilibrium
A Walrasian equilibrium consists of an equilibrium price vector p ∗ and
an equilibrium allocation x ∗ which are such that:
1 The individual allocation x ∗i equals consumer i’s optimal choice
at prices p ∗ , that is, x ∗i = x i p ∗ , p ∗ .ω i for each consumer i .

2 Prices are such that aggregate excess demands are all equal to
zero, that is, we have: ∀l, zl (p ∗ ) = 0 ⇐⇒ i=I ∗i = ω .
P
x
i=1 l l
If (p ∗ , x ∗ ) is a Walrasian equilibrium, then for any λ > 0, (λp ∗ , x ∗ )

is also a Walrasian equilibrium. One can thus normalize one of the
prices to 1 (for instance, set p1∗ = 1) and express all the other prices
are relative to the normalized price.
The equilibrium does not fully determine nominal prices but only rela-
tive prices.
Characterizing the equilibrium
We suppose now that preferences are monotonic, strictly convex and

that the utility functions are C 2 .
Demand functions are then given for each consumer i by the conditions
i = pl .
p.x i = p.ω i and ∀l, l 0 , we have MRSl,l 0 p0 l
In equilibrium, it must thus be the case that:

Pi=I
1
i=1 x ∗i = ω (i.e., the equilibrium allocation is feasible).
2 ∀i ∈ {1, . . . , I } : p ∗ .x ∗i = p ∗ .ω i .
pl∗
3 ∀i 6= k ∈ {1, . . . , I } and ∀l 6= l 0 ∈ {1, . . . , L} : MRSl,l
i k
0 = MRSl,l 0 =
pl∗0 .

Characterizing the equilibrium
Beware: MRS may not necessarily be equal (and equal to the relative
prices) in equilibrium.
This can for instance be the case when:
Preferences (for at least one consumer) are not convex.
Utility functions (for at least one consumer) are not C 2 .
The equilibrium allocation is not interior.
Under some (limited) conditions, one can prove that an equilibrium

necessarily exists. In particular, if the excess demand functions
are continuous, one can prove that there is a price vector p ∗ that
ensures that z(p ∗ ) = 0 and x ∗ i = x i (p∗, p ∗ .ωi ) for each consumer
i. However, the equilibrium may not be unique (even once we have
normalized one price).

Walrasian Equilibrium Walras law
Walras Law
Recall that for each good j and each price vector p, the Walrasian demand
equals
i=I
X
xji p, p.ω i − ωji p.x i (p, p.ω i ) = p.ω i

zj (p) = and
i=1
Therefore,
j=L
X
p.z(p) = pj zj (p)
j=1
j=L
X
pj (xji p, p.ω i − ωji )

=
j=1 (1)
j=L
X j=L
X
= pj xji p, p.ω i − pj ωji
j=1 j=1
i i i
= p.x (p, p.ω ) − p.ω = 0
Walras Law
Given the previous computations, we can write that:

Walras Law
∀p ∈ RL++ : p.z(p) = 0.
Note that Walras law is valid for any price vector p and therefore it is
valid for the equilibrium price vector p ∗ . To solve for the equilibrium
prices, it is thus sufficient to find a price vector for which L − 1
markets are in equilibrium: if aggregate excess demands are equal
to zero for L − 1 markets, then aggregate excess demand is necessarily
equal to zero on the last market.

How to characterize the equilibrium in practice?
1 For each consumer i, compute for each price vector, the optimal
choice (demand). This amounts to solving:
x i (p, p.ω i ) ∈ arg maxx i u i x i such that p.x i ≤ p.ω i .

Can be done in two steps:

1 Compute x i (p, R), i.e., the consumer’s Walrasian demand,
2 Replace R by the value of consumer i’s initial endowment (R = p.ω i ).
2 Solve the system

P of market equilibrium conditions, that is, for any
good j, solve i xji (p) = ωj .
Only L − 1 of the L conditions may be independent.

Welfare theorems
Outline
1 Introduction
2 Exchange Economy
5 Welfare theorems

Welfare theorems Efficiency
First Welfare Theorem
First Welfare Theorem: Efficiency

If consumers all have strictly monotonic preferences, the equilibrium
allocation of any Walrasian equilibrium is a Pareto-optimal allocation.
Simple proof (interior solution): in equilibrium, MRS are all equal to

the relative price. But the relative price is the same for all consumers.
General intuition: as long as consumers can find mutually profitable

exchanges to realize, they continue to exchange. Therefore, in equi-
librium, mutually profitable exchanges have been exhausted: this
is exactly the definition of a Pareto-optimal allocation.

Welfare theorems Decentralization
Second Welfare Theorem
Second Welfare Theorem: Decentralization

If consumers all have strictly monotonic and strictly convex prefer-
ences, then for any interior Pareto-optimal P allocation x ∗ , there exists
∗
feasible transfers t (that is for any l, ∗i
i tl = 0) and a vector of
prices p ∗ such that (p ∗ , x ∗ ) constitutes a Walrasian equilibrium for
initial endowments given by ω − t ∗ .
One can thus“decentralize”any Pareto-optimal allocation (as the equi-

librium allocation of a Walrasian equilibrium).
If transfers are possible, then one could just reallocate some of the
initial endownment and let the market reach an equilibrium to sustain
any given Pareto-optimal allocation.

Welfare theorems Decentralization
Decentralizating a Pareto-optimal allocation
x2 A
1B
x1 B
2B
2A
x1 A
1A
x2 B

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Exchange

ECO201 - Intermediate Microeconomics

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 1 / 41

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 2 / 41

General Equilibrium Theory

Analyzing the allocation of (scarce) resources in a decentralized

First Welfare Theorem: An equilibrium is “efficient”.

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 3 / 41

The origins of general equilibrium theory

Antoine-Augustin Cournot (1801 - 1877, France), Recherches sur les

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 4 / 41

Other “actors” of general equilibrium theory

Léon Walras (1834 - 1910, France)

Vilfredo Pareto (1848 - 1923, Italy)

Gérard Debreu (1921 - 2004, France/USA) - Nobel Prize 1983

Main results (existence and optimality) derived in the 1950’s (e.g.,

In the 1970’s: uniqueness, stability.

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 5 / 41

Competition and perfect markets

General equilibrium theory relates to perfectly competitive markets.

Agents (firms and consumers) are price-takers:

No transaction cost, perfect information, no externalities, no public

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 6 / 41

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 7 / 41

Consumer i’s demand for good j: xji

Price vector: p = (p1 , . . . , pL ) ∈ RL++ .

Useful special case: 2 goods, 2 consumers.

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 8 / 41

Preferences / Utility functions

Consumer i’s utility function is u i : RL+ → R.

Function u i is assumed to be continuous and at least monotonic.

max u i x i , s.t. p.x i ≤ p.ω i .

For L = 2, indifference curves are strictly decreasing and strictly convex.

Moreover, we often assume that u i is C 2 (twice-continuously differen-

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 9 / 41

Francis Ysidro Edgeworth (1845-1926), Irish economist and lawyer.

In the special case with two consumers (i = A, B) and two goods

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 10 / 41

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 11 / 41

Edgeworth box and preferences

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 12 / 41

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 13 / 41

Vilfredo Pareto (1848-1923, Italy)

∀i u i y i ≥ u i x i for some i0 , u i0 y i0 > u i0 x i0

Pareto-optimal allocations are feasible allocations for which it is

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 14 / 41

Pareto-improvement and Pareto-optimality

i y i ≥ u i x i for any i and

A feasible allocation x is Pareto-optimal if and only if it is not

The Pareto-domination order is not complete.

The Pareto-optimality concept is purely based on consumers’ prefer-

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 15 / 41

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 16 / 41

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 17 / 41

Characterizing (interior) Pareto-optimal allocations

One way to characterize Pareto-optimal allocations is to fix I − 1 con-

max u A x1A , x2A , s.t.: u B ω1 − x1A , ω2 − x2A ≥ u B .

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 18 / 41

Characterizing (interior) Pareto-optimal allocations

It is possible to have a Pareto-optimal allocation for which MRS are

Interior Pareto-optimal allocation

Matı́as Núnẽz (CREST & CNRS) Exchange X - Bach.2 - ECO201 20 / 41