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Exchange: ECO201 - Intermediate Microeconomics
Exchange: ECO201 - Intermediate Microeconomics
Outline
1 Introduction
2 Exchange Economy
3 Pareto-optimal Allocations
4 Walrasian Equilibrium
5 Welfare theorems
Theory of Value
Determines relative prices and the allocation of resources.
Explains how prices can optimally coordinate individual decisions (the
“invisible hand”).
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.
A single price for each good: all units of a given product are ex-
changed on the market at the same price.
Outline
1 Introduction
2 Exchange Economy
3 Pareto-optimal Allocations
4 Walrasian Equilibrium
5 Welfare theorems
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 .
Edgeworth Box
Edgeworth box
x2A
1B
x1B
2B
2A
x1A
1A
x2B
x2A
1B
x1B
2B
2A
x1A
1A
x2B
Outline
1 Introduction
2 Exchange Economy
3 Pareto-optimal Allocations
4 Walrasian Equilibrium
5 Welfare theorems
Pareto-optimal allocations
Pareto-optimal allocations
A feasible allocation x is Pareto-optimal (or is a Pareto-optimum)
when there does not exist any feasible allocation y such that:
x (or x is Pareto-dominated by y ).
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
With two goods and two consumers, this program simplifies to:
∀l 6= l 0 and ∀i 6= k : i i k k
MRSl,l 0 x = MRSl,l 0 x .
x2A
1B
x1B
2B
PARETO-OPTIMUM
MRSA1/2=MRSB1/2
2A
x1A
1A
x2B
Pareto-optimal allocations
x2A
1B
x1B
2B
2A
Set of Pareto-optimal
allocations
x1A
1A
x2B
Outline
1 Introduction
2 Exchange Economy
3 Pareto-optimal Allocations
4 Walrasian Equilibrium
5 Welfare theorems
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.
x2A
1B
x1B
2B
Set of affordable
bundles for consumer B
x1A
1A
Budget constraint
x2B
x2A
2A
x2A(p, A)
x2A
x1B
x1A
x2B
x2A
x1B
x1A
x2B
Consumer demand
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
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:
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) xli p, p.ω i − ωj .
∀l : zj (p) = =
i=1 i=1
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
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
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.
Walras Law
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.
1 For each consumer i, compute for each price vector, the optimal
choice (demand). This amounts to solving:
Outline
1 Introduction
2 Exchange Economy
3 Pareto-optimal Allocations
4 Walrasian Equilibrium
5 Welfare theorems
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.
x2 A
1B
x1 B
2B
2A
x1 A
1A
x2 B