Lecture16 General Equilibrium

Lecture 16.
General Equilibrium
A Banerji
November 16, 2023

Exchange Economy
Social Planner
Suppose an economy has many millions of people, with different preferences/

utility functions over many goods.
Suppose we abstract away from production, or assume production has already
happened, and now there is an endowment of all these goods to be
distributed among people.
Keep the story simple: 2 Agents a, b, 2 goods 1, 2, endowment w1 , w2 .
How to allocate these goods to the agents for consumption, to satisfy a
welfare criterion?
A Banerji Lecture 16. General Equilibrium November 16, 2023 2 / 48

Exchange Economy
Feasible Allocation
A non-negative allocation (x1a , x2a ), (x1b , x2b ) to the 2 agents is called feasible if
x1a + x1b ≤ w1 , x2a + x2b ≤ w2 .
For each good, what the agents get must aggregate to at most what the
economy is endowed with.
If agents have monotone preferences (increasing utility functions), it would
always be good not to waste any endowment; so
x1a + x1b = w1 , x2a + x2b = w2 would be a good requirement for any allocation.
We can show these allocations in an Edgeworth Box.

Exchange Economy
Edgeworth Box
The length and height of the Edgeworth box are respectively w1 , w2 . We

measure x a ≡ (x1a , x2a ) from the usual origin, and x b ≡ (x1b , x2b ) from a
different origin: the Northeast vertex of the box. In case the diagram is not
here, I will draw it in class.
So each agent has his/her own co-ordinate system.
Each point x = (x a , x b ) in the box (interior and boundary) therefore satisfies
x1a + x1b = w1 , x2a + x2b = w2 ; so, is a feasible allocation where everything is
consumed.
But a given point x ≡ (x1a , x2a , x1b , x2b ) may not exhaust possibilities of mutual
improvement of utilities.
Draw the agents’ indifference curves through a point x.
Exchange Economy
Pareto superior allocation
In the diagram, Agent b’s indifference curve is viewed from the perspective of
Agent b’s origin in the Northeast.
The Agents both have strictly convex preferences. Their indifference curves
cross at x.
So, if a Social Planner reallocates the goods so we move from x to y , both
Agents are made better off: each moves to a higher indifference curve /
utility.
We define a slightly weaker notion: A feasible allocation y is Pareto superior
to the feasible allocation x if u i (y1i , y2i ) ≥ u i (x1i , x2i ) for both agents i ∈ {a, b},
with the inequality holding with strict 0 >0 for at least one of the agents.

Exchange Economy
Pareto Optimality
An allocation x is Pareto optimal (or Pareto efficient) if there does not exist
any allocation y in this economy that is Pareto superior.
With strictly convex indifference curves, we see that any Pareto optimal
allocation in the interior of the Edgeworth Box must be a point of tangency
of the 2 agents’ indifference curves.
See the diagram. (In case the diagram is not here, I will draw it in class).
Example: w1 = w2 = w ; u i (x1i , x2i ) = (x1i )1/2 (x2i )1/2 , i = a, b. Then, the
45-degree line segment is the set of all Pareto optimal allocations.

Exchange Economy
Pareto Optimal Allocations
Indeed, any tangency of the indifference curves will satisfy

∂ u a /∂ x1a ∂ u b /∂ x1b
∂ u a /∂ x2a = ∂ u b /∂ x2b
With the Cobb-Douglas utility function above, this gives us

x2a /x1a = x2b /x1b .
Using allocations aggregate to endowments, we have:
x2a /x1a = (w − x2a )/(w − x1a )
So, at a tangency, the slope of the ray from the agent a’s origin equals that
from agent b’s origin; this only happens on the 45-degree line.

Exchange Economy
Take a slightly different example: w1 = 4, w2 = 2, utility functions the same

as earlier.
Using allocations aggregate to endowments, we have:
x2a /x1a = (2 − x2a )/(4 − x1a )
Rearranging terms, this gives: x2a /x1a = 1/2.
This is the diagonal of the Edgeworth Box.
The set of all Pareto optimal allocations in the Edgeworth Box is called the
contract curve.

Exchange Economy
In the examples above, at a tangency of indifference curves, the rate at which

either agent can substitute one good for the other on the indifference curve is
the same: so, there are no Pareto improvements possible from reallocation.
Example: If u i (x1i , x2i ) = x1i + x2i for i = a, b, and w1 = w2 = w , then all points
in the Edgeworth Box are Pareto optimal.
Example: If u a (x1a , x2a ) = 2x1a + x2a and u b (x1b , x2b ) = x1b + x2b , and
w1 = w2 = w , the horizontal axis segment of the Edgeworth Box is the set of
Pareto optimal allocations: Agent a likes good 1 more, marginal rates of
substitution don’t equalize, but a is allocated all of good 1, b is allocated all
of good 2.

Exchange Economy
Social Planner
How might a ’social planner’ compute all possible Pareto optimal allocations
in an economy with a billion agents?
A social planner is all-knowing. She knows everyone’s preferences, and the
endowments of all goods.
The 2-agent, 2-good analogue says that if the utility functions are
continuous, increasing and concave, every Pareto optimal allocation is a
solution to a maximization problem
Maximizeθ u a (x1a , x2a ) + (1 − θ )u b (x1b , x2b ), subject to
x1a + x1b = w1 , and x2a + x2b = w2 , for some θ ∈ [0, 1].
To see one side of this, suppose the social planner fixes the weight θ , makes
substitutions, and Maximizes θ u a (x1a , x2a ) + (1 − θ )u b (w1 − x1a , w2 − x2a ).

Exchange Economy
Social Planner
Maximize θ u a (x1a , x2a ) + (1 − θ )u b (w1 − x1a , w2 − x2a ).

With differentiability, the interior first-order conditions are
a b
θ ∂∂ ux a − (1 − θ ) ∂∂ ux b = 0
1 1
∂ ua ∂ ub
θ ∂ x2a − (1 − θ ) ∂ x2b
=0
Dividing, we get the tangency of the indifference curves:
∂ u a /∂ x1a ∂ u b /∂ x1b
∂ u a /∂ x2a = ∂ u b /∂ x2b

Exchange Economy
Feasible Allocation
We say any allocation (x a , x b ) is feasible if,
x1a + x1b ≤ e1a + e1b .
and
x2a + x2b ≤ e2a + e2b .

Exchange Economy
Pareto Optimality:
Definition
An allocation (x a , x b ) is Pareto efficient if
1 it is feasible.
2 there exists no other feasible allocation (y a , y b ) such that for all i ∈ {a, b} :

u i y1i , y2i ≥ u i x1i , x2i
and for at least one i ∈ {a, b} :

u i y1i , y2i > u i x1i , x2i .

Exchange Economy
Markets and Pareto Optimality
For economies with these kinds of preferences, where people have preferences
only over what they consume, and not over what others consume (so, they
are not envious of others), economists argued that markets are much more
economical in achieving Pareto optimality.
A social planner needs to know everyone’s preferences to solve the above
optimization problem.
But if markets function well, and every consumer faces the same prices p1 , p2 ,
then each consumer would maximize their own utility by consuming at a
point where:
∂ u a /∂ x1a p1
∂ u a /∂ x2a = p2 ,
∂ u b /∂ x1b p1
∂ u b /∂ x2b
= p2
attaining tangency of indifference curves and Pareto optimality.
Exchange Economy
Markets and Pareto Optimality
So, without anyone sharing private information on their preferences,

responding to market prices would bring about a Pareto optimal allocation.
We formalize this argument by modeling trades between agents in a private
ownership, exchange economy.

Exchange Economy
Agents in an Exchange Economy
There are two agents in the economy {a, b}.

This is shorthand for saying that there are, say, a million agents each with the
preferences of Agents a and b respectively. And it is simple to extend the
model to have many kinds of agents.
They can consume only two goods x1 and x2 (for simplicity).
Their utilities are given by
u a (x1a , x2a ), u b (x1b , x2b ).
Each agent has some endowment of both goods
e a = (e1a , e2a ), e b = (e1b , e2b ).
They can either eat their endowment or participate in trading them.

Exchange Economy
Market Equilibrium:
all utility functions are continuous, monotone and concave.

Exchange Economy
Market Equilibrium:
Each consumer a’s problem is to maximize utility given prices (p1 , p2 )
max u a (x1a , x2a )

x1a ,x2a ≥0
s.t. p1 x1a + p2 x2a ≤ p1 e1a + p2 e2a .
Each consumer b’s problem is to maximize utility given prices (p1 , p2 )
max u b (x1b , x2b )

x1b ,x2b ≥0
s.t. p1 x1b + p2 x2b ≤ p1 e1b + p2 e2b .

Exchange Economy
Market Equilibrium:
Let’s take the Cobb-Douglas utility function
u a (x1a , x2a ) = (x1a )α (x2a )1−α
and
β 1−β
u b (x1b , x2b ) = x1b x2b
for 0 < α, β < 1.

Exchange Economy
Market Equilibrium:
For Cobb-Douglas, we can easily find their demands
α(p1 e1a + p2 e2a ) (1 − α)(p1 e1a + p2 e2a )

x1a = , x2a = .
p1 p2
and
β (p1 e1b + p2 e2b ) (1 − β )(p1 e1b + p2 e2b a)
x1b = , x2b = .
p1 p2

Exchange Economy
Market Equilibrium:
x2 x2
e a∗
x a∗ x b∗
e b∗
x1 x1

Exchange Economy
Market Equilibrium:
x2 x1
e b∗
x b∗
e a∗
x a∗
x1 x2

Exchange Economy
Market Equilibrium:
x2
x2
e a∗
x b∗ x a∗
x1
A Banerji Lecture 16. General Equilibrium

x1 November 16, 2023 23 / 48
Exchange Economy
Edgeworth Box:
e1b
B
x2
e2b
e2a
A x1
e1a
Exchange Economy
Edgeworth Box:
e1b
B
x2
e2b
x a∗
e2a
A x1
e1a
Exchange Economy
Edgeworth Box:
e1b
B
x2
e2b
x b∗
e2a
A x1
e1a
Exchange Economy
Edgeworth Box:
e1b
B
x2
e2b
x b∗
x a∗
e2a
A x1
e1a
Exchange Economy
Edgeworth Box: Excess Demand for Good 1.
e1b
B
x2
e2b
x1b∗
e2a x1a∗
A x1
e1a
Exchange Economy
Edgeworth Box: Supply=Demand.
e1b
B
x2
e2b
e2a
A x1
e1a
Exchange Economy
Supply equals Demand
In the diagrams above, notice that if supply equals demand for one good,
then automatically, supply equals demand for the other good. We will come
back to this point.
And on the same point, if there is excess demand in the market for one good,
there is excess supply in the other.

Exchange Economy
Market Equilibrium:
A competitive equilibrium is a tuple consisting of prices and an allocation of the

goods to the agents {(p1∗ , p2∗ ), (x a∗ , x b∗ )} such that
1 Given price (p1∗ , p2∗ ), the bundle x a∗ maximizes consumer a’s utility given her
budget constraint.
2 Given price (p1∗ , p2∗ ), the bundle x b∗ maximizes consumer b’s utility given his
budget constraint.
3 Markets clear: demand equals supply in both markets.
x1a∗ + x1b∗ = e1a + e1b

x2a∗ + x2b∗ = e2a + e2b .

Exchange Economy
Competitive Equilibrium
Notice that the 2 demand equals supply equations are not independent. If
one holds, the other will hold also.
Indeed, add up the budget equations of the 2 agents, at any levels of demand.
p1 x1a + p2 x2a + p1 x1b + p2 x2b = p1 e1a + p2 e2a + p2 e1b + p2 e2b
This always holds with increasing utility functions.
Now suppose demand equals supply in market 1: x1a + x1b = e1a + e1b . Multiply
both sides by p1 and subtract this from the aggregated budget equations
above. We get:
p2 x2a + p2 x2b = p2 e2a + p2 e2b . Dividing by p2 , we see demand equals supply in
market 2.

Exchange Economy
Solving for Market Equilibrium
Step 1: Get the Marshallian demands for the 2 agents: suppressing the
endowments, I write them here as functions of the 2 prices:
x1a (p1 , p2 ), x2a (p1 , p2 ), x1b (p1 , p2 ), x2b (p1 , p2 ).
Step 2: Set up demand equals supply equations.
x1a (p1 , p2 ) + x1b (p1 , p2 ) = e1a + e1b
x2a (p1 , p2 ) + x2b (p1 , p2 ) = e2a + e2b .
As shown earlier, these equations are not independent. So we may use one of
them; say, the one for market 1.
Normalize one price, say p1 to equal 1; solve for p2 .

Exchange Economy
Solving for market equilibrium
So if (p1 , p2 ) = (1, p2∗ ) is a solution equating demand and supply in market 1,

then (1, p2∗ , x1a (1, p2∗ ), x2a (1, p2∗ ), x1b (1, p2∗ ), x2b (1, p2∗ )) is a competititve
equilibrium.
This works unless we have an edge case where in equilibrium, p1 = 0.

Exchange Economy
Competitive Equilibrium: Example
Let’s assume α = β
e a = (2, 6), e b = (6, 2).
The Marshallian demands are given by
α(2p1 + 6p2 ) (1 − α)(2p1 + 6p2 )

x1a (p1 , p2 ) = , x2a (p1 , p2 ) = .
p1 p2
and
α(6p1 + 2p2 ) (1 − α)(6p1 + 2p2 )

x1b (p1 , p2 ) = , x2b (p1 , p2 ) = .
p1 p2

Exchange Economy
The first market clearing condition (demand=supply) gives
α(2p1∗ + 6p2∗ ) α(6p1∗ + 2p2∗ )

+ =8
p1∗ p1∗
which simplifies to
p2∗ 1−α
∗ = .
p1 α

Exchange Economy
The second market clearing condition gives
(1 − α)(2p1∗ + 6p2∗ ) (1 − α)(6p1∗ + 2p2∗ )

+ =8
p2∗ p2∗
which also simplifies to

p2∗ 1−α
∗ = .
p1 α

Exchange Economy
Comeptitive Equilibrium Example
we normalize one price p1∗ = 1.

Exchange Economy
Consider the case α = β = 2/3,
x a∗ = (10/3, 10/3), x b∗ = (14/3, 14/3),
and
p ∗ = (p1∗ , p2∗ ) = (1, 1/2).

Exchange Economy
Intertemporal Equilibrium and Interest Rate
Let’s reinterpret the above example, in an intertemporal consumption setting.

There is one consumption good, 2 periods t = 1, 2. Endowments:
e1a = 2, e2a = 6, e1b = 6, e2b = 2.
But here, these are the agents’ endowments of the consumption good at time
1 and 2.
x1a , x2a refers to agent a’s consumption demands at times 1 and 2; similarly for
agent b.
Let both utility functions be
u(x1 , x2 ) = u(x1 ) + δ u(x2 ) = ln(x1 ) + (1/2) ln(x2 ).

Exchange Economy
Intertemporal equilibrium and interest rate
1/2
The preferences are the same as e u (x1 , x2 ) = x1 x2 = x1α x21−α with α = 2/3.
So all the data in the above example is retained here.
Normalize p1 = 1. Suppose at time t = 2, the good sells for q2 = 1 (so there
is zero inflation). Suppose I can borrow or lend at interest rate r .
Then, to be able to buy an additional unit of the good to consume at t = 2, I
need to save and invest 1/(1 + r ), which will grow to q2 = 1 tomorrow. Call
this p2 : p2 = 1/(1 + r ); the ’price’ I need to pay today, to be able to buy an
additional unit of the good in the next period.
The budget constraint of agent a will then be:
p1 x1a + p2 x2a = x1a + (1/(1 + r ))x2a = e1a + (1/(1 + r ))e2a

Exchange Economy
Intertemporal equilibrium and interest rate
The budget constraint of agent a will then be:

p1 x1b + p2 x2b = x1b + (1/(1 + r ))x2b = e1b + (1/(1 + r ))e2b
With e a = (2, 6), e b = (6, 2), we know competitive equilibrium prices are
p1 = 1, p2 = 1/2.
So, p2 = (1/(1 + r )) = 1/2, or r = 1: the equilibrium interest rate = 100
percent.
This suggests an impatience theory of how the interest rate is determined in
equilibrium: if the agents become more patient, δ is greater than the value
1/2 in this example, the demand for consumption in period 2 will rise: this
will increase p2 , that is, r will decrease.
Seen another way, the demand for consumption in period 1 will decrease, so
the supply of savings will increase, reducing the interest rate r .
Exchange Economy
First Theorem of Welfare Economics
What follows completes the slides but will not be discussed or tested.
The Theorem states that a competitive equilibrium is Pareto optimal.
The rough idea or special case being that if everyone faces the same prices
and optimizes in interior optima, and demand equals supply in all markets,
then everyone’s marginal rates of substitution (MRS) will equal the same
price ratios, and so will be equal to each other’s MRS. Under convexity of
indifference curves, this guarantees Pareto optimality.

Exchange Economy
Feasible Allocation
Recall that an allocation (x a , x b ) is called feasible if
x1a + x1b ≤ e1a + e1b .
and
x2a + x2b ≤ e2a + e2b .

Exchange Economy
Pareto Optimality
Definition
Recall that nn allocation (x a , x b ) is Pareto optimal if
1 it is feasible.
2 there exists no other feasible allocation (y a , y b ) such that for all i ∈ {a, b} :

u i y1i , y2i ≥ u i x1i , x2i
and for at least one i ∈ {a, b} :

u i y1i , y2i > u i x1i , x2i .

Exchange Economy
Competitive Equilibrium is Pareto Optimal
Theorem (First Welfare Theorem)

Every Competitive Equilibrium allocation (p ∗ , x a∗ , x b∗ ) is Pareto Efficient.

Exchange Economy
Proof:
Suppose not. Then there exists another allocation (y a , y b ), which is feasible,

such that
for all i : u i (y1i , y2i ) ≥ u i x1i∗ , x2i∗

for some i : u i (y1i , y2i ) > u i x1i∗ , x2i∗
If u i (y1i , y2i ) ≥ u i x1i∗ , x2i∗ , then the budget constraint (and monotone

preferences) implies that
p1∗ y1i + p2∗ y2i ≥ p1∗ x1i∗ + p2∗ x2i∗
and for some i 0

0 0 0 0
p1∗ y1i + p2∗ y2i > p1∗ x1i ∗ + p2∗ x2i ∗

Exchange Economy
Proof:
Adding these gives
∑ p1∗ y1i + p2∗ y2i > ∑ p1∗ x1i∗ + p2∗ x2i∗ = ∑ p1∗ e1i + p2∗ e2i ,
i i i
This is a contradiction because feasibility of (y a , y b ) means that
y1a + y1b ≤ e1a + e1b

y2a + y2b ≤ e2a + e2b .
Multiplying first by p1∗ and second by p2∗ and adding together gives
∑ p1∗ y1i + p2∗ y2i ≤ ∑ p1∗ e1i + p2∗ e2i .

i i

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Lecture 16.

November 16, 2023

Suppose an economy has many millions of people, with different preferences/

A Banerji Lecture 16. General Equilibrium November 16, 2023 2 / 48

A Banerji Lecture 16. General Equilibrium November 16, 2023 3 / 48

The length and height of the Edgeworth box are respectively w1 , w2 . We

Pareto superior allocation

A Banerji Lecture 16. General Equilibrium November 16, 2023 5 / 48

A Banerji Lecture 16. General Equilibrium November 16, 2023 6 / 48

Pareto Optimal Allocations

Indeed, any tangency of the indifference curves will satisfy

With the Cobb-Douglas utility function above, this gives us

A Banerji Lecture 16. General Equilibrium November 16, 2023 7 / 48

Pareto Optimal Allocations

Take a slightly different example: w1 = 4, w2 = 2, utility functions the same

A Banerji Lecture 16. General Equilibrium November 16, 2023 8 / 48

Pareto Optimal Allocations

In the examples above, at a tangency of indifference curves, the rate at which

A Banerji Lecture 16. General Equilibrium November 16, 2023 9 / 48

A Banerji Lecture 16. General Equilibrium November 16, 2023 10 / 48

Maximize θ u a (x1a , x2a ) + (1 − θ )u b (w1 − x1a , w2 − x2a ).

A Banerji Lecture 16. General Equilibrium November 16, 2023 11 / 48

We say any allocation (x a , x b ) is feasible if,

x1a + x1b ≤ e1a + e1b .

A Banerji Lecture 16. General Equilibrium November 16, 2023 12 / 48

and for at least one i ∈ {a, b} :

A Banerji Lecture 16. General Equilibrium November 16, 2023 13 / 48

Markets and Pareto Optimality

Markets and Pareto Optimality

So, without anyone sharing private information on their preferences,

A Banerji Lecture 16. General Equilibrium November 16, 2023 15 / 48

Agents in an Exchange Economy

There are two agents in the economy {a, b}.

A Banerji Lecture 16. General Equilibrium November 16, 2023 16 / 48

all utility functions are continuous, monotone and concave.

A Banerji Lecture 16. General Equilibrium November 16, 2023 17 / 48

Each consumer a’s problem is to maximize utility given prices (p1 , p2 )

max u a (x1a , x2a )

s.t. p1 x1a + p2 x2a ≤ p1 e1a + p2 e2a .

Each consumer b’s problem is to maximize utility given prices (p1 , p2 )

max u b (x1b , x2b )

s.t. p1 x1b + p2 x2b ≤ p1 e1b + p2 e2b .

A Banerji Lecture 16. General Equilibrium November 16, 2023 18 / 48

Let’s take the Cobb-Douglas utility function

u a (x1a , x2a ) = (x1a )α (x2a )1−α

for 0 < α, β < 1.

A Banerji Lecture 16. General Equilibrium November 16, 2023 19 / 48

For Cobb-Douglas, we can easily find their demands

α(p1 e1a + p2 e2a ) (1 − α)(p1 e1a + p2 e2a )

A Banerji Lecture 16. General Equilibrium November 16, 2023 20 / 48

A Banerji Lecture 16. General Equilibrium November 16, 2023 21 / 48

A Banerji Lecture 16. General Equilibrium November 16, 2023 22 / 48

A Banerji Lecture 16. General Equilibrium

Edgeworth Box: Excess Demand for Good 1.

Edgeworth Box: Supply=Demand.

Supply equals Demand

A Banerji Lecture 16. General Equilibrium November 16, 2023 30 / 48