Part IIa: Paper 1

General Equilibrium and Welfare

Economics

Dr Sönje Reiche
 Outline
• Summarising competitive equilibrium
– Cowell 6.4
– Varian 32.9-32.13
• Questions remaining
• Excess demand functions and defining
equilibrium
• Properties of excess demand functions
– Cowell 7.4-7.4.2
Competitive Equilibrium in a
p Closed Economy
 x

py

y px
MRS   MRT
py

yd  ys
Agg I.C.

Contract
PPF Curve
xd  xs x
Competitive Equilibrium in an
p
Open Economy
 x
py px
MRT 
y py
px
MRS 
py
ys
Export

yd

xs Import xd x
 Points to Note
• Spending power determined by position of PPF

• Well-behaved functions:
• concave production function
• indifference curves are convex

only one point of tangency

 Questions to Address
• Existence: Under what circumstances can we be
sure that an equilibrium exists?

• Uniqueness:Will an economy have only one

equilibrium?

• Stability: Will the economy somehow “tend to” or

“revert to” this equilibrium?

• Price Determination: And will this determine the

price system for us?
 Excess Demand Function

Ex  p   x d
 p   x  p   Rx
s

Aggregate Aggregate Economy’s

demand for x supply for x natural
given prices given prices resource of x

This function Ex  p  gives excess demand for good x as a

function of the price vector p.
 Aggregation of Consumer Demand

Partial equilibrium approach

x d
 p    x  p, mi 
d
i
i

General equilibrium approach

x d  p    xid  p 
i
 px Individual 1 px Individual 2

Conveniently
downward x x
sloping! px
Market Demand

x
 Aggregation of Supply
x s  p    x sf  p 
f
px Firm 1 Firm 2
px

x x
px Market Supply

Conveniently
upward sloping!

x
 Resource Stock

px

Rx
Putting these three elements together ...

Ex  p   x d
 p   x  p   Rx
s

px

Excess demand
Excess supply

Ex  p 
Ex  p   0
 Competitive Equilibrium
Equilibrium given by price vector p* which
satisfies 3 conditions

No excess demand
E  p *  0
Prices non-negative p*  0 for each good
So, if strongly
E  p *  p*  monotone
0 preferences,

p*  0 and
If excess supply,
equilibrium given by
price must be zero E  p *  0
Properties of Excess Demand
Functions
(these properties hold in and out of equilibrium)

(1) Homogenous of degree zero

Ex  t  p   Ex  p  t 0

so, we can normalise prices aribitrarily:

E.g. divide by plabour

or, divide by p
h
h so that prices sum to 1.
Individuals spend all their income because of non satiation.
Income is determined by resources and profits.
(2) Walras’s Law (local non-satiation)

 p E  p  0
h
h h

Once we know excess demand in H-1 markets, we

know excess demand in the Hth market

Diagram for two goods and normalised prices

1
px

Excess demand
Excess supply

Ex  p 
 Existence
Is there a set of prices such that Ex  p   0 ?

Well-behaved economy

1
p x

Excess demand
Excess supply

Ex  p 
Problems
• Discontinuous excess demand

1
px

Excess demand
Excess supply

Ex  p 
Existence requires each excess demand
function to be continuous
• production function concave
• indifference curves continuous and strictly convex
 Problem of non-concavity of production
w xs
p
One firm BUT:
if increasing returns to
scale, then only a
labour
small number of
… more generally, non-concave if
increasing returns to scale
firms, so non-
x concavity remains
s
Many firms

labour
Non-Convexity of indifference curves
y

x
px
Discontinuous demand function

x
 Summary
• Defined excess demand functions and showed
requirements for competitive equilibrium using these
functions

• Properties of excess demand functions

• Homogenous of degree 0
• Walras’s Law

• Using excess demand functions to consider

existence