1.

Examples of General Equilibrium Analysis

1.1. Pure Exchange Economy

Main aim:
provide example that contains basic ideas of general equilibrium theory

Literature:
Mas-Colell, A., Whinston, M.D. and J.R. Green (1995), Microeconomic
Theory, Oxford University Press, Chapter 15.B

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 Basic Structure and Notation
structure of the economy:
I no production, only trade
I two consumers i = 1, 2, two commodities ` = 1, 2
endowment:
I consumer i’s endowment of commodity `: ω`i ∈ R+
I consumer i’s endowment vector: ωi = (ω1i , ω2i ) ∈ R2+
I total endowment of commodity `: ω̄` = ω`1 + ω`2
consumption:
I consumer i’s consumption of commodity `: x`i ∈ R+
I consumer i’s consumption vector: xi = (x1i , x2i ) ∈ R2+
allocation:
I allocation: x = (x1 , x2 ) = ((x11 , x21 ), (x12 , x22 )) ∈ R4
+
I feasible allocation: x is feasible if x`1 + x`2 ≤ ω̄` for ` = 1, 2

I note: free disposal x`1 + x`2 < ω̄` is possible

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 Edgeworth-Box
I depicts all allocations x with x`1 + x`2 = ω̄` for ` = 1, 2

I examples: ω = endowment, x 6= ω
I note: all allocations in the Edgeworth-box are nonwasteful

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 Budget
I price of commodity `: p` ∈ R+ ; price vector: p = (p1 , p2 ) ∈ R2+
I consumer i’s wealth: p · ωi = p1 ω1i + p2 ω2i
I consumer i’s budget set: Bi (p ) = {xi ∈ R2+ : p · xi ≤ p · ωi }
I budget sets and budget lines:

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 Preferences
I consumer i has preference relation %i over consumption vectors xi
I strictly convex, continuous, strongly monotone
I indifference curves:

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 Demand
I consumer i chooses most preferred consumption vector in Bi (p )
I consumer i’s demand: xi (p, p · ωi ) = (x1i (p, p · ωi ), x2i (p, p · ωi ))
I homogenous of degree 0 in p (→ Why?)
I illustration for consumer 1 (consumer 2 analogous):

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 Offer Curve
I variation of price vector p → rotation of budget line arround ω
I offer curve of consumer i = set of all xi (p, p · ωi ) for alternative p
I illustration for consumer 1 (consumer 2 analogous):

I tangent to indifference curve through ω, since xi (p, p · ωi ) %i ωi

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 Excess Demand
I consumer i’s excess demand for commodity `: x`i (p, p · ωi ) − ω`i
I illustration for given price vector p:

I commodity 2 in excess demand: x21 + x22 > ω̄2

commodity 1 in excess supply: x11 + x12 < ω̄1
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 Walrasian Equilibrium
I Definition 1: A Walrasian (or competitive) equilibrium is a price
vector p ∗ and an allocation x ∗ = (x1∗ , x2∗ ) such that
(1) for i = 1, 2: xi∗ %i xi0 for all xi0 ∈ Bi (p ∗ )
(2) for ` = 1, 2: x`∗1 + x`∗2 = ω̄`
I illustration:

I How to come from disequilibrium on p. 8 to equilibrium above?

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 Some Properties of Equilibrium
I tangent point of indifference curves (exceptions on edge of the box)
I any intersection of offer curves (except at ω) is an equilibrium:

I equilibrium determines only relative price p1∗ /p2∗

reason: xi (θp ∗ , θp ∗ · ωi ) = xi (p ∗ , p ∗ · ωi ) for any θ > 0
→ if p ∗ = (p1∗ , p2∗ ) is an equilibrium, then θp ∗ = (θp1∗ , θp2∗ ), too
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 Example I
I consumer i’s preferences: u (x1i , x2i ) = x1αi x21i−α with α ∈]0, 1[
endowment: ω1 = (1, 2) and ω2 = (2, 1)
I consumer 1’s offer curve (check!): wealth is p1 + 2p2
α(p1 + 2p2 ) (1 − α)(p1 + 2p2 )
 
OC1 (p ) = ,
p1 p2
I consumer 2’s offer curve (check!): wealth is 2p1 + p2
α(2p1 + p2 ) (1 − α)(2p1 + p2 )
 
OC2 (p ) = ,
p1 p2
I equilibrium price vector p ∗ = (p1∗ , p2∗ ) clears market for good 1:
α(p1∗ + 2p2∗ ) α(2p1∗ + p2∗ )
+ =3
p1∗ p1∗
p∗ α
I solving: 1∗ =
p2 1−α
I note: p ∗ also clears market for good 2 (check) → Walras’ Law
thus: one equilibrium condition can be ignored
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 Uniqueness

I above: unique equilibrium

I but: there may be multiple equilibria

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 Example II
−8
I consumer 1’s preferences: u1 (x11 , x21 ) = x11 − x21 /8
−8
consumer 2’s preferences: u2 (x12 , x22 ) = x22 − x12 /8
endowment: ω1 = (2, r ), ω2 = (r , 2) with r = 28/9 − 21/9
I consumer 1’s offer curve (check!): wealth is 2p1 + rp2
    8/9   −1/9 !
p2 p2 p2
OC1 (p ) = 2 + r − ,
p1 p1 p1
I consumer 2’s offer curve (check!): wealth is rp1 + 2p2
  −1/9     8/9 !
p1 p1 p1
OC2 (p ) = ,2+r −
p2 p2 p2
I equilibrium price vector p ∗ = (p1∗ , p2∗ ) clears market for good 1:
    8/9   −1/9
p2 p2 p1
2+r − + = 2+r
p1 p1 p2
p∗ p∗ p∗
I solving: 1∗ = 0.5 or 1∗ = 1 or 1∗ = 2
p2 p2 p2
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 Existence
I so far: equilibrium exists
I but: there may be cases where an equilibrium does not exist
I example: non-convex preferences (consumer 1)

I note: no intersection of the offer curves

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 Pareto Efficiency
I Definition 2: An allocation x is Pareto optimal (or Pareto efficient)
if there is no other allocation x 0 with
(1) xi0 %i xi for all i = 1, 2 and
(2) xi0 i xi for some i = 1, 2.
I illustration:

I if optimum is an interior point: indifference curves are tangent

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 Pareto Set and Contract Curve
I Pareto set: set of all Pareto optimal allocations
I contract curve: part of the Pareto set where both consumers do at
least as well as at the initial endowment
I illustration:

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First Fundamental Theorem of Welfare Economics
I Theorem: Any Walrasian Equilibrium is Pareto efficient!
I repeat illustration of the equilibrium:

I efficiency because no lense between indifference curves

I microeconomic foundation of Adam Smith’s ’invisible hand’
only justification of policy intervention: distributional objectives
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Second Fundamental Theorem of Welfare Economics
I Definition: An allocation x ∗ is supportable as an equilibrium with
transfers if there is a price vector p ∗ and welfare transfers T1 and
T2 satisfying T1 + T2 = 0, such that for all i = 1, 2 we have:
xi∗ %i xi0 for all xi0 ∈ R2+ satisfying p ∗ · xi0 ≤ p ∗ · ωi + Ti .
I Theorem: Any Pareto optimal allocation is supportable as an
equilibrium with transfers (fulfills distributional objectives!).
I illustration for wealth transfers and transfers of endowments:

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 Non-Convexities
I second welfare theorem does not hold if preferences are non-convex
I illustration: consumer 1 has non-convex preferences

I x ∗ is Pareto efficient, but not supportable as an equilibrium with

transfers (consumer 2 chooses x2∗ , but 1 prefers e.g. x10 )

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 Exercises

Mas-Colell/Whinston/Green (1995, pp. 540):

I Exercise 15.B.1

I Exercise 15.B.2

I Exercise 15.B.6

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