Lesson 12: General Equilibrium

1. Production
2. Exchange
1. Production
 Robinson Crusoe’s Economy

 One agent, RC.

 Endowed with a fixed quantity of one
resource -- 24 hours.
 Use time for labor (production) or
leisure (consumption).
 Labor time = L. Leisure time = 24 - L.
 What will RC choose?
 Robinson Crusoe’s Technology

 Technology: Labor produces output

(coconuts) according to a concave
production function.
 Robinson Crusoe’s Technology
Coconuts

Production function

Feasible production
plans
0 24 Labor (hours)
 Robinson Crusoe’s Preferences

 RC’s preferences:
– coconut is a good
– leisure is a good
 Robinson Crusoe’s Preferences
Coconuts

More preferred

0 24 Leisure (hours)
 Robinson Crusoe’s Preferences
Coconuts
More preferred

24 0 Leisure (hours)
 Robinson Crusoe’s Choice
Coconuts

Production function

Feasible production
plans
0 24 Labor (hours)
24 0 Leisure (hours)
 Robinson Crusoe’s Choice
Coconuts

Production function

Feasible production
plans
0 24 Labor (hours)
24 0 Leisure (hours)
 Robinson Crusoe’s Choice
Coconuts

Production function
C*
Output

Labor Leisure
0 L* 24 Labor (hours)
24 0 Leisure (hours)
 Robinson Crusoe’s Choice
Coconuts

MRS = MPL
Production function
C*
Output

Labor Leisure
0 L* 24 Labor (hours)
24 0 Leisure (hours)
 Robinson Crusoe as a Firm

 Now suppose RC is both a utility-

maximizing consumer and a profit-
maximizing firm.
 Use coconuts as the numeraire
good; i.e. price of a coconut = $1.
 RC’s wage rate is w.
 Coconut output level is C.
 Robinson Crusoe as a Firm

 RC’s firm’s profit is  = C - wL.

  = C - wL  C =  + wL, the
equation of an isoprofit line.
 Slope = + w .
 Intercept =  .
 Isoprofit Lines
Coconuts
C    wL
Higher profit;  1 2 3

3 Slopes = + w
2
1

0 24 Labor (hours)
 Profit-Maximization
Coconuts

Production function

Feasible production
plans
0 24 Labor (hours)
 Profit-Maximization
Coconuts

Production function

0 24 Labor (hours)
 Profit-Maximization
Coconuts

Production function
C*

0 L* 24 Labor (hours)
 Profit-Maximization
Coconuts Isoprofit slope = production function slope
i.e. w = MPL = 1 MPL = MRPL.

Production function
C*
* Given w, RC’s firm’s quantity
Labor Output demanded of labor is L*
demand supply And output quantity
supplied is C*.
0 L* 24 Labor (hours)
RC gets  *  C *  wL *
 Utility-Maximization

 Now consider RC as a consumer

endowed with $* who can work for
$w per hour.
 What is RC’s most preferred
consumption bundle?
 Budget constraint is C   *  wL.
 Utility-Maximization
Coconuts

Budget constraint
C   *  wL.
*

0 24 Labor (hours)
 Utility-Maximization
Coconuts

Budget constraint; slope = w

C   *  wL.
*

0 24 Labor (hours)
 Utility-Maximization
Coconuts
More preferred

0 24 Labor (hours)
 Utility-Maximization
Coconuts

Budget constraint; slope = w

C   *  wL.
*

0 24 Labor (hours)
 Utility-Maximization
Coconuts

MRS = w
Budget constraint; slope = w
C*
C   *  wL.
* Given w, RC’s quantity
Labor supplied of labor is L*
supply

0 L* 24 Labor (hours)
 Utility-Maximization
Coconuts

MRS = w
Budget constraint; slope = w
C*
C   *  wL.
* Given w, RC’s quantity
Labor Output supplied of labor is L* and
supply demand output quantity demanded is C*.

0 L* 24 Labor (hours)
 Utility-Maximization & Profit-
Maximization
 Profit-maximization: Coconut and labor
– w = MPL markets both clear.
– quantity of output supplied = C*
– quantity of labor demanded = L*
Utility-maximization:
w = MRS
quantity of output demanded = C*
quantity of labor supplied = L*
 Utility-Maximization & Profit-
Maximization
Coconuts
MRS = w = MPL

Given w, RC’s quantity

supplied of labor = quantity
C* demanded of labor = L* and
* output quantity demanded =
output quantity supplied = C*.

0 L* 24 Labor (hours)
 Pareto Efficiency

 Must have MRS = MPL.

 Pareto Efficiency
Coconuts
MRS  MPL

Preferred consumption
bundles.

0 24 Labor (hours)
 Pareto Efficiency
Coconuts
MRS = MPL

0 24 Labor (hours)
 Pareto Efficiency
Coconuts
MRS = MPL. The common slope  relative
wage rate w that implements
the Pareto efficient plan by
decentralized pricing.

0 24 Labor (hours)
 First Fundamental Theorem of
Welfare Economics
A competitive market equilibrium is
Pareto efficient if
– consumers’ preferences are convex
– there are no externalities in
consumption or production.
Second Fundamental Theorem of
Welfare Economics
 Any Pareto efficient economic state
can be achieved as a competitive
market equilibrium if
– consumers’ preferences are convex
– firms’ technologies are convex
– there are no externalities in
consumption or production.
 Non-Convex Technologies

 Do the Welfare Theorems hold if

firms have non-convex
technologies?
The 1st Theorem does not rely upon
firms’ technologies being convex.
 Non-Convex Technologies
Coconuts
MRS = MPL The common slope  relativ
wage rate w that
implements the Pareto
efficient plan by
decentralized pricing.

0 24 Labor (hours)
 Non-Convex Technologies

 Do the Welfare Theorems hold if

firms have non-convex
technologies?
 The 2nd Theorem does require that
firms’ technologies be convex.
 Non-Convex Technologies
Coconuts
MRS = MPL. The Pareto optimal allocation
cannot be implemented b
a competitive equilibrium

0 24 Labor (hours)
 Production Possibilities

 Resource and technological

limitations restrict what an economy
can produce.
 The set of all feasible output bundles
is the economy’s production
possibility set.
 The set’s outer boundary is the
production possibility frontier.
 Production Possibilities
Coconuts
Production possibility frontier (ppf)
Production possibility set

Fish
 Production Possibilities
Coconuts

Feasible and efficient

Infeasible
Feasible but
inefficient

Fish
 Production Possibilities
Coconuts
Ppf’s slope is the marginal rate
of product transformation.

Fish
 Production Possibilities
Coconuts
Ppf’s slope is the marginal rate
of product transformation.
Increasingly negative MRPT
 increasing opportunity
cost to specialization.

Fish
 Production Possibilities

 Ifthere are no production

externalities then a ppf will be
concave w.r.t. the origin.
 Why?

Because efficient production

requires exploitation of comparative
advantages.
 Comparative Advantage

 Two agents, RC and Man Friday (MF).

 RC can produce at most 20 coconuts
or 30 fish.
 MF can produce at most 50 coconuts
or 25 fish.
 Comparative Advantage
C RC

20 MRPT = -2/3 coconuts/fish so opp. cost of one

more fish is 2/3 foregone coconuts.
RC has the comparative
30 F opp. cost advantage in
C MF
50 producing fish.

MRPT = -2 coconuts/fish so opp. cost of one

more fish is 2 foregone coconuts.

25 F
 Comparative Advantage
C RC

20 MRPT = -2/3 coconuts/fish so opp. cost of one

more coconut is 3/2 foregone fish.

30 F
C MF
50
MRPT = -2 coconuts/fish so opp. cost of one
more coconut is 1/2 foregone fish.
MF has the comparative
opp. cost advantage in
producing coconuts.
25 F
 Comparative Advantage
C RC
Economy
C Use RC to produce
20
fish before using MF.
70
30 F
C Use MF to
MF 50
50 produce
coconuts before
using RC.

30 55 F
25 F
 Comparative Advantage
C RC
Economy
C Using low opp. cost
20
producers first results
70 in a ppf that is concave
30 F w.r.t the origin.
C MF 50
50

30 55 F
25 F
 Comparative Advantage
Economy
C
More producers with
different opp. costs
“smooth out” the ppf.

F
 Coordinating Production &
Consumption
 The ppf contains many technically
efficient output bundles.
 Which are Pareto efficient for
consumers?
 Coordinating Production &
Consumption
Coconuts
Output bundle is ( F  , C  )
C

F Fish
 Coordinating Production &
Consumption
Coconuts
Output bundle is ( F  , C  )
C and is the aggregate
endowment for distribution
to consumers RC and MF.

F Fish
 Coordinating Production &
Consumption
Coconuts
Output bundle is ( F  , C  )
OMF and is the aggregate
C
endowment for distribution
to consumers RC and MF.

ORC
F Fish
 Coordinating Production &
Consumption
Coconuts
Allocate ( F  , C  ) efficiently;
OMF  , CRC
say ( FRC  ) to RC
C


CRC

ORC

FRC F Fish
 Coordinating Production &
Consumption
Coconuts

FMF Allocate ( F  , C  ) efficiently;
OMF
C  , CRC
say ( FRC  ) to RC and
 , CMF
( FMF  ) to MF.


CRC 
C MF

ORC

FRC F Fish
 Coordinating Production &
Consumption
Coconuts

FMF
C
OMF MRS  MRPT


CRC 
C MF

ORC

FRC F Fish
 Coordinating Production &
Consumption
Coconuts

FMF ( F  , C  ).
Instead produce
OMF
C
O’MF
C 


CRC 
C MF

ORC

FRC F F  Fish
 Coordinating Production &
Consumption
Coconuts

FMF ( F  , C  ).
Instead produce
OMF
C
O’MF
C 


CRC 
C MF

ORC

FRC F F  Fish
 Coordinating Production &
Consumption
Coconuts

FMF Instead produce( F  , C  ).
OMF
C Give MF same allocation

FMF O’MF
C  as before.


CRC 
C MF

C MF

ORC

FRC F F  Fish
 Coordinating Production &
Consumption
Coconuts

FMF Instead produce ( F  , C  ).
OMF
C Give MF same allocation

FMF O’MF as before. MF’s
C 
utility is
unchanged.

CRC 
C MF

C MF

ORC

FRC F F  Fish
 Coordinating Production &
Consumption
Coconuts
Instead produce ( F  , C  ).
OMF
Give MF same allocation

FMF O’MF as before. MF’s
C 
utility is
unchanged


C MF

ORC
F  Fish
 Coordinating Production &
Consumption
Coconuts
Instead produce ( F  , C  ).
OMF
Give MF same allocation

FMF O’MF as before. MF’s
C 
utility is
unchanged


CRC 
C MF

ORC

FRC F  Fish
 Coordinating Production &
Consumption
Coconuts
Instead produce ( F  , C  ).
OMF
Give MF same allocation

FMF O’MF as before. MF’s
C 
utility is
unchanged, RC’s
utility is higher

CRC 
C MF

ORC

FRC F  Fish
 Coordinating Production &
Consumption
Coconuts
Instead produce ( F  , C  ).
OMF
Give MF same allocation

FMF O’MF as before. MF’s
C 
utility is
unchanged, RC’s
utility is higher;
Pareto

CRC 
C MF
improvement.

ORC

FRC F  Fish
 Coordinating Production &
Consumption
 MRS  MRPT  inefficient
coordination of production and
consumption.
 Hence, MRS = MRPT is necessary for
a Pareto optimal economic state.
 Coordinating Production &
Consumption
Coconuts

FMF OMF
C

CRC C MF

ORC
FRC F Fish
 Decentralized Coordination of
Production & Consumption
 RC and MF jointly run a firm
producing coconuts and fish.
 RC and MF are also consumers who
can sell labor.
 Price of coconut = pC.
 Price of fish = pF.
 RC’s wage rate = wRC.
 MF’s wage rate = wMF.
 Decentralized Coordination of
Production & Consumption
 LRC, LMF are amounts of labor
purchased from RC and MF.
 Firm’s profit-maximization problem is
choose C, F, LRC and LMF to
max   pC C  pF F  w RC LRC  w MF LMF .
 Decentralized Coordination of
Production & Consumption
max   pC C  pF F  w RC LRC  w MF LMF .
Isoprofit line equation is
constant   pC C  pF F  w RC LRC  w MF LMF
which rearranges to
  w RC LRC  w MF LMF pF
C  F.
pC pC
 Decentralized Coordination of
Production & Consumption
max   pC C  pF F  w RC LRC  w MF LMF .
Isoprofit line equation is
constant   pC C  pF F  w RC LRC  w MF LMF
which rearranges to
  w RC LRC  w MF LMF pF
C  F.

pC 2pC
slope
intercept
 Decentralized Coordination of
Production & Consumption
Coconuts
Higher profit

pF
Slopes =
pC

Fish
 Decentralized Coordination of
Production & Consumption
Coconuts

The firm’s production

possibility set.

Fish
 Decentralized Coordination of
Production & Consumption
Coconuts

Profit-max. plan
pF
Slopes =
pC

Fish
 Decentralized Coordination of
Production & Consumption
Coconuts

Profit-max. plan
pF
Competitive markets Slope =  p
C
and profit-maximization
 MRPT   pF .
pC

Fish
 Decentralized Coordination of
Production & Consumption
 So
competitive markets, profit-
maximization, and utility
maximization all together cause
pF
MRPT    MRS ,
pC
the condition necessary for a Pareto
optimal economic state.
 Decentralized Coordination of
Production & Consumption
Coconuts
Competitive markets
and utility-maximization
FMF OMF
C MRS   pF .
pC

CRC C MF

ORC
FRC F Fish
 Decentralized Coordination of
Production & Consumption
Coconuts
Competitive markets, utility-
maximization and profit-
FMF OMF maximization 
C pF
MRS    MRPT .
pC

CRC C MF

ORC
FRC F Fish
 2. Exchange
 Two consumers, A and B.
 Their endowments of goods 1 and 2
are A A A and B
  ( 1 ,  2 )   ( 1B ,  2B ).
A B
 E.g.   ( 6,4 ) and   ( 2, 2).
 The total quantities available
A B
are  1   1  6  2  8 units of good 1
A B
and 2  2  4  2  6 units of good 2.
 Exchange

 Edgeworth and Bowley devised a

diagram, called an Edgeworth box, to
show all possible allocations of the
available quantities of goods 1 and 2
between the two consumers.
 Starting an Edgeworth Box

Height =
A B The dimensions of
2  2 the box are the
 42 quantities available
6 of the goods.

A B

Width = 1   1  6 2 8
 Feasible Allocations
 What allocations of the 8 units of
good 1 and the 6 units of good 2 are
feasible?
 How can all of the feasible
allocations be depicted by the
Edgeworth box diagram?
 Feasible Allocations
 What allocations of the 8 units of
good 1 and the 6 units of good 2 are
feasible?
 How can all of the feasible
allocations be depicted by the
Edgeworth box diagram?
 One feasible allocation is the before-
trade allocation; i.e. the endowment
allocation.
 The Endowment Allocation

Height = The endowment

A B allocation is
2  2
 A  ( 6 ,4 )
 42 and
6  B  ( 2, 2).

A B

Width = 1   1  6 2 8
 The Endowment Allocation

Height =
A B
2  2
 42
6

 A  ( 6 ,4 )
B
 A
  B   ( 2, 2)
Width = 1 1  6 2 8
 The Endowment Allocation
OB

OA
 A  ( 6 ,4 )
B
  ( 2, 2)
8
 The Endowment Allocation
OB

6
4

OA
 A  ( 6 ,4 )
6
8
 The Endowment Allocation
2
OB
2

6
4

OA
6 B
  ( 2, 2)
8
 The Endowment Allocation
2
OB
2

6 The
4 endowment
allocation
OA
 A  ( 6 ,4 )
6 B
  ( 2, 2)
8
The Endowment Allocation

More generally, …
 The Endowment Allocation
 1B
OB
B
A 2
2

A The
B
2 2 endowment
allocation
OA
A
1
A B
1  1
 Other Feasible Allocations
A A
 ( x1 , x 2 ) denotes an allocation to
consumer A.
B B
 ( x1 , x 2 ) denotes an allocation to
consumer B.
 An allocation is feasible if and only if

x1A  xB1   1
A
  B
1
A B A B
and x 2  x 2   2   2 .
 Feasible Reallocations
xB
1
OB
A
2 xB
2

B
2
A
x2
OA
x1A
A B
1  1
 Feasible Reallocations
xB
1
OB
A B
2 x2

B
2 A
x2

OA
x1A
A B
1  1
 Feasible Reallocations

 Allpoints in the box, including the

boundary, represent feasible
allocations of the combined
endowments.
 Feasible Reallocations

 All points in the box, including the

boundary, represent feasible
allocations of the combined
endowments.
 Which allocations will be blocked by
one or both consumers?
 Which allocations make both
consumers better off?
Adding Preferences to the Box
xA For consumer A.
2

A
2
OA
 1A x1A
Adding Preferences to the Box
xB For consumer B.
2

B
2

OB
 1B xB
1
Adding Preferences to the Box
B
xB For consumer B.  1 OB
1

B
2

xB
2
Adding Preferences to the Box
xA For consumer A.
2

A
2
OA
 1A x1A
 Adding Preferences to the Box
xA
2
B
x1  1B OB

B
2
A
2
OA
 1A x1A
B
x2
 A
Edgeworth’s Box
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Pareto-Improvement

 An allocation of the endowment that

improves the welfare of a consumer
without reducing the welfare of
another is a Pareto-improving
allocation.
 Where are the Pareto-improving
allocations?
 A
Edgeworth’s Box
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 A
Pareto-Improvements
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1
The set of Pareto-
improving allocations xB
2
 Pareto-Improvements

 Since each consumer can refuse to

trade, the only possible outcomes
from exchange are Pareto-improving
allocations.
 But which particular Pareto-
improving allocation will be the
outcome of trade?
 A
Pareto-Improvements
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1
The set of Pareto-
improving reallocations xB
2
Pareto-Improvements
 Pareto-Improvements
New mutual gains-to-trade region
is the set of all further Pareto-
improving
reallocations.

Trade
improves both
A’s and B’s welfares.
This is a Pareto-improvement
over the endowment allocation.
Pareto-Improvements
Further trade cannot improve
both A and B’s
welfares.
 Pareto-Optimality
Better for
consumer A

Better for
consumer B
 Pareto-Optimality
Both A and
B are worse A is strictly better off
off but B is strictly worse
off

B is strictly better Both A

off but A is strictly and B are
worse off worse
off
 Pareto-Optimality

The allocation is
Pareto-optimal since the
only way one consumer’s
welfare can be increased is to
decrease the welfare of the other
consumer.
 Pareto-Optimality
An allocation where convex
indifference curves are “only
just back-to-back” is
Pareto-optimal.

The allocation is
Pareto-optimal since the
only way one consumer’s
welfare can be increased is to
decrease the welfare of the other
consumer.
 Pareto-Optimality

 Where are all of the Pareto-optimal

allocations of the endowment?
 A
Pareto-Optimality
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 A
Pareto-Optimality
x2 All the allocations marked by
a are Pareto-optimal.
B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Pareto-Optimality

 Thecontract curve is the set of all

Pareto-optimal allocations.
 A
Pareto-Optimality
x2 All the allocations marked by
a are Pareto-optimal.
B
xB 1 OB
1

 2A  2B
OA A A
1 x1
The contract curve
xB
2
 Pareto-Optimality

 But to which of the many allocations

on the contract curve will consumers
trade?
 That depends upon how trade is
conducted.
 In perfectly competitive markets? By
one-on-one bargaining?
 A
The Core
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1
The set of Pareto-
improving reallocations xB
2
 A
The Core
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 A
The Core
x 2 Pareto-optimal trades blocked
by B
B
xB 1 OB
1

 2A  2B
OA A A
1 x1
Pareto-optimal trades blocked
by A xB
2
 A
The Core
x2 Pareto-optimal trades not blocked
by A or B
B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 A
The Core
x2 Pareto-optimal trades not blocked
by A or B are the core.
B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 The Core
 The core is the set of all Pareto-
optimal allocations that are welfare-
improving for both consumers
relative to their own endowments.
 Rational trade should achieve a core
allocation.
 The Core

 Butwhich core allocation?

 Again, that depends upon the
manner in which trade is conducted.
 Trade in Competitive Markets

 Consider trade in perfectly

competitive markets.
 Each consumer is a price-taker trying
to maximize her own utility given p1,
p2 and her own endowment. That is,
...
Trade in Competitive Markets
xA For consumer A.
2
p1x1A  p 2x A
2  p 
1 1
A
 p 
2 2
A

*A
x2
A
2
OA
x*1A  1A x1A
 Trade in Competitive Markets

 So given p1 and p2, consumer A’s net

demands for commodities 1 and 2
are
*A A *A A
x1   1 and x 2   2 .
 Trade in Competitive Markets

 And, similarly, for consumer B …

Trade in Competitive Markets
xB For consumer B.
2
p1xB
1  p x
2 2
B
 p 
1 1
B
 p 
2 2
B

B
2
x*2B

OB
 1B x*1B xB
1
 Trade in Competitive Markets

 So given p1 and p2, consumer B’s net

demands for commodities 1 and 2
are
*B B *B B
x1   1 and x 2   2 .
 Trade in Competitive Markets

A general equilibrium occurs when

prices p1 and p2 cause both the
markets for commodities 1 and 2 to
clear; i.e.
*A *B A B
x1  x1   1   1
and x*2A  x*2B   2A   2B .
 Trade
A
in Competitive Markets
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Trade
A
in Competitive Markets
x2 Can this PO allocation be
achieved?
B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Trade
A
in Competitive Markets
x 2 Budget constraint for consumer A

B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Trade
A
in Competitive Markets
x 2 Budget constraint for consumer A

B
xB 1 OB
1

*A
x2
 2A  2B
OA A A
1 x1
x*1A
xB
2
 Trade
A
in Competitive Markets
x2

B
xB 1 OB
1

*A
x2
 2A  2B
OA A A
1 x1
x*1A
B
x
Budget constraint for consumer B 2
 Trade
A
in Competitive Markets
x2
x*1B
B
xB 1 OB
1
*B
x2
*A
x2
 2A  2B
OA A A
1 x1
x*1A
B
x
Budget constraint for consumer B 2
 Trade
A
in Competitive Markets
x2
x*1B
B
xB 1 OB
1
*B
x2
*A
x2
 2A  2B
OA A A
1 x1
x*1A
But
x*1A  x*1B   1A   1B xB
2
 Trade
A
in Competitive Markets
x2
x*1B
B
xB 1 OB
1
*B
x2
*A
x2
 2A  2B
OA A A
1 x1
x*1A
and
x*2A  x*2B   2A   2B xB
2
 Trade in Competitive Markets

 So at the given prices p1 and p2 there

is an
– excess supply of commodity 1
– excess demand for commodity 2.
 Neither market clears so the prices
p1 and p2 do not cause a general
equilibrium.
 Trade
A
in Competitive Markets
x2 So this PO allocation cannot be
achieved by competitive trading.
B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Trade
A
in Competitive Markets
x2 Which PO allocations can be
achieved by competitive trading?
B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Trade in Competitive Markets

 Since there is an excess demand for

commodity 2, p2 will rise.
 Since there is an excess supply of
commodity 1, p1 will fall.
 The slope of the budget constraints
is - p1/p2 so the budget constraints
will pivot about the endowment point
and become less steep.
 Trade
A
in Competitive Markets
x2 Which PO allocations can be
achieved by competitive trading?
B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Trade
A
in Competitive Markets
x2 Which PO allocations can be
achieved by competitive trading?
B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Trade
A
in Competitive Markets
x2 Which PO allocations can be
achieved by competitive trading?
B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Trade
A
in Competitive Markets
x 2 Budget constraint for consumer A

B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Trade
A
in Competitive Markets
x 2 Budget constraint for consumer A

B
xB 1 OB
1

x*2A  2A  2B
OA A A
1 x1
x*1A
xB
2
 Trade
A
in Competitive Markets
x2

B
xB 1 OB
1

x*2A  2A  2B
OA A A
1 x1
x*1A
Budget constraint for consumer B xB
2
 Trade
A
in Competitive Markets
x2 *B
x1
B
xB 1 OB
1

x*2B

x*2A  2A  2B
OA A A
1 x1
x*1A
Budget constraint for consumer B xB
2
 Trade
A
in Competitive Markets
x2 *B
x1
B
xB 1 OB
1

x*2B

x*2A  2A  2B
OA A A
1 x1
x*1A
So *A *B A B
x1  x1   1   1 xB
2
 Trade
A
in Competitive Markets
x2 *B
x1
B
xB 1 OB
1

x*2B

x*2A  2A  2B
OA A A
1 x1
x*1A
and *A *B A B
x2  x2   2   2 xB
2
 Trade in Competitive Markets
 At the new prices p1 and p2 both
markets clear; there is a general
equilibrium.
 Trading in competitive markets
achieves a particular Pareto-optimal
allocation of the endowments.
 This is an example of the First
Fundamental Theorem of Welfare
Economics.
 First Fundamental Theorem of
Welfare Economics
 Giventhat consumers’ preferences
are well-behaved, trading in perfectly
competitive markets implements a
Pareto-optimal allocation of the
economy’s endowment.
Second Fundamental Theorem of
Welfare Economics
 The First Theorem is followed by a
second that states that any Pareto-
optimal allocation (i.e. any point on
the contract curve) can be achieved
by trading in competitive markets
provided that endowments are first
appropriately rearranged amongst
the consumers.
Second Fundamental Theorem of
Welfare Economics
 Giventhat consumers’ preferences
are well-behaved, for any Pareto-
optimal allocation there are prices
and an allocation of the total
endowment that makes the Pareto-
optimal allocation implementable by
trading in competitive markets.
 Second Fundamental Theorem
A
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1
The contract curve
xB
2
 Second Fundamental Theorem
A
x2

*B B
xB x1 1 OB
1

*A *B
x2 x2
 2A  2B
OA *A A A
x1 1 x1

xB
2
 Second Fundamental Theorem
A Implemented by competitive
x2
trading from the endowment .
*B B
xB x1 1 OB
1

*A *B
x2 x2
 2A  2B
OA *A A A
x1 1 x1

xB
2
 Second Fundamental Theorem
A Can this allocation be implemented
x2
by competitive trading from ?
B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Second Fundamental Theorem
A Can this allocation be implemented
x2
by competitive trading from ? No.
B
xB 1 OB
1

 2A  2B
OA A A
1 x1

xB
2
 Second Fundamental Theorem
A But this allocation is implemented
x2
by competitive trading from q.
B
xB q1 OB
1

A B
q2 q2

OA A A
q1 x1

xB
2
 Walras’ Law
 Walras’Law is an identity; i.e. a
statement that is true for any
positive prices (p1,p2), whether these
are equilibrium prices or not.
 Walras’ Law
 Every consumer’s preferences are
well-behaved so, for any positive
prices (p1,p2), each consumer spends
all of his budget.
 For consumer A:
p1x*1A  p 2x*2A  p1 1A  p 2 2A
For consumer B:
p1x*1B  p 2x*2B  p1 1B  p 2 2B
 Walras’ Law
p1x*1A  p 2x*2A  p1 1A  p 2 2A
p1x*1B  p 2x*2B  p1 1B  p 2 2B
Summing gives
p1 ( x*1A  x*1B )  p 2 ( x*2A  x*2B )
 p1 ( 1A   1B )  p 2 ( 2B   2B ).
 Walras’ Law
p1 ( x*1A  x*1B )  p 2 ( x*2A  x*2B )
 p1 ( 1A   1B )  p 2 ( 2B   2B ).
Rearranged,
p1 ( x*1A  x*1B   1A   1B ) 
p 2 ( x*2A  x*2B   2A   2B )  0.
That is, ...
 Walras’ Law
*A *B A B
p1 ( x1  x1  1  1 ) 
*A *B A B
p2 (x2  x 2  2  2 )
 0.
This says that the summed market
value of excess demands is zero for
any positive prices p1 and p2 --
this is Walras’ Law.
 Implications of Walras’ Law
Suppose the market for commodity A
is in equilibrium; that is,
*A *B A B
x1  x1  1  1  0.
Then *A *B A B
p1 ( x1  x1  1  1 ) 
*A *B A B
p 2 ( x 2  x 2  2  2 )  0
implies
*A *B A B
x2  x2  2  2  0.
 Implications of Walras’ Law

So one implication of Walras’ Law for

a two-commodity exchange economy
is that if one market is in equilibrium
then the other market must also be in
equilibrium.
 Implications of Walras’ Law
What if, for some positive prices p1 and
p2, there is an excess quantity supplied
of commodity 1? That is,
*A *B A B
x1  x1  1  1  0.
Then *A *B A B
p1 ( x1  x1  1  1 ) 
*A *B A B
p 2 ( x 2  x 2  2  2 )  0
implies
*A *B A B
x2  x2  2  2  0.
 Implications of Walras’ Law

So a second implication of Walras’ Law

for a two-commodity exchange economy
is that an excess supply in one market
implies an excess demand in the other
market.