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Exchange (Chapter 17)

1) The document discusses concepts from general equilibrium theory including Walrasian equilibrium, Pareto efficiency, and the First and Second Theorems of Welfare. 2) A Walrasian equilibrium exists when supply equals demand in all markets and consumers maximize utility given prices and budgets. 3) The First Theorem of Welfare states that any allocation resulting from a Walrasian equilibrium will be Pareto efficient, meaning there is no other allocation where someone can be made better off without making someone else worse off. 4) The Second Theorem of Welfare shows that any Pareto efficient allocation can result from a Walrasian equilibrium for the appropriate price vector, if preferences are convex and monotonic.

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166 views8 pages

Exchange (Chapter 17)

1) The document discusses concepts from general equilibrium theory including Walrasian equilibrium, Pareto efficiency, and the First and Second Theorems of Welfare. 2) A Walrasian equilibrium exists when supply equals demand in all markets and consumers maximize utility given prices and budgets. 3) The First Theorem of Welfare states that any allocation resulting from a Walrasian equilibrium will be Pareto efficient, meaning there is no other allocation where someone can be made better off without making someone else worse off. 4) The Second Theorem of Welfare shows that any Pareto efficient allocation can result from a Walrasian equilibrium for the appropriate price vector, if preferences are convex and monotonic.

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gopshal
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© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Exchange (Chapter 17) (General Equilibrium) Pure Exchange Economy n consumers and k goods. Allocation to consumer i, x i  x i1 , ...

, x ik Each consumer has -utility function u i x i -initial endowments w i  w i1 , ..., w ik Let x  x 1 , ..., x n denote a specific allocation of all goods to all consumers. n n x is feasible iff i1 x i i1 w i . If we have 2 goods and 2 consumers, the whole economy can be represented in an Edgeworth box. We want to analyze link between market equilibrium and efficiency.

Walrasian Equilibrium Definition: Market equilibrium refers to a situation where each consumer receives a bundle maximizing his utility and where the price is such that the final allocation is feasible: For all i, x i p arg max x i u i x i n n and i1 x i p i1 w i . Note that m i  p.w i thus only variables are prices. Graphical Analysis.

Existence of Walrasian Equilibria Will there always exist p such that the makets clear? Define z p  xi p wi
i1 n

the aggregate excess demand. Walras Law: For any p we have p.z p 0. The value of excess demand is equal to zero. p.z p  p.x i p p.w i  0
i1 n

since Walrasian demand satisfy the budget constraint for any p.

Walras law  definition of equilibrium  1) Market clearing: If demand equals supply in k 1 markets and if p k  0, then demand equals supply in the k th market. Proof: If not Walras Law would be violated. 2) If p is an equilibrium price and z j p  0 then p j  0. If some good is in excess supply in equilibrium then it must be free. Proof: In equilibrium z p 0. Thus for all p k 0, p .z p is a sum of non positive  0 terms. If z j p  0 and p j  0  p .z p which contracdicts Walras Law.

3) If all goods are desirable and p is an equilibrium price then z p  0 . Definition: A good j is desirable if at p j  0 we have z j 0  0. Proof: Assume all goods are desirable and assume that there exist a good for which z j p  0. Then we would have p j  0 according to 2). But then since j is desirable, we should have z j 0  0 which contradicts our assumption. Existence of an equilibrium If z . : S k1 R k is a continuous function which satisfies Walras Law, then there always exists p in S k1 such that z p 0. In an economy with 2 goods, there always p forming an equilibrium. All we get exist p 2 1 are relative prices.

The 1st Theorem of Welfare Definition: Pareto Efficiency: An allocation x is Pareto Efficient if there is no other feasible allocation x such that

x i x i for all i
i

and x i x i for at least 1 i.


i

In a setting with 2 consumers and 2 goods, where utilities are differentiable the set of Pareto Efficient allocations solve MRS A  MRS B
B A B xA 1  x1  w1  w1 B A B xA 2  x2  w2  w2

The set of all Pareto Efficient allocations is called the contract curve.

First theorem of Welfare: If x p , p forms a Walrasian Equilibrium, then x p is a Pareto efficient allocation. Proof. Definition 2 of W.E.: x p , p is a WE if n n (1) x p is feasible: i1 x i p  i1 w i (2) Each agent is making an optimal choice from his budget set: If there exists x i x i such that x i i x i then px i  px i .

Assume x p is not Pareto efficient. Then x x such that x is feasible and such that x i i x i for all i. Since x i i x i for all i, we have px i  px i  pw i for all i. Summung over all individuals we get

p wi  p xi  p wi

i1

i1

i1

which is a contradiction.

Second theorem of Welfare Suppose x is a PE allocation in which each agent holds a positive amount of each good. Suppose that are convex, continuous and monotonic. Then there exists p such that x is a WE for the initial endowments w i  x i . We prove that x is a WE considering definition 2 of WE but where we will show that if there exists x i x i such that x i i x i then px i  px i . Define V i  x i R k : x i i x i the set of bundles strictly preferred to x i by i. Define

V

z : z  xi, xi Vi
i1

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