Chapter 32

Exchange
 Exchange
 Two consumers, A and B.
 Their endowments of goods 1 and 2
are A A A B B B
  ( 1 ,  2 ) and   ( 1 ,  2 ).
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
 Starting an Edgeworth Box

A B

Width = 1   1  6 2 8
 Starting an Edgeworth Box

Height =
A B
2  2
 4 2
6

A B

Width = 1   1  6 2 8
 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
B
1
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
B
x1
OB
A
2 xB
2

B
2
A
x2
OA
x1A
A B
1  1
 Feasible Reallocations
B
x1
OB
A B
2 x2

B
2 A
x2

OA
x1A
A B
1  1
 Feasible Reallocations

 All points 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
xA For consumer A.
2 M
or
e
pr
ef
er
re
d

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
xB For consumer B.
2 M
or
e
pr
ef
er
B re
2 d

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

M B
2
or
e
pr
ef
er
r ed
x B
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
x B
2
 A Edgeworth’s Box
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1

x B
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

x B
2
 A Pareto-Improvements
x2

B
xB 1 OB
1

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

Trade
improves both
A’s and B’s welfares.
This is a Pareto-improvement
over the endowment allocation.
 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
A is strictly better off
but B is strictly worse
off
 Pareto-Optimality
A is strictly better off
but B is strictly worse
off

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

B is strictly better
off but A is strictly
worse off
 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

x B
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

x B
2
 Pareto-Optimality

 The contract 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
x B
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 x B
2
 A The Core
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1

x B
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 x B
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

x B
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

x B
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

 But which 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

x B
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

x B
2
 Trade in Competitive
A Budget Markets
constraint for consumer A
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1

x B
2
 Trade in Competitive
A Budget Markets
constraint for consumer A
x2

B
xB 1 OB
1

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

B
xB 1 OB
1

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

x B
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

x B
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

x B
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

x B
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

x B
2
 Trade in Competitive
A Budget Markets
constraint for consumer A
x2

B
xB 1 OB
1

 2A  2B
OA A A
1 x1

x B
2
 Trade in Competitive
A Budget Markets
constraint for consumer A
x2

B
xB 1 OB
1

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

B
xB 1 OB
1

x  2A  2B
*A
2

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

x*2B

x  2A  2B
*A
2

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

x*2B

x  2A  2B
*A
2

OA A A
1 x1
x*1A
and *A *B A B x B
x2  x2   2   2 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
 Given that 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
 Given that 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
x B
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

x B
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

x B
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

x B
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

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

A B
2 2

OA A A
1 x1

x B
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,
*A *B A B
p1 ( x1  x1   1   1 ) 
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
p 2 ( x 2  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.