Econ 101: Introduction to Microeconomics, Fall 2014, University of Waterloo

COURSE INTRODUCTION

See Slides for Week 1 (the slides will appear in LEARN later this week).

WEEK 1: A Model of Consumer Choice with One Good

Class 1: “Behavior is Optimization”

See Slides for Week 1 (the slides will appear in LEARN later this week).

Class 2: Marginal Analysis as a Solution to the Optimization Principle

Remark. Please remember: these slides are meant to be used with lectures and slides as
well as problem sets. Studying only the notes is typically not enough for success.

Remark. In this class 2 we study a simple example to provide an introduction to how

economists use “marginal analysis”to provide behavioral predictions. The example examines
consumer choice with one good.

Remark. Economists refer to physical commodities and objects that people trade and desire
as goods. In addition to goods, economists examine the allocation of services as well as bads.
Bads are undesired products. Pollution is an example of a bad.

Example.

Joe is asked how much he is willing to pay 1,2,3,4 and 5 Soda cans.

Joe’s answers reveal his total willingess to pay (“TWP”) schedule for Soda cans:

1
$4 for 1 Soda can
$7 for 2 Soda cans
$9 for 3 Soda cans
$10 for 4 Soda cans
$10 for 5 Soda cans

Total willingness to pay for N soda cans measures Joe’s total bene…t of N Soda cans in
terms of money. The following graph depicts Joe’s TWP schedule.

FIGURE 2.1 HERE

Question. How many Soda cans will Joe buy if the price of a Soda can is $2.50?

Answer with solution approach 1: We assume that Joe maximizes "Total Bene…t - Total
Cost". Thus we …rst determine "Total Bene…t - Total Cost" for all possible quantities. The
following graph depicts Joe’s "Total Bene…t - Total Cost" for di¤erent quantities.

FIGURE 2.2 HERE

Thus, in this example, the quantity at which "Total Bene…t - Total Cost" is the highest is 2
Soda cans. Our prediction is thus that Joe purchases 2 Soda cans.

2
Answer with solution approach 2: First determine Joe’s willingness to pay for each addi-
tional Soda can. Economists’ refer to the willingness to pay for additional units as the
marginal willingness to pay. When economists say “marginal”, they are talking about “ad-
ditional”.

Joe’s marginal willingness to pay (“MWP”) schedule for Soda cans is

$4 for 1st Soda can (subtract TWP for 1 can from TWP for 0 cans)
$3 for 2nd Soda can (subtract TWP for 2 cans from TWP for 1 can)
$2 for 3rd Soda can (subtract TWP for 3 cans from TWP for 2 cans)
$1 for 4th Soda cans (subtract TWP for 4 cans from TWP for 3 cans)
$0 for 5th Soda cans (subtract TWP for 5 cans from TWP for 4 cans)

Joe’s marginal willingness to pay for the N th Soda can measures Joe’s marginal bene…t from
the N th Soda can in terms of money. Marginal bene…t measures how much total bene…t
increases from the consumption of an additional unit.

Price in turn measures the cost of each additional unit. Economists refer to this cost of
additional units as the marginal cost.

An optimizing individual buys additional units as long as marginal bene…t exceeds marginal
cost.

Thus, to get a behavioral prediction in this example, we must next compare the Joe’s will-
ingness to pay schedule with the unit price. That comparison gives us the answer “Joe will
purchase 2 Soda cans”. This answer is, of course, the same as the answer we got using the
solution approach 1.

Remark. Joe’s willingness to pay schedule can also be used to draw Joe’s demand curve.
A demand curve is a function that tells how many units Joe purchases at any given price.
Economists draw price on the vertical axis and quantity on the horizontal axis.

The following graph depicts Joe’s demand curve for Soda cans.

3
FIGURE 2.3 HERE

Next we draw the demand curve and a horizontal line representing the cost in the same
graph.

FIGURE 2.4 HERE

Because the demand curve represents marginal bene…t and the line depicting price represents
marginal cost, the graph immediately reveals how many units Joe purchases.

Remark. Because an optimizing individual will keep buying additional units as long as mar-
ginal bene…t exceeds marginal cost, marginal bene…t equals marginal cost at the optimum
IF one can purchase fractions of a soda can (such as 0.721 soda cans). Of course, in real-
ity buying fractions of a soda is not always possible/practical and we can only buy integer
amounts (i.e. 0,1,2,3,4,5 or 6 soda cans). The optimum condition “marginal bene…t =
marginal cost”holds only approximately when a consumer can only choose integer amounts.

Remark. "Total Bene…t" - "Total Cost" is referred to as the "Net Bene…t".

4
WEEK 2: Model of Consumer Choice with Multiple Goods

This week’s classes demonstrate how economists perceive and model consumer choice. The
model enables us to explain and predict consumer choices. The model also enables us to
examine how changes in prices or income in‡uence a consumer’s well-being. Next week,
this model of consumer choice will be used repeatedly in our analysis of the interaction of
consumers in a marketplace.

Class 3: The Budget Constraint and Preferences

The Budget Constraint

De…nition. The budget constraint states that

expenses income:

Remark. In this course we examine only consumers who have no saving motive. The
consumer thus spends all income so that

expenses = income

holds at the optimum.

Formally: Budget constraint is

p1 x1 + p2 x2 m;

where p1 and p2 are the prices of goods 1 and 2; respectively, x1 and x2 are the quantities
consumed of goods 1 and 2; respectively, and m is income.

Remark. Good 2 may stand for the composite good –“everything else except good 1”.

Remark. If the price of good 2 is set to equal 1; i.e. p2 = 1, that good is referred to as
the numeraire good –the prices of all other goods are expressed relative to the price of this
good.

Example: Suppose that good 2 is the numeraire good and p1 = 3. Then, for a consumer to
buy and consume 1 unit of good 1, the consumer must forgo 3 units of the numeraire good.

5
De…nition. Budget set is the set of combinations of x1 and x2 that satisfy the budget
constraint.

De…nition. Budget line is the set of combinations of x1 and x2 that satisfy the budget
constraint exactly: p1 x1 + p2 x2 = m:

Graphical description of the budget line and budget set

Rearranging the equation p1 x1 + p2 x2 = m for the budget line yields (…rst subtract p1 x1
from both sides, then divide both sides by p2 ):

m p1
x2 = x2 :
p2 p2

This equation reveals that in a graph where the vertical axis measures consumption of good
2 and the horizontal axis measures consumption of good 1, the slope of the budget line is
p1
p2
: The same equation also reveals that the budget line intercepts with the vertical axis at
point pm2 :

The next graph illustrates the budget line.

FIGURE 3.1 HERE

Remark. The slope of the budget line shows the opportunity cost of consuming good 1: to
increase consumption of good 1 by 1 unit the consumer has to decrease the consumption of
good 2 by pp12 units.

6
 m m
Remark. If income increases from m to m0 , the intercept increases from p2
to p2
.

The next graph illustrates how an income increase shifts the budget line shifts outward:

FIGURE 3.2 HERE

Remark. If price of good 1 increases from p1 to p01 ; the slope of the budget line changes
p0
from pp21 to - p12 ; making the budget line steeper.

The next graph illustrates the impact of an increase in the price of good 1 on the budget
line.

FIGURE 3.3 HERE

7
Preferences

Remark. Below x1 refers to some amount of good 1, and y1 refers to some amount of the
same good. These quantities x1 and y1 may be the same or di¤erent. Similarly, x2 and y2
refer to some amounts of good 2, and these quantities may be the same or di¤erent.

De…nition. Each consumer’s preferences rank each conceivable consumption combination

(x1 ; x2 ) of goods 1 and 2 relative to any other conceivable consumption combinations (y1 ; y2 )
of goods 1 and 2.

Remark. Remember: preferences rank any conceivable consumption combination–even

those combinations that are una¤ordable to any consumer such a combination that involves
a space shuttle ride to mars.

De…nition. Notation (x1 ; x2 ) (y1 ; y2 ) means that for the consumer the combination
(x1 ; x2 ) is strictly preferred to the combination (y1 ; y2 ) i.e. consumer is better o¤ with com-
bination (x1 ; x2 ) than with combination (y1 ; y2 ).

De…nition. Notation (x1 ; x2 ) (y1 ; y2 ) means that the consumer is indi¤erent between the
combination (x1 ; x2 ) and the combination (y1 ; y2 ) i.e. the consumer is equally well of with
combination (x1 ; x2 ) and with combination (y1 ; y2 ).

De…nition. Notation (x1 ; x2 ) (y1 ; y2 ) means that either the consumer is better o¤ with
combination (x1 ; x2 ) than with combination.(y1 ; y2 ) or the consumer is equally well o¤ with
combination (x1 ; x2 ) and with combination (y1 ; y2 ).

Three assumptions about preferences

Economists typically make three assumptions about preferences:

1. Preferences are Complete: Any two combinations can be compared.

2. Preferences are Re‡exive: Any combination is at least as good as itself.

3. Preferences are Transitive: If (x1 ; x2 ) (y1 ; y2 ) and (y1 ; y2 ) (z1 ; z2 ) then (x1 ; x2 )
(z1 ; z2 ).

Remark. The …rst two of these assumptions are somewhat unintuitive and technical but
the third assumption is a really important assumption to remember!

8
De…nition. An indi¤erence curve depicts a set of combinations among which a consumer
is indi¤erent.

The next graph depicts an indi¤erence curve of a consumer.

FIGURE 3.4 HERE

Remark. In this course we assume that the consumer always prefers more to less. Therefore
a more outward indi¤erence curve represents combinations that are preferred to combinations
on any indi¤erence curve that lies close to the origin. Combinations on more outward
indi¤erence curves are preferred to combinations on indi¤erence curves closer to the origin.

The next graph depicts multiple (but not all as there are in…nitely many!) indi¤erence curves
of a consumer.

FIGURE 3.5 HERE

Result. The indi¤erence curves of a consumer cannot cross one another.

Proof (By contradiction): Assume that (x1 ; x2 ) and (y1 ; y2 ) are on the same indi¤erence
curve and (y1 ; y2 ) and (z1 ; z2 ) are on the same indi¤erence curve but (x1 ; x2 ) and (y1 ; y2 )
are not on the same indi¤erence curve and (y1 ; y2 ) (x1 ; x2 ). By transitivity the properties
(x1 ; x2 ) (z1 ; z2 ) and (y1 ; y2 ) (z1 ; z2 ) imply that (x1 ; x2 ) (z1 ; z2 ) : This result (x1 ; x2 )

9
(y1 ; y2 ) contradicts the assumption (y1 ; y2 ) (x1 ; x2 ) and therefore indi¤erence curves cannot
cross.

The next graph illustrates the proof.

FIGURE 3.6 HERE

De…nition. Preferences are said to be convex if for all two combinations among which the
consumer is indi¤erent the average of the two combinations is preferred to either of the two
combinations.

The next graph illustrates convex preferences.

FIGURE 3.7 HERE

Remark. The slope of an indi¤erence curve at a given point measures how much of one
good the consumer is willing to give up to receive more of the other good.

Suppose that consumption of good 1 is increased by x1 : In order to remain on the same

indi¤erence curve, the consumption of good 2 then has to decrease. Denote the decrease that
keeps the consumer on the same indi¤erence curve by x2 . The slope of the indi¤erence
curve at the original consumption point is approximately xx12 when x1 is very small.

10
 x2
The next graph illustrates how x1
captures (approximately) the slope of the indi¤erence
curve.

FIGURE 3.8 HERE

De…nition. At a given point on an indi¤erence curve, the slope of the indi¤erence curve is
referred to as the consumer’s marginal rate of substitution (MRS) between goods 1 and 2.
x2
Remark. MRS= x1
:

Result: For convex indi¤erence curves the MRS exhibits diminishing marginal rate of substitution:
the absolute value jM RSj of the marginal rate of substitution decreases as x1 is increased.

Remark. What does diminishing MRS mean in practice? When the consumption of good 1,
x1 , is low, increasing x1 by some small amount x1 increases the consumer’s well-being a lot
–thus for the consumer to remain on the same indi¤erence curve, x2 needs to be decreased
by a lot (hence MRS is large). When x1 is high, increasing x1 by the same small amount
x1 increases the consumer’s well-being only a little bit –thus for the consumer to remain
on the same indi¤erence curve x2 needs to be decreased only a little bit (hence MRS is low).

The next graph illustrates the diminishing marginal rate of substitution for a convex indif-
ference curve.

FIGURE 3.9 HERE

11
Class 4: Optimal Choice: The Marginal Rate of Substitution Condition

Recap: The budget line tells us what consumption combinations are feasible for the con-
sumer. Indi¤erence curves tell us how consumers rank all feasible and unfeasible consumption
combinations (in other words, indi¤erence curves tell us how consumers rank combinations
that are a¤ordable to her, as well as combinations that she cannot a¤ord; indi¤erence curves
do not tell us anything at all about how much money a consumer has!).

The next graphs illustrates the budget line and preferences in isolation.

FIGURES 4.1a and 4.1b HERE

Remark. The optimal consumption combination is determined by preferences and the

budget line.

Remark. As economists believe that consumers choose the optimal combination, the opti-
mal consumption combination is also the economists’prediction and description of the actual
consumption combination.

Remark. An optimizing consumer always chooses the allocation on the budget line that
allows the consumer to attain the indi¤erence curve that touches the budget line but is as
far away from the origin as possible.

Result. The optimal choice is the consumption combination at which an indi¤erence curve
just touches ("is tangent to") the budget line.

12
The next graph illustrates how the budget line and the indi¤erence curves of a consumer
reveal the consumer’s optimal choice.

FIGURE 4.2 HERE

Remark. This result, that at the optimum an indi¤erence curve just touches the budget
line, is the key result of the consumer choice model. Above we have a graphical description
of this result. Next we explore a more formal description of the same result.

x2
Recap: The slope of the indi¤erence curve is measured by MRS= x1

p1
Recap: The slope of the budget constraint is p2
:

Result (The MRS Condition): At the optimal choice the property

x2 p1
=
x1 p2

holds.

Proof (By contradiction): Suppose that (x1 ; x2 ) is the optimal choice and xx12 < pp21 at this
point. The monetary cost of increasing the consumption of good 1 by x1 would be x1 p1
and the monetary bene…t from decreasing consumption of good by an amount x2 that
leaves the consumer on the same indi¤erence curve as the consumer was before the change
x1 would be x2 p2 : These changes x1 and x2 were to save money for the consumer if
the change in consumer’s expenses was negative:

x1 p1 + x2 p2 < 0:

Rearranging this equation gives

x2 p2 < x1 p1 :

13
Dividing both sides by x1 p2 gives xx21 < pp12 which holds by assumption. The consumer
could thus remain on the same indi¤erence curve as (x1 ; x2 ) by changing to (x1 + x1 ; x2 + x2 )
and save money! With this extra money the consumer could now increase the consump-
tion of both goods from (x1 + x1 ; x2 + x2 ) and thus reach a more outward indi¤erence
curve! This contradicts the assumption that (x1 ; x2 ) is the optimal choice. Hence
x2
x1
< pp12 cannot hold at an optimum.

The case xx21 > pp12 is treated similarly as we just treated the case xx12 < pp12 , except that
in considering the case xx12 > pp12 we must increase consumption of good 2 and decrease
consumption of good 1. Following the steps again leads us to observe that such changes
would make the consumer better o¤ and hence xx21 > pp12 cannot hold at an optimum.

Because neither xx21 < pp12 nor x2

x1
> p1
p2
can hold at an optimum, x2
x1
= p1
p2
must hold
at an optimum. (End of proof).

x2 p1
The next graph illustrates how any optimum must satisfy the property x1
= p2
.

FIGURE 4.3 HERE

Result: MRS is the same for all consumers.

Proof: The condition "MRS= pp12 at an optimum" holds for all consumers. The ratio pp21
of market prices p1 and p2 is the same for all consumers. Hence also MRS must be the same
for all consumers (when all consumers choose optimally).

Remark. Relative price pp12 re‡ects how people value di¤erent goods at the margin; how
much of good 2 any person is willing to sacri…ce to get one more unit of good 1. The total
valuation of goods may di¤er greatly among people but the marginal valuation is always the
same across people.

14
WEEK 3: The Competitive Model of Interaction

Up until now we have focused on analyzing behavior of individual consumers. We have

learned how economists employ indi¤erence curves, budget constraints, and the “behavior is
optimization”assumption to model decision making of consumers.

We now turn our focus to interactions. This week’s classes demonstrate how economists
model interaction in markets that have a large number of individuals who buy and sell.
We …rst construct a model of exchange and then use the model to examine how prices are
determined. The model of exchange that we employ builds on the tools introduced last week
(budget constraints and indi¤erence curves). Our analysis this week yields a prediction of
how goods are allocated in a market economy i.e. who gets what and how much. Next
week, we use this model of the market economy to examine whether market economies have
any desirable properties and to compare well-being in a market economy to well-being in a
command economy.

Class 5: An Exchange Economy

We consider an economy with 2 goods and a large number of 2 types of agents. Each agent
of type A has endowment ! A A
1 of good 1 and endowment ! 2 of good 2. Each agent of type
B has an endowment ! B B
1 of good 1 and endowment ! 2 of good 2. The endowment (! 1 ; ! 2 )
of an agent is the amount of goods the agent has before trading with anyone.

Interaction among agents occurs in a market. All the agents in the economy meet in the
same market place to trade goods. After trading, each agent consumes the goods the agent
j
has after trading. An allocation is denoted by X = xA A B B
1 ; x2 ; x1 ; x2 ; where xi denotes the
consumption of good i by agent j: (All type A agents are similar to one another and thus
make the exact same trades; also all type B agents are similar to one another and thus make
the exact same trades).

Price of good 1 in the market is denoted p1 and price of good 2 in the market is denoted
by p2 : Since there are a large number of both types of agents, we assume that no agent can
set these prices on their own. In other words, each agent takes prices p1 and p2 as given.
Moreover, since all agents meet in the same market place, all agents face the same prices.

Budget Constraint in the Exchange Economy

15
To construct each agent’s budget constraint in this exchange economy, it instructive to
consider …rst the value of the endowment of an agent with an endowment (! 1 ; ! 2 ): When
this individual comes to the market, we can imagine that she could …rst sell her whole
endowment. Given the prices p1 and p2 , she would receive income p1 ! 1 + p2 ! 2 for selling her
endowment at the market. After selling her endowment, she would then use her income to
buy some amounts x1 and x2 of good 1 and good 2; respectively. Given the prices p1 and p2 ,
purchasing x1 units of good 1 and x2 units of good 2 would cost her p1 x1 + p2 x2 . Given that
the agent’s expenditures are p1 x1 + p2 x2 and income is p1 ! 1 + p2 ! 2 , the budget constraint
of this agent with endowment (! 1 ; ! 2 ) and consumption (x1 ; x2 ) is

p1 x1 + p2 x2 = p1 ! 1 + p2 ! 2 :

The budget constraint of the agent can be rewritten as

p1
x2 = (! 1 x1 ) + ! 2 :
p2

The budget constraint holds with equality when x1 = ! 1 and x2 = ! 2 : Therefore, when we
draw the budget constraint, it must go through the endowment point (! 1 ; ! 2 ) :

The following graph demonstrates a budget constraint of an agent with an endowment

(! 1 ; ! 2 ).

FIGURE 5.1 HERE

The following graph illustrates what happens to the budget constraint when the price of
good 1 increases.

16
FIGURE 5.2 HERE

Preferences

We assume that all agents have preferences that satisfy the following assumptions: (1) “more
of everything is better”; (2) transitivity; and (3) diminishing marginal rate of substitution
(i.e. indi¤erence curves are strictly convex).

17
Optimal Consumption

Let’s consider now the optimal consumption point (x1 ; x2 ) of an agent with an endowment
(! 1 ; ! 2 ) : In the analysis here we look at this one consumer in isolation at some arbitrary
prices p1 and p2 . We are not yet examining how prices p1 and p2 are determined as a result
of the interaction in the market and what allocation such interaction would give to each
agent in the economy. At this point, we are just modelling an individual consumer’s decision
making. In the next class (Class 6) we will then predict what the prices would be as a
result of the interaction at the market and what allocation each agent would get.

We maintain the “behavior is optimization”assumption. Thus, an agent’s optimal consump-

tion is still found at the point where the budget constraint just touches (“is tangent to”) an
indi¤erence curve.

The next graph illustrates how the budget constraint of an agent with endowment (! 1 ; ! 2 )
and the agent’s indi¤erence curves together reveal the optimal consumption (x1 ; x2 ). The
…gure also reveals whether the agent buys or sells good 1 and whether the agent buys or sells
good 2, given prices p1 and p2 .

FIGURE 5.3 HERE

18
The next graph illustrates that an agent with the same endowment but with di¤erent pref-
erences would have a di¤erent optimal consumption point.

FIGURE 5.4 HERE

The next graph illustrates how an increase in p1 would in‡uence the optimal consumption
point of an agent. Of course, how the optimal consumption point changes depends on what
the indi¤erence curves look like.

FIGURE 5.5 HERE

In the next class we predict what the prices and allocation will be in the exchange economy.

19
Class 6: Competitive Equilibrium

Let’s consider …rst what allocations are possible after trade in an exchange economy. This
analysis is applicable regardless of whether the trade is voluntary (market economy) or
involuntary (command economy).

In the absence of magic, the only allocations that are possible after trades in an exchange
economy are allocations for which the economy’s total consumption of each good is no larger
than the economy’s total endowment of the good. Such possible allocations are referred to
as feasible allocations.

We also assume that individuals cannot destroy goods before consuming them. Consequently,
in all feasible allocations the economy’s total consumption of each good has to be just as
large as is the economy’s total endowment of the good.

The exchange economy that we consider (see Class 5) has a large number of two types of
agents, type A and type B agents. The total endowment of good 1 is ! A B
1 + ! 1 and the
total endowment of good 2 is ! A B A B
2 + ! 2 : The total consumption of good 1 is x1 + x1 and the
total consumption of good 2 is xA B
2 + x2 : The set of feasible allocations is characterized by
conditions
xA B A B
1 + x1 = ! 1 + ! 1

and
xA B A B
2 + x2 = ! 2 + ! 2 :

The set of feasible allocations is illustrated by the Edgeworth’s box.. The width of the box is
the economy’s total endowment of good 1 and the height of the box is the economy’s total
endowment of good 2.

20
The following graph depicts the Edgeworth’s box for our exchange economy. The lower
left corner represents the perspective of agent A and the upper right corner represents the
perspective of agent B. We also draw the endowment point ! in the graph.

FIGURE 6.1 HERE

The next graph depicts each agent’s preferences in the Edgeworth’s box. To draw agent B’s
indi¤erence curves, it is better to …rst turn the page 180 degrees.

FIGURE 6.2 HERE

The next graph depicts each agent’s budget constraint in the Edgeworth’s box. To "see"
agent B’s budget constraint, it is better to …rst turn the page 180 degrees. For each agent,
the budget constraint must, of course, pass through the agent’s endowment point. Since
both types of agents face the same prices p1 and p2 at the market, the budget constraint is
the same for both types of agents.

21
FIGURE 6.3 HERE

The next graph depicts the endowment point, each agent’s budget constraint, and a bunch
of each agent’s indi¤erence curves in an Edgeworth’s box. What allocation do you predict
we get as a result of interaction at the market place?

FIGURE 6.4 HERE

We now use the model of the exchange economy and the Edgeworth’s box to give the econo-
mists’prediction of who gets what in a market economy. Economists refer to the predicted
allocation as a competitive equilibrium.

A key ingredient of the economists’model of interaction in a market economy is the view

that trade in a market economy is voluntary. Only agents themselves decide how much to
trade. Politicians and bureaucrats do not in‡uence what people buy, sell, and consume in a
market economy.

The following de…nition formalizes economists’ view of the allocation we get in a market
economy. This predicted allocation is referred to as the competitive equilibrium.

22
De…nition. In a competitive equilibrium the following three conditions are satis…ed:

1. Each agent takes prices as given.

2. Each agent makes optimal choice.
3. The equilibrium allocation is feasible.

The idea that trade is voluntary is implicit in condition (2) in the above de…nition. Condition
(2) also captures the “behavior is optimization”assumption.

The next graph illustrates the competitive equilibrium using an Edgeworth’s box. In the
Edgeworth’s box, the equilibrium prices are such that both agents indi¤erence curves are
tangent to one another and the budget constraint (this re‡ects assumption 2 of the above
de…nition of a competitive equilibrium).

FIGURE 6.5 HERE

The allocation depicted in the above graph is economists’prediction of what allocation and
what prices we get in a market economy. The predicted allocation of course depends on the
endowment point and on the agents’ preferences. The equilibrium prices (denoted p1 and
p2 ) are captured by the slope of the budget constraint. The allocation is referred to as an
“equilibrium”allocation to capture the idea that at the prices associated this allocation the
economy is balanced in the sense that the individuals in the economy as a whole want to
buy just as many units of each good as is the total endowment of the good in the economy.
The allocation is referred to as a “competitive” allocation to capture the idea prices in the
market place are formed as a result of competition among a large number of buyers and
sellers. Later in the course we will examine interaction in non-competitive environments,
including in the extreme case when one agent determines the price of a good for everyone
else.

The next graph depicts a hypothetical situation in which prices are such that the two agents’

23
indi¤erence curves would not be tangent to the budget constraint at the same point. What
do you expect to happen at the market in this situation?

FIGURE 6.6 HERE

At these “o¤-equilibrium” prices the agents’ total optimal consumption of good 1 would
involve more of the good 1 than is the total endowment of good 1 in the economy. Clearly
impossible! At such prices there would be a shortage of good 1. What would happen when
there is a looming shortage of good 1? As soon as agents would see that at these prices they
would soon be a shortage of good 1 and they might thus not get as many units of good 1 as
they would like at these prices, many agents would start shouting "I will pay a bit more for
good 1 than what others are currently paying!!" in an attempt to buy some of the remaining
units good 1 before it is sold out. As a result of such auction-like shouting mechanism, the
price of good 1 would start to increase in the market even before there is any actual shortage
of good 1. This price adjustment would continue there is no more a threat of a shortage of
good 1. The only point where there is no more shortage of good 1, is the equilibrium price
scenario depicted in the earlier Figure 6.5.

Hence, according to economists, prices in a market adjust automatically through such an

auction-like adjustment mechanism. There is no need for a central authority to determine
prices. Instead, buyers and sellers acting in their own self-interest the economy to an outcome
that is balanced (“in equilibrium”) in the sense that the total consumption of each good by
individuals in the economy will equal the total endowment of each good in the economy.

24
WEEK 4: A Comparison of the Competitive Equilibrium and a Command Econ-
omy

This week we examine how good is the allocation that we get in a market economy. First,
we study how economists determine whether an allocation is a good allocation. Next, we
determine whether the competitive equilibrium allocation of the exchange economy that we
studied last week is a good allocation. We will also compare the competitive equilibrium
allocation to allocations we would get in a command economy.

Class 7: Pareto E¢ ciency

Economists’main approach for determining whether an allocation is a good allocation is a

concept referred to as Pareto E¢ ciency.

De…nition. An allocation X is Pareto E¢ cient (or “Pareto Optimal”) if there is no alter-

native allocation Y in which at least one agent is better o¤ and all other agents are at least
as well o¤ compared to the allocation X.

Remark. The condition for Pareto e¢ ciency of an equilibrium can alternatively be stated
as

“no way to make all agents better o¤”(when preferences are strictly convex)

and

“no way to make someone better o¤ without making someone else worse o¤”

and

“no mutually advantageous trades exist”.

and

“no free lunch”.

De…nition. A Pareto Improvement is a change in an allocation that makes at least one

agent better o¤ and nobody else worse o¤.

25
Remark. The condition for Pareto e¢ ciency can be stated as “There does not exist a Pareto
Improvement”.

A Pareto E¢ cient allocation can be illustrated in an Edgeworth’s box. In any Pareto e¢ cient
allocation the agents’indi¤erence curves are tangent to one another. The following graph
illustrates a Pareto e¢ cient allocation.

FIGURE 7.1 HERE

Not all allocations are Pareto E¢ cient. The following graph illustrates a Pareto ine¢ cient
allocation in an Edgeworth’s box.

FIGURE 7.2 HERE

An important aspect of Pareto E¢ ciency is that it has absolutely nothing to do with equality.
A very unequal allocation can be Pareto E¢ cient. And a very equal allocation can be Pareto
Ine¢ cient. The following graph illustrates this.

26
FIGURE 7.3 HERE

The set of all Pareto E¢ cient allocations is called as the Pareto Set. When preferences are
strictly convex, the Pareto set is depicted in an Edgeworth’s box by a curve that extends
from the bottom left corner of the box to top right corner of the box. The exact shape
of the curve depends on the preferences. The next graph illustrates the Pareto set in an
Edgeworth’s box.

FIGURE 7.4 HERE

One more thing to remember about Pareto E¢ ciency is that it has nothing to do with
what the agents’endowments are, as you can see from the fact that endowments were not
mentioned in this class prior to this paragraph! So when we try to determine what allocations
are Pareto E¢ cient, we do not have to worry about what the agent’s endowments are.
To know what allocations are Pareto E¢ cient, we only need to know agent’s
preferences.

27
Class 8: The First Welfare Theorem

The next result examines the economic e¢ ciency of the competitive equilibrium allocation
in the exchange economy studies in week 3.

Result (The First Theorem of Welfare Economics): The competitive equilibrium allocation
is Pareto E¢ cient.

Graphical Proof of the The First Welfare Theorem.

FIGURE 8.1 HERE

(First depict the competitive equilibrium allocation in an Edgeworth’s box. In this allocation
the agents’ indi¤erence curves are tangent to one another. Then examine whether there
are other allocations in which no agent is worse o¤ than in the competitive equilibrium
allocation.)

Formal Proof of the First Welfare Theorem. Suppose that there is an alternative
feasible allocation Y = y1A ; y2A ; y1B ; y2B such that at least one agent is better o¤
and no agent is worse o¤ compared to the competitive equilibrium allocation X =
xA A B B
1 ; x2 ; x1 ; x2 :
The assumed feasibility of Y requires that

y1A + y1B = ! A B
1 + !1 (1)

and
y2A + y2B = ! A B
2 + !2 : (2)

The assumed relationship between allocations Y and X requires that

y1A ; y2A A xA A
1 ; x2

28
and
y1B ; y2B B xB B
1 ; x2

with strict preference for at least one of the agents. Here A denotes preferences of
agent A and B denotes preferences of agent B:
Because all agents view allocation Y as at least as good as allocation X but did not choose
allocation Y at the competitive equilibrium, in which by de…nition all agents make optimal
choices, the allocation Y must be at least as expensive for each agent as the value of the
agent’s endowment and the allocation Y must be strictly more expensive than the value
of the agent’s endowment for at least one agent (more speci…cally, for the agent who
prefers allocation Y strictly over allocation X): Denoting the competitive equilibrium prices
by p1 and p2 this can be formally stated as

p1 y1A + p2 y2A p1 ! A A
1 + p2 ! 2 (3)

and
p1 y1B + p2 y2B p1 ! A A
1 + p2 ! 2 (4)

with strict inequality for at least one of the agents.

Adding together left-hand sides of the preceding two inequalities yields

p1 y1A + p2 y2A + p1 y1B + p2 y2B

and adding together the right-hand sides of the preceding two inequalities yields

p1 ! A A B B
1 + p2 ! 2 + p1 ! 1 + p2 ! 2 :

Because the left-hand sides of inequalities (3) and (4) are at least as large than the left-hand
sides and at least one of the left-hand sides is strictly larger than the right-hand
side, the sum of the left-hand sides must be strictly higher than the sum of the right-hand
sides. Therefore

p1 y1A + p2 y2A + p1 y1B + p2 y2B > p1 ! A A B B

1 + p2 ! 2 + p1 ! 1 + p2 ! 2 :

This can be rewritten as

p1 y1A + y1B + p2 y2A + y2B > p1 ! A B A B

1 + ! 1 + p2 ! 2 + ! 2 :

The feasibility conditions (1) and (2) imply in the above inequality we can substitute ! A B
1 +! 1

29
for y1A + y1B and ! A B A B
2 + ! 2 for y2 + y2 . This yields the inequality

p1 ! A B A B A B A B
1 + ! 1 + p2 ! 2 + ! 2 > p 1 ! 1 + ! 1 + p2 ! B + ! 2 :

Both sides of this inequality are the same, and therefore the inequality cannot be true. We
have thus reached a contradiction which proves that there does not exist an allocation Y
that is both feasible and makes at least one agent better o¤ and no agent worse o¤ compared
to the competitive equilibrium allocation X.

To the extent that the exchange economy depicts the relevant characteristics of a market
economy, the First Welfare Theorem shows the allocation that we get in a market economy
is a good allocation in the following sense: there is no other allocation in which all agents are
better o¤. One implication of this result is that government intervention in markets
would not make everyone better o¤. But would we get a Pareto E¢ cient allocation also
in a command economy–in an economy in which a government decides what everyone gets?
For the government to know what allocations are Pareto E¢ cient, it would have to know
the citizens’ preferences. The government, of course, does not know people’s preferences.
Thus it is unlikely that even a benevolent government (or a “benevolent dictator”) would
choose an allocation that is Pareto E¢ cient. In a market economy, by contrast, prices adjust
and act as the invisible hand of the market so that the economy arrives at a Pareto E¢ cient
allocation even though nobody knows others’preferences in a market economy either!

The next graph illustrates the likely outcome of a benevolent government choosing an allo-
cation.

FIGURE 8.2 HERE

The next graphs illustrate (again!) the price adjustment through which a market economy
arrives at a Pareto E¢ cient allocation.

30
FIGURE 8.3 HERE

The First Welfare Theorem thus implies that there is no economic e¢ ciency rationale for
government intervention in markets–government would not choose an allocation that is better
for everyone (and government would probably choose an allocation that is not e¢ cient!).
The result thus suggests that from an economic e¢ ciency perspective the optimal size of
government involvement in economic activity is 0% (in contrast with the 30%-60% that we
observe in industrialized countries–see slides to Class 1)! However, like any result derived
from a theoretical model, this result is useful only to the extent to which the model that
we used captured the relevant characteristics of the real world. In the coming weeks we
will examine whether relaxing di¤erent implicit or explicit assumptions of the model change
this conclusion that there is no economic e¢ ciency rationale for government intervention in
economic activity.

31