Nechyba 2e CH 16AB

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Microeconomics:
An Intuitive Approach, 2E
Chapter 16
General Equilibrium
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General vs. Partial
Click to edit MasterEquilibrium
title style
Partial Equilibrium Models consider a single market in isolation.

But often changes in one market spill over into other markets, giving rise to
income or wealth effects and altering prices elsewhere that in turn feed back
into the market of interest.
General Equilibrium Models view the economy as a closed system of related
markets.
It is within such general equilibrium models that the first welfare theorem (and
related results) have been formally demonstrated.
The models are mathematically complex when they allow for large numbers of
individuals, large numbers of goods and firms, etc.
But the underlying insights that emerge can be illustrated in very simple
general equilibrium economies with just two individuals and two goods.
We will being with an exchange economy in which no production takes place
and then consider production in a very simple general equilibrium model.
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Click The Edgeworth
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Master title
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The simplest possible exchange economy begins with 2 individuals and 2 goods.
To represent this economy

in a single picture, we
begin by flipping one of
the graphs
and moving the other

underneath the flipped
graph.
Finally, we move the two

on top of one another
until their endowment
bundles overlap.
The resulting graph is

known as an Edgeworth
Box.
GainsClick
fromtoTrade in the Edgeworth
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Every point in the Edgeworth Box represents one possible way of dividing the economys
endowment between the two individuals. Such bundles are called allocations.
The allocations in the green shaded area are preferred by both individuals to their
initial endowment.
Allocation A, for instance, would involve a trade of 2 oranges for 2 bananas.
If the individuals engage in this trade, A

becomes the new endowment with a
smaller green shaded region indicating the
possibility of further gains from trade.
Such gains from trade are not exhausted

until the individuals reach an allocation
where their indifference curves are
tangent to one another.
Efficiency in the
Click to edit Edgeworth
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An allocation is efficient if and only if there is no other allocation that makes someone
better off without making anyone else worse off.
To find such an allocation, we can begin by choosing a utility level for individual 1
and then get individual 2 to her highest indifference curve without
making individual 1 worse off than the utility level we have chosen for him.
We could have started with a

different utility level for individual 1
and derives other similarly efficient
allocations.
These efficient allocations lie

on a curve that connects the
origins for the two individuals
and this curve is called the
contract curve.
The
ClickCore in an
to edit Edgeworth
Master Box
title style
An allocation in an exchange economy lies in the core of the economy if and only if there
does not exist a coalition of individuals in the economy that can do better by trading only
amongst themselves.
In the Edgeworth Box, there are only 3 possible coalitions: the 2 individuals together,
and each individual by him or herself.
A core allocation must then be at least
as good for each individual as the
endowment (or else at least one of the
individuals can do better trading just
with herself),
and it must be efficient (or else
not all gains from trade have
been exhausted).
The core is then the set of
allocations that lies on the
intersection of the contract
curve and the shaded set of
mutually beneficial trades.
Competitive
Click Equilibrium
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service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Suppose bananas and oranges are priced the same. Then we can derive individual 1s
budget constraint.
If he optimizes at A, he becomes a net supplier of bananas and a net demander of oranges.
We can similarly determine what is supplied and demanded by individual 2 at these prices.
Forming the Edgeworth Box, we see

the two individuals optimizing on
two sides of the same line whose
slope is set by the prices.
But demand is not equal to

supply because the two
individuals optimize at different
points in the Box.
Thus, pricing bananas and

oranges the same results in a
Disequilibrium.
ClickCompetitive Equilibrium
to edit Master title style
Since there is an excess demand for bananas, we could raise the price of bananas.
Or, since there is an excess supply of oranges, we could lower the price of oranges.
Either of these price changes results in a shallower price line in the Box.
If we have changed prices just right, the two
individuals will optimize at the same point in the Box.
As a result, demand equals supply in

both markets.
A competitive equilibrium in
an exchange economy is then
a set of prices and an
allocation such that, at those
prices, everyone would in fact
choose the bundle implied by
that allocation.
The 1st Click
Welfare Theorem
to edit in the
Master Edgeworth
title style Box
The first welfare theorem holds if the competitive equilibria in an economy are efficient.
In the Edgeworth Box, all allocations on the contract curve i.e. all allocations where the
indifference curves of the two individuals are tangent to one another are efficient.
It can then be immediately

seen that the first welfare
theorem must hold in the
Edgeworth Box because
the equilibrium allocation C
lies at a point where the
two individuals optimize on
the same line.
We see again that their

MRS will be the same
when they face the same
prices at least as long as
they are at an interior
solution.
The 2ndClick
Welfare Theorem
to edit in the
Master Edgeworth
title style Box
The second welfare theorem holds if any efficient allocation can be implemented as a
competitive equilibrium allocation after some redistribution of endowments.
In the Edgeworth Box, this means that any allocation on the contract curve can be a
competitive equilibrium after some redistribution of endowments.
Consider, for instance, the efficient allocation D.
For this to be an equilibrium allocation, the
budget line for the two individuals has to
be tangent to their indifference curves at D.
And we can in fact make this into
a budget line by moving the
endowment bundle from E to E.
Are there other redistributions that
would work? Would those result in
different equilibrium prices?
Yes, any redistribution to the green line.
But the slope of the green line would
remain implying the same prices.
Welfare
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2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a
certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
The first welfare theorem outlines the conditions under which markets allocate
resources efficiently but not necessarily equitably.
The second welfare theorem assures us that we can achieve a more equitable
allocation that is also efficient so long as we can redistribute endowments.
But, in the real world, we almost never have ways of redistributing endowments
because we use distortionary taxes.
When distortionary taxes are used to redistribute for equity reasons, efficiency is lost
in the process of redistributing even if markets then allocate the smaller pie
efficiently.
The issue of equity with reference to Edgeworth Box economies is discussed more in
Chapter 29 under the topic of normative economics.
A third important result in general equilibrium theory is the core convergence theorem
which says that the set of core allocations shrinks to the set of competitive equilibria as
economies become large.
The core convergence result is intellectually interesting in the following sense: The
core is a formalization of a stable allocation in the sense that no group can do
better on its own and thus no one has an incentive to split off. When economies get
large, the only such stable allocations are competitive equilibrium allocations.
Robinson
Click to editCrusoe
MasterOptimum
title style
The simplest possible economy with production is a single-person economy in which the
individual is producer, worker and consumer.
He faces a single-input production frontier and has tastes over labor and the good x.
His optimal choice then involves moving to the highest possible indifference curve
subject to choosing fro the producer choice set.
This is an optimum
not a competitive
equilibrium (since there
are no prices that the
individual takes as given
when making choices as
producer, worker and
consumer.)
Robinson Crusoe
Click to edit as Price
Master Taker
title style
If this person acts as a price taker, he takes the output price p and the wage w as given.
In his role as producer, the individual then chooses the profit maximizing production plan.
Since someone in the economy must own the firm and thus earn the profits, the
individuals consumer choice set is formed both from the firm profit and the wage
and as a consumer, the individual chooses the best possible bundle from this choice set.
Competitive
Click toEquilibrium
edit Masterintitle
R-Cstyle
Economy
At these prices, however, supply is not equal to demand in either market.

In particular, there is excess supply of labor and excess demand for the output
which implies either wage has to fall or output price has to rise.
Either of these price changes will
cause the isoprofit/consumer
budget line to become shallower.
And if price and wage change

sufficiently, the
consumer/worker and producer
optimum will occur at the same
Excess
Demand point implying supply=demand
in both markets.
The first welfare theorem

can then be seen in this
Excess Supply
picture (as can the second
welfare theorem).
A Pure
Click Exchange
to edit MasterEconomy
title style
An exchange economy is fully defined by specifying the set of individuals, including their
endowments and their preferences.
For an exchange economy with N individuals and M goods, this would imply specifying
where is person ns endowment of good m and is person ns utility function.
The economy-wide endowment of good m is then simply
And all possible ways of dividing the economys endowment the feasible allocations
are given by the set
The Edgeworth
Click Box title
to edit Master Example
style
The Edgeworth Box is an example of an exchange economy in which N=2 and M=2.
Here, for instance, and . The Edgeworth Box is then
The definition of this Edgeworth Box

economy is then completed by a
specification of the two individuals
tastes.
Here we represent those tastes with
which then give rise to indifference

curves, including those passing through
the endowment allocation.
Mutually Beneficial
Click to edit MasterAllocations
title style
Each individual n can guarantee herself the utility she gets from consuming her endowment
and will thus agree to a trade only if she gets at least that level of utility.
This then lets us define the set of

mutually beneficial allocations that
result from mutually beneficial trades:
MB
EfficientClick
Allocation
to edit Master
i.e. thetitle
Contract
style Curve
The contract curve or the set of

Pareto efficient allocations, on the
other hand, has nothing to do with
endowments and is defined as
In our 2-person, 2-good Edgeworth

Box economy, this curve can
typically be calculated by simply
setting the MRSs of the two
individuals equal to one another.
The Contract
Click to Curve in the title
edit Master Edgeworth
style Box
For our Edgeworth Box economy with and ,

for instance,
3x12 x 22
MRS 1 and MRS 2 .
1 2
x1 3x1
Since the economys endowment of good 1 is 13 and the economys endowment of good
2 is 10, we can write x12 13 x11 and x 22 10 x12 and thus

10 x12
MRS 2
.
3(13 x1 )
1

Along the contract curve, MRS1 = MRS2 which implies
The can then be solved to give us the contract curve

The
ClickCore in the
to edit Edgeworth
Master Box
title style
The set of core allocations in general is defined as the set of allocations that cannot be
blocked by any coalition of individuals where blocking means that the coalition can
do better for all of its members if it splits of with its own endowment.
In the 2-person, 2-good Edgeworth Box economy, however, this definition reduces to
the simple set
In our example, the reservation

utility levels are
The core is then

Competitive
Click to edit Equilibrium
Master titlePrices
style
Consumer ns endogenous income in the Edgeworth Box is p1e1n p2e2n .

Her demand functions therefore take the form , and she is a
net supplier whenever

and a net demander whenever
A set of equilibrium prices (p1, p2 ) then has to satisfy

or simply
Equilibrium in our
Click to edit Edgeworth
Master Box
title style
2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed
with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
In our example, and and
Acting as price taker, consumer 1 then solves
max x13 / 4 x1/2 4 subject to p1 x1 p2 x 2 3p1 6 p2 ,

x1 ,x 2
while consumer 2 solves

max x11/ 4 x 23 / 4 subject to p1 x1 p2 x 2 10 p1 4 p2 .

x1 ,x 2
When solved in the usual way, this gives demands

Equilibrium in Master
Click to edit the Edgeworth Box
title style
Equilibrium in the first market then implies
which reduces to
Since multiplying both prices by the same

constant has no impact on demands, any
combination of prices that satisfies this
relationship gives equilibrium prices.
Walras
Click to edit Lawtitle style
Master
We know that, for each consumer, the budget constraint binds at the optimal choice; i.e.
In the 2-person, 2-good exchange economy, this implies what is known as Walras Law:
This simply states that the aggregate budget constraint for the economy binds and it is
similarly true for larger economies with more goods and more individuals.
As a result of Walras Law, each of the two equilibrium equations for the Edgeworth
Box economy implies the other and we only have to solve one of them.
More generally, when there are M goods, we only have to solve (M-1) equations
because of Walras Law.
First Welfare
Click toTheorem in thetitle
style Box
2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Suppose is a competitive equilibrium in the Edgeworth Box

economy described by .
The first welfare theorem then asserts that is (Pareto) efficient (assuming
the implicit underlying conditions of the theorem hold).
One way to prove this theorem formally is to begin by assuming it is not true and then
showing that such an assumption leads to a logical contradiction. This is known as a proof
by contradiction.
So we can begin by assuming that the theorem is false which implies that there exists a
feasible allocation that is preferred by at least one of the
individuals and is considered no worse by the other.
Without loss of generality, we can assume that is in fact preferred by both
individuals.
Why is this without loss of generality?

Because whenever one of the individuals prefers an allocation to the equilibrium while the
other individual is indifferent, monotonicity and continuity imply we can slightly reduce the
first persons allocation and slightly increase the second persons and thereby create an
allocation that is preferred by both to the equilibrium allocation.
First Welfare
Click toTheorem in thetitle
style Box
If is in fact preferred by both to , then it must be that

is not affordable for individual 1 and is not affordable to individual 2 at the
equilibrium prices; i.e.
This implies
Recall Walras Law:
which can also be written as
This implies that either is greater than

zero which in turn implies either or
But that implies that is not feasible, which is the contradiction that
proves the theorem.
Robinson
ClickCrusoe
to editDoing thetitle
Master Best
styleHe Can
Suppose Robinson Crusoe faces a production process and has tastes
In the absence of prices, Robinson Crusoe then solves the problem
Solving this in the usual way, we get
When and
, we get the optimum at 30 hours of
labor and 72 units of output/consumption.
Robinson
ClickCrusoe
to editasMaster
Price-Taking Producer
title style
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a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
As price-taking producer, Robinson Crusoe takes output price and wage as given when
solving
which can also be written as
Solving this in the usual way, we get
and
Plugging this into our expression for

profit, we also get
Robinson Crusoe
Click to editasMaster
Price-Taking Consumer
title style
This profit then becomes part of income for Robinson Crusoe as a consumer who also
works and earns a wage at the firm. He thus solves the problem
This gives us labor supply of
and consumer good demand of

Robinson
ClickCrusoe in Master
to edit Competitive
title Equilibrium
style
We can now set price-taking Robinson Crusoes labor demand and supply functions equal
to another or, alternatively, set his output demand and supply functions equal to one
another to solve for the relationship between wage and price:
When and
, we get
And since neither the consumers nor the

producers problem is affected by a
simultaneous scaling up of prices and
wages, we can simply set price equal to 1
and equilibrium wage to 1.2 to get
equilibrium labor of 30 and output of 72.
ClickFirst Welfare
to edit Theorem
Master title style
2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with
a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
The first welfare theorem in the Robinson Crusoe economy is then almost immediately
obvious when we compare
Robinson Crusoes Optimum with the competitive equilibrium.

16B TheClick
Mathematics of General
to edit Master titleEquilibrium
style
16B.1 A Pure Exchange Economy

A collection of consumers with preferences and
endowments; if the economy contains N consumers (n = 1,
2, ) who choose among M goods (m = 1, 2)
For any good m, we can define the economys overall

endowment Em by simply adding up all the individual
endowments:
2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or
school-approved learning management system for classroom use.
16B.1 AClick
PuretoExchange Economy
edit Master title style
16B.1 A Pure Exchange Economy (cont)

When M = N = 2, this set is equivalent to what we have
drawn as the allocations in the Edgeworth Box, written as:
16B.1.1 Mutually Beneficial Trades

Letting individual ns reservation utility be denoted by Un, we
can calculate the appropriate reservation utility value by
simply evaluating utility at the endowment:
16B.1 AClick
16B.1.1 Mutually Beneficial Trades (cont)
The set of allocations that is mutually beneficial for all in the
economy (denoted MB) is then the set of feasible allocations
is then the set of feasible allocations that give each
consumer at least his or her reservation utility:
16B.1 AClick
16B.1.2 The Contract Curve
To calculate the contract curve, we had to find allocations in
the Edgeworth Box where indifference curves are tangent to
one another, so that no area of mutually beneficial trades is
possible; we can define this set PE as:
The tangency of our indifference curves implies that:
16B.1 AClick
16B.1.2 The Contract Curve
We can use this equation to define the set PE for this
exchange economy as:
16B.1.2 The Core

The core in the two-person case is simply the intersection of
the set MB and PE:
The core can then be written as:
16B.1 AClick
16B.1.4 Competitive Equilibrium
A set of equilibrium prices for a two-person, two-good
exchange economy can therefore be defined as a set of prices
(p1, p2) such that:
Solving our optimization problems, we get:
16B.1 AClick
16B.1.4 Competitive Equilibrium
Plugging in the relevant expressions from (16.15), we get:
To determine what my wife and I will consume in equilibrium,

we can then simply plug in the equilibrium prices p1 = 1 and p2
= 3/2 into (16.15) to get:
16B.1 AClick
16B.1.5 Walrass Law
The aggregate budget constraint for the economy binds
In the two-person, two-good economy, this aggregate budget
constraint for the economy simply becomes:
The condition is known as Walrass Law
16B.2 The Fundamental
Click Welfare
to edit Master Theorems
title style and
Other Results
16B.2.1 The First Welfare Theorem
To get to the equilibrium allocation, it must be that is
not affordable for individual 1 at the equilibrium prices, and
xxxxx is not affordable for individual 2 under those prices,
so:
The right-hand side of this equation is the same as the left-

hand side of equation (16.19), which is Walrass Law. Thus,
equations (16.19) and (16.21) imply:
Click Welfare
title style and
Other Results
16B.2.2 The Second Welfare Theorem
Formal proof of the second welfare theorem is more difficult
Second welfare theorem states that there always exists a
redistribution of the economys endowment such that any
point on the contract curve can be supported as a
competitive equilibrium after the redistribution
One could redistribute the endowment so that it coincides
with the Pareto efficient allocation on the contract curve and
then demonstrate that there exists a set of prices such that
each individual would in fact choose to remain at this new
endowment point
Any other endowment allocation on the budget line formed
this way would also work
Click Welfare
title style and
Other Results
16B.2.3 Equilibrium and the Core
Once we are convinced of the first welfare theorem in an
exchange economy, it is almost immediately obvious that the
competitive equilibrium of a two-person exchange economy
must lie within the core of the economy
The second result involving competitive equilibria and the
core is that, as an economy expands in the sense of having
many individuals of each type, the core shrinks to the set of
competitive equilibria; this is known as the core convergence
theorem
The core convergence theorem tells us that when
competition in bargaining becomes sufficiently intense, each
persons bargaining power is reduced sufficiently for the
outcome to become identical to the outcome of competitive
behavior in markets
16B.3 A Click
SimpletoRobinson Crusoe
edit Master title Production
style
Economy
16B.3.1 Robinson Crusoe Doing the Best he Can
Suppose the production frontier is defined by the
production function:
My optimization problem is to maximize utility subject to

the production constraint I face:
16B.3 A Click
style
Economy
16B.3.2 Robinson Crusoe as Consumer & Producer
As a producer, I solve the profit maximization problem:
We can calculate profits by subtracting labor costs from

revenues to get the profit function:
16B.3 A Click
style
Economy
16B.3.2 Robinson Crusoe as Consumer & Producer
Assuming a total of L leisure hours are available per week,
this allows us to write my consumer utility maximization
problem as:
Solving this in the usual way, we can derive labor supply:
16B.3 A Click
style
Economy
16B.3.3 Equilibrium in the Robinson Crusoe Economy
By setting from equation (16.30) equal to from
equation (16.34), we can solve for the equilibrium wage
w* in terms of the output price p:
As in the case of exchange economies, we can only solve

for the equilibrium price ratio, and any set of w and p that
satisfies this ratio can support an equilibrium in the
economy; equation (16.37) then becomes:
16B.3 A Click
style
Economy
16B.3.4 Welfare Theorems in the Robinson Crusoe
Economy
We can quite easily derive the equilibrium labor supply
and demand as:
Which is exactly what we concluded in equation (16.27) is

the efficient level of labor

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Click to edit Master title style

Partial Equilibrium Models consider a single market in isolation.

To represent this economy

and moving the other

Finally, we move the two

The resulting graph is

Allocation A, for instance, would involve a trade of 2 oranges for 2 bananas.

If the individuals engage in this trade, A

Such gains from trade are not exhausted

We could have started with a

These efficient allocations lie

Forming the Edgeworth Box, we see

But demand is not equal to

Thus, pricing bananas and

As a result, demand equals supply in

It can then be immediately

We see again that their

At these prices, however, supply is not equal to demand in either market.

And if price and wage change

The first welfare theorem

where is person ns endowment of good m and is person ns utility function.

The economy-wide endowment of good m is then simply

Here, for instance, and . The Edgeworth Box is then

The definition of this Edgeworth Box

Here we represent those tastes with

which then give rise to indifference

This then lets us define the set of

The contract curve or the set of

In our 2-person, 2-good Edgeworth

For our Edgeworth Box economy with and ,

The can then be solved to give us the contract curve

In our example, the reservation

The core is then

Consumer ns endogenous income in the Edgeworth Box is p1e1n p2e2n .

A set of equilibrium prices (p1, p2 ) then has to satisfy

In our example, and and

Acting as price taker, consumer 1 then solves

max x13 / 4 x1/2 4 subject to p1 x1 p2 x 2 3p1 6 p2 ,

while consumer 2 solves

When solved in the usual way, this gives demands

Equilibrium in the first market then implies

Since multiplying both prices by the same

Suppose is a competitive equilibrium in the Edgeworth Box

Why is this without loss of generality?

If is in fact preferred by both to , then it must be that

Recall Walras Law:

which can also be written as

This implies that either is greater than

Suppose Robinson Crusoe faces a production process and has tastes

In the absence of prices, Robinson Crusoe then solves the problem

Solving this in the usual way, we get

which can also be written as

Solving this in the usual way, we get

Plugging this into our expression for

This gives us labor supply of

and consumer good demand of

And since neither the consumers nor the

Robinson Crusoes Optimum with the competitive equilibrium.

16B.1 A Pure Exchange Economy

For any good m, we can define the economys overall

16B.1 A Pure Exchange Economy (cont)

16B.1.1 Mutually Beneficial Trades

The tangency of our indifference curves implies that: